Understanding and defining qualitative risk rating factors

Libby Sharman
January 7, 2015
Read Time: min

Risk rating is a primary function at any bank or credit union, and the methodology used will impact everything from the loans the institution will originate, to concentration limits and lending strategy to reserve levels and, as a result, bank earnings.

With such a widespread effect throughout the bank, getting the methodology right is critical.

Regulators have made it clear there is no, one, right methodology or system a bank should use to rate credit quality. Instead, it will have to be commensurate to the institution’s risk and the complexity of its lending activities.

Within most methodologies, however, a bank or credit union will have to account for some hard-to-quantify risks and characteristics of borrowers. These qualitative risk rating factors make the risk rating process more complicated because they are

•    Hard to measure objectively
•    Difficult to compare between borrowers
•    Harder to communicate when speaking with borrowers

But despite these challenges, risk profiles are undoubtedly impacted by qualitative factors, making the practice of “quantifying the qualitative” a necessary step.

Some examples of these qualitative risk rating factors include but are not limited to

1.    Financial statement strength
2.    Industry of the business and perceived strength of that industry
3.    Character of the borrower
4.    Economic strength of the borrower’s location
5.    Management competence
6.    Risk of externalities (e.g., regulations on that industry, pending legal action, etc.)
7.    Quality of the financial statements or information used to rate the loan

To make some of these factors more measurable and comparable, the best practice is for an institution to establish standards and criteria used to rate against those standards. For example, economic strength may be graded on the following scale

Excellent
Good
Above Average
Average
Below Average
Poor

 
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For each of these options, the bank would define what scenario would merit that standard. In the case of economic strength, the bank may determine that Unemployment Rate in the M.S.A. is the driving factor and then establish thresholds so that an Unemployment Rate lower than 8 percent equates to an Excellent score. Or between 8-9.5% is Good. These numbers and even the driving factor used can be different bank to bank, but the important step is establishing the methodology and then requiring bank-wide application.

The objective with that exercise is to, as much as possible, remove the element of judgment that goes into risk rating and reduce it, as much as possible, to a decision tree. “If X, then Y.” The more consistent and objective the risk rating methodology, especially in the case of qualitative risk factors, the better prepared the institution will be for an exam with regulators.

 
About the Author

Libby Sharman

Libby Sharman is a Vice President of Marketing at Abrigo.

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About Abrigo

Abrigo enables U.S. financial institutions to support their communities through technology that fights financial crime, grows loans and deposits, and optimizes risk. Abrigo's platform centralizes the institution's data, creates a digital user experience, ensures compliance, and delivers efficiency for scale and profitable growth.

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