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