The importance of a sound risk rating process continues and possibly grows in the coming years as financial institutions grapple with the increased emphasis on estimating credit losses. With Basel III focusing more attention on credit risk management, and the more granular review of loans required by the FASB’s current expected credit loss (CECL) model, financial institutions can likely expect to see an increased emphasis by examiners on the importance and effectiveness of risk rating systems.
One of the principles underlying the Basel Committee on Banking Supervision’s December 2015 supervisory guidance on accounting for expected credit losses is that “A bank should have a credit risk rating process in place to appropriately group lending exposures on the basis of shared credit risk characteristics.”
While some people may fixate on the capital calculations required by Basel, the key point to remember is that Basel asks banks to understand and identify the risk that exists in their portfolio and to quantify the risk accurately. Only then can banks determine how much capital should be applied to that risk. Financial institutions need to focus on where the risk is in the portfolio, and this focus starts with the risk rating. At the end of the day, the risk rating is the one indicator of risk that exists in a portfolio.
Risk ratings are among the credit quality data elements that are strongly recommended for accurate ALLL calculations under CECL, as well. Having loan-level data on credit quality provides flexibility so that an institution can use the methodology believed to best measure expected credit losses in that particular portfolio. For example, risk ratings are one way institutions can subsegment their portfolios – a necessary step for performing a migration analysis, which is already largely viewed as one of the more robust methodologies to calculate loss in the ALLL calculation because it incorporates specific loss rates for specific risk levels.
Subsegmenting the portfolio by risk rating will also allow financial institutions to add more qualitative factor (Q factor) adjustments to reflect risk they believe exists in the portfolio -- and to more easily defend those assumptions. For example, interest rates are expected to increase over the next few years, and financial institutions may want to incorporate Q factor analysis that takes into account how credits with varying risk ratings may perform over time amid such changes.
Finally, risk ratings could be important as financial institutions meet CECL’s new disclosure requirements. “Any documentation changes to the risk rating policy should be approved by the board of directors and the risk management team. Examiners will most likely review this documentation to ensure it is in compliance with future GAAP: CECL,” Buzzerio says. The new accounting standard requires institutions to explain what influenced the allowance estimate as well as changes in the estimate, and information about risk ratings could be incorporated into this process.
To learn more about the importance of an effective risk rating model, check out this post.