Credit Risk Rating: Four Issues for Community Banks
As a first step, we’ll cover the “bottom” end of the scale, which are the four “bad loan” categories as defined by our banking regulators.
For smaller loans it’s not practical to determine ratings loan-by-loan, so we’ll cover the automated, Uniform Retail Credit Classification and Account Management Policy (URCCAMP) endorsed by Federal regulators. Then we’ll examine the evolution of multi-score “pass loan” categories devised by bankers for loan-by-loan or manual ratings.
As a final step, we’ll look at what many large banks are doing: two-digit or two-factor ratings. The first factor is probability of default (PD), then a second factor is loss given default (LGD). These seem intimidating and confusing, but as a practical matter, they mirror the approach most community banks already are using.
The four key issues:
- Timeliness – The most common criticism from regulators about bank risk rating systems is that lenders do not adjust or change them on a timely basis. This problem occurs due to the other three issues.
- Granularity -This borders on being regulatory jargon, but some banks have too few rating categories, which makes it harder to “move” on the scale. We’ll look at the typical progression community banks go through as they become experienced with the risk rating process.
- Transitional – Many systems have a jump from the lowest pass category to special mention that is too “big.” This prohibits timely recognition of problems, especially those that are event driven and not apparent in the financial statements.
- Objective – Early systems were totally subjective, but many banks have added clear grading lines based on combinations or minimum/maximum levels of key ratios. Newer systems still have room for subjectivity, but objective benchmarks enhance the lender’s ability to make timely adjustments.
Commercial & business lenders, community bank lenders, private bankers, credit analysts and portfolio managers, credit officers, loan review specialists and others involved in the consumer and commercial lending process.
Richard Hamm has been training bankers for 25 years, including both creating and teaching courses for the ABA and the RMA, plus regional banking schools (Graduate School of Banking – Wisconsin, Graduate School of Banking at Colorado, Southwestern Graduate School of Banking and Barret School of Banking – Memphis), numerous state banking and community banking associations and individual banks. While specializing in all phases of lending and credit, he also covers “top of the bank” issues & provides director training.
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