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3 risk rating best practices

Posted by Sageworks

In Sageworks’ Bank and Credit Union Examination Survey, risk ratings were repeatedly mentioned as a key topic discussed by examiners in financial institutions’ most recent federal safety and soundness exams. [To see an updated version of this survey and the related discussion of risk ratings and examiners’ concerns, download the 2015 Sageworks Bank & Credit Union Examination Survey.]

Risk ratings methodologies differ bank by bank; in fact, the OCC’s Comptroller’s Handbook on “Rating Credit Risk” notes that “No single credit risk rating system is ideal for every bank…A bank’s risk rating system should reflect the complexity of its lending activities and the overall level of risk involved.”

Nevertheless, we’ve compiled a list of three risk rating best practices that are relevant across all financial institutions:

1) Make sure your risk rating system has an adequate number of ratings. Specifically, it’s important to have varying degrees of “pass” ratings in order to appropriately differentiate between risk levels of non-adversely rated loans. This is critical in determining the amount of credit to be extended, the structure of the loan offered (collateral required, covenants, etc.) loan pricing, frequency of review, frequency of contact with the borrower, appropriate ALLL reserves and strategic decisions related to concentrations of credit.

2) Make sure your risk ratings are dynamic and timely. When levels of risk change, so should the related risk rating(s). The effectiveness of risk ratings as a key tool to manage credit risk and to prevent loan losses is enhanced when risk ratings are dynamic enough to change as new information becomes available. The credit analyst, loan officer or loan administration personnel responsible for determining risk ratings should re-evaluate risk ratings when new information is received about a borrower, business or piece of collateral. This information includes updated financial statements, data on conditions of an industry, appraisal documents, past due payments, data related to management changes, lawsuits, etc.

At a minimum, all loans should be reviewed annually to make sure ratings are current. Credits that should be reviewed more regularly include new loans, complex or large credits and loans with higher risk ratings. To ensure ratings are dynamic and timely, staff responsibilities for review should be designated in loan policies.

3) Make sure criteria for each risk rating are well-defined. In order to ensure that risk ratings are both consistent and accurate, the criteria used to determine the appropriate rating should be precise. Both quantitative and qualitative factors that determine risk ratings should be outlined and documented in policies for the reference of all personnel involved.

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While the specific criteria and related weightings of factors in risk ratings differ by institution, generally, the “Five Cs of Credit” are used to drive the factors that make up risk ratings. These “Cs” include character, capacity, capital, conditions and collateral. Here is more on the “Five Cs” and the risk rating factors to which they are related:

Character: What is the character of the borrower? This is where qualitative or subjective elements of your risk ratings may come in. Related factors that may go into risk ratings include the institution’s relationship with the borrower, the quality of management, strength of references, payment history and credit scores.
Capacity: What is the borrower’s capacity to repay the debt? Related factors that may go into risk ratings include debt service coverage ratio, interest coverage ratio and credit scores.
Capital: Is the borrower well capitalized? Related factors include debt to equity ratio, current ratio, quick ratio, debt to capitalization, return on equity and return on assets.
Conditions: How are current economic conditions? Related quantitative factors that may go into risk ratings include data on local and regional economic conditions such as unemployment statistics and industry data such as average net profit margins, sales growth and debt service ratios.
Collateral: What is the value of the collateral that will serve as a secondary source of repayment of the loan? A key quantitative factor that may go into risk ratings is the loan to value ratio. Note that collateral can vary in importance, depending on the type of loan. When rating C&I loans, collateral is less important; for CRE loans, it is very important.

Risk ratings that are well-defined, dynamic and appropriately categorized are more useful in evaluating the current health of the loan portfolio than subjective and inconsistent risk ratings.

To learn how our clients are ensuring objective risk ratings using both quantitative and qualitative factors while standardizing their risk rating documentation, watch the Sageworks Risk Rating demo.

For more information on evaluating borrowers, watch the webinar The Real Price of Risk.

tags: 5 Cs of credit, ALLL reserves, bank exams, global cash flow analysis, risk rating