For credit unions, a popular instrument for monitoring credit risk is a standardized risk rating system, which can serve several purposes. These systems often determine credit approval processes, covenants placed on the member business and how loans should be priced. They can also form the basis for broader risk management practices – for instance, setting the reserve, stress testing the loan portfolio, setting risk appetites and strategic planning. Unfortunately, there are no specific requirements for credit risk rating systems, though there are several expectations outlined in the NCUA Examiners Guide. That said, credit unions have the ability to customize a rating system to best fit the unique risk characteristics of their institution.
For most credit unions, internally-developed risk rating systems are used. These systems typically use a scorecard rating based on level of risk in Pass and Criticized categories. Some institutions may have one system for all loan types, while others may have different templates for various loan types.
The goal of a risk rating system should be to assess a member business' potential amd future payment volatility by reviewing several characteristics. For instance, when assessing the current financial health of a member's business, global cash flow, global debt service coverage, global debt to equity, and financial statement strength should be considered. To measure a particular loan – proposed or existing – the credit union may look at loan to value or quality of the collateral. In addition, financial projections for the member business and industry health should be reviewed and incorporated into the grade. If the member is in a declining industry, it suggests that the future of that business and its ability to repay debt may be problematic. The important item to remember here is to focus on future performance, not just historical data.
As noted above, credit unions have the flexibility to customize their risk rating system and the number of ratings on the scale. Many institutions use a nine-grade system, though five to ten total ratings is common. The ratings are typically divided into two categories – Pass and Criticized. Within Pass, one to five ratings are used depending on the level of granularity needed. The ratings can vary from essentially risk-free to modest risk to additional review required.
If a credit union has three Pass categories but has loans pooling in just one of them, that's a good sign that the credit union should refine gradings to be more granular.
Within the Criticized portion of the risk rating system, four categories are commonly used to identify different degrees of credit weakness:
- Special Mention – The loan has a potential weakness that could lead to future credit deterioration without appropriate monitoring.
- Substandard – The loan has identified weakness(es) that will likely lead to loss without appropriate action.
- Doubtful – The loan has identified weakness(es) that makes full repayment unlikely. In this category, the loan is placed on nonaccrual status.
- Loss – The loan is uncollectible, usually because the member has declared bankruptcy, discontinued payments or closed the business.
The below example of a risk rating system is based on a nine-rating scale commonly used at institutions. Again, credit unions are not required to use a nine-rating scale. A scale that makes the most sense, based on the credit union's portfolio and risk, should be used.
It is also important to remember there are limitations to credit risk rating systems – the numbers may look good based on tax returns or financial statements, but credit unions should use caution under certain circumstances. Some situations for which to watch include:
- Commingled debt or income in a complex entity
- Substantial risk in the industry (e.g., the risk that Uber and Lyft created by entering the taxi or personal transportation industry)
- Inconsistency of income
- Non-diversified cash flow
- Litigation involving the member additional scrutiny may be necessary
- Business projections that seem overly optimistic
- Collateral that may be inaccessible without litigation
- M&A for the member business
- Small or new business where member income is more important than a more established business
Some of these situations may be addressed through a robust risk rating system, but they illustrate that numbers alone may not be sufficient for developing an accurate risk rating. The credit union's loan officers – particularly MBL officers – will have to gather more information than just what's submitted on financial statements.
Billy Burnet is marketing manager for Sageworks. He can be reached at 919-427-6324 or [email protected].
© 2025 ALM Global, LLC, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.
