In today's lending environment, having an effective risk rating system in place helps beyond determining a credit union's loan approval or pricing processes. These systems also impact broader risk management practices, including setting a credit union's reserve, stress testing, determining risk appetites and strategic planning.
With little prescriptive guidance available, credit unions can customize their risk rating system to fit the unique characteristics of their portfolio, and given the NCUA's principle-based member business lending rules, credit unions may be putting more resources toward business loans and the complicated risk rating systems they require.
Determining the right risk rating scale – typically from five to nine ratings – is only one step of the process. To determine the thresholds that comprise each rating and the significance of each risk dimension, credit unions should implement a weighting system. In many cases, there are certain risk dimensions that are more closely tied to loan performance and should have more impact on the final rating.
The five Cs of credit are often the basis for determining the risk rating, so the first step is to weight each of the five Cs. The weighting percentages will vary from credit union to credit union, so documenting why each component is weighted a certain way is important. Here's an example of how a credit union might weight the five Cs of credit: Capacity (35%), capital (15%), collateral (10%), conditions (15%) and character (25%).
After weighting each of the five Cs, the next step is to weight the dimensions within each. Both banks and credit unions should show priority for more objective criteria, like financial performance, over more subjective criteria, like management experience.
After weighting each dimension, the next step is to define the thresholds to be used in rating loans. For example, with the current debt service coverage ratio, credit unions can assign a certain pass (or criticized) rating based on the ratio. In this scenario, perhaps a risk rating of 1 is assigned when current DSCR is greater than 2.5, a risk rating of 2 when current DSCR is between 1.75 and 2.5, a 3 rating when it's between 1.4 and 1.75, etc.
Once the risk scores have been calculated for each dimension, credit unions will then need to multiply the risk score for each by the pre-determined weight percentage (see figure 1). Then, each raw score is added together for a total for each component (e.g., capacity).
The final step to assigning a risk rating is to multiply the raw score of each of the five Cs of credit by their weight to get a raw score for each. Then, the raw scores should be totaled and fit into a corresponding rating range to provide the appropriate risk rating (see figure 2 for an example). In that example, if all the five Cs add up to 312, the loan would receive a risk rating of 4. This standardized process will reduce subjectivity and increase defensibility on why loans are rated a certain way, which not only helps conversations with other functional areas, but also with examiners.
Billy Burnet is marketing manager for Sageworks. He can be reached at 919-427-6324 or [email protected].
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