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How Risk Ratings Can Enable Optimal Growth for Financial Institutions

By Elise Hauser, May 10, 2017

Today’s banking industry is defined by tight interest margins and increased regulatory oversight. At the same time that banks and credit unions are facing these challenges, threats from alternative lenders and mega banks make it imperative that institutions grow in order to achieve economies of scale and remain competitive and profitable. These opposing pressures mean that community banks and credit unions must optimize their opportunities to grow profitably while mitigating risk.

To get a sense of just how crucial risk ratings are to every part of the credit process, consider a few different ways risk ratings are used at various points in the life of the loan:

Credit Analysis
Risk ratings come in handy even before a loan is booked. By assigning a risk rating to a loan during the initial spreads for a proposed loan, the analyst is able to see a holistic picture of the risk of that loan, and make a lending recommendation based on that information. 

Loan Pricing
An important consideration when pricing loans is the level of risk the institution is taking on with that credit. Especially with pressures to price competitively, it is important that when the institution makes a pricing decision, it is adequately compensated for that risk. By risk-rating proposed loans, the loan officer or lending committee can make an informed decision about what price to set, or whether to walk away from the deal entirely.

Loan Administration
Throughout the life of any loan, it is important that the loan is risk-rated at regular intervals, such as annual reviews. The loan administration department plays a critical role in making sure that updated risk ratings are reflected in the management of the loan. For example, if a loan were to receive a worse risk rating at annual review, the institution may want to begin collecting additional documentation, update the terms of the covenants or make other changes to the way the loan is managed. These changes are implemented through the loan administration department, so they are also able to leverage the risk-rating on a loan to reduce risk through loan management.

ALLL and Stress Testing
When it comes to managing the risk of the entire portfolio, risk ratings come in handy in a variety of ways. Beyond just grouping loans by risk rating to stress test a particular segment, some ways risk ratings can be helpful in portfolio risk management include:
- Migration of risk ratings by segment 
- Exposure in watch, special mention or substandard ratings 
- Changes in risk ratings under stress scenarios 
- Risk rating by loan officer 

In today’s banking environment of tight margins and ever-increasing regulatory oversight, it is crucial that community banks and credit unions find ways to grow without compromising the desired risk levels of their portfolios. Risk ratings are crucial to accomplishing risk-managed growth. By implementing a robust risk-rating methodology, banks and credit unions can make credit risk management easier and more effective at every stage of the life of the loan.

For the full story featuring Sageworks, visit FMS Perspectives - How Risk Ratings Can Enable Optimal Growth for Financial Institutions.