A credit union must maintain a credit risk rating system that allows the credit union to actively manage risk at both the loan and overall portfolio level per NCUA regulation § 723.4(g). Such a system begins with a comprehensive evaluation of risk at loan inception, which is documented in a credit approval document (see Financial Analysis and Credit Approval Document). Ratings are then maintained through a diligent loan administration process to ensure ongoing risk monitoring. (See Commercial Loan Administration.)
A credit risk rating system is a formal process that a credit union uses to identify and assign a credit risk rating to each commercial loan in a federally insured credit union’s portfolio. It allows management to assess credit quality, identify problem loans, monitor risk performance, and manage risk levels. It should also guide loan pricing to ensure loans are appropriately priced for the risks. A well-managed risk rating system also gives the board of directors, auditors, and regulators information they can use to assess the overall health of the commercial portfolio, as well as the effectiveness of credit union management.
A credit risk rating system involves categorizing the risk associated with an individual loan using a thorough credit analysis that takes into consideration market conditions, industry data and other factors necessary to assess a borrower’s credit quality. Loans are rated using a series of graduated ratings that represent increasing risk. Risk ratings are applied to all commercial loans.
No single credit risk rating system is best for all credit unions. The scope and scale of a credit risk rating system will depend on the variety in a credit union’s commercial credit product types, and complexity of the commercial loan portfolio.
Because there is not a standard credit risk rating model, each credit union should customize a system to fit its individual needs. Each institution must determine if unique risk factors require different systems for different loan types and industries. In some cases, a credit union with a complex and diverse portfolio may need to use multiple risk-rating systems to accurately rate the level of risk.
System Development
Credit risk rating systems rank individual commercial loans into a series of categories based on the risk associated with a loan and the associated borrowing relationship. A credit union should assign credit risk ratings after it evaluates quantitative factors based on financial performance and qualitative factors based on management, operational, market, and business environmental influences.
A credit union should assign each commercial loan a credit risk rating at inception, and review ratings as often as necessary to ensure the:
- Reported risk in the commercial loan portfolio is accurate
- Ratings satisfy the federally insured credit union’s risk monitoring and reporting policies
- Credit union promptly identifies loans with well-defined credit weaknesses so that timely action can be taken to minimize credit loss, and
- Credit union has adequate reserves as required and the ALLL is funded as required by GAAP
The criteria used to assign each rating should be risk sensitive, suitable for the types of loans underwritten, and should produce a consistent and repeatable assessment of risk. The rating criteria should be clear and precisely defined using objective (quantitative) factors and subjective (qualitative) factors.
An example of a quantitative factor is a financial measurement such as debt service coverage, debt-to-worth, or liquidity. Qualitative factors include the quality and stability of management, a borrower’s willingness to repay, the state of the industry of the borrower, and relevant competition for a borrower’s business.
A credit risk rating system should have an adequate number of ratings to sufficiently differentiate varying levels of risk. Categorizing commercial loans into graduated levels allows credit union management and examiners to monitor changes and trends in risk levels more effectively. This allows for:
- Proper risk differentiation
- More accurate pricing of risk
- Improved early warning detection of credit-quality deterioration
- Stronger portfolio management, and
- Increased reliability for establishing ALLL levels
The number of ratings in a credit risk rating system depends on the complexity of a credit union’s portfolio and the institution’s risk rating system objectives. Most ratings systems have between six and ten ratings. Larger, more complex credit unions will have a more extensive rating system in comparison to smaller, less complex credit unions.
Credit risk rating systems should be dynamic. Ratings of individual loans should change when the level of risk changes. Actively managed risk rating systems that respond promptly to changes in risk can lead to an earlier detection of deteriorating trends, allowing more time for management to establish corrective action plans designed to improve the likelihood of repayment.
Dual Rating Systems
A credit union with a large and more complex portfolio may benefit from dual rating systems. These systems typically assign a rating to the general creditworthiness of an obligor, the borrowing entity, and a rating to each outstanding individual loan (also known as a facility rating).
A facility rating considers the loss protection from the associated collateral and other elements of the loan structure in addition to the obligor’s creditworthiness, which is evaluated based on a borrower’s financial strength, repayment ability, and repayment performance.
Dual rating systems have emerged because a single rating may not adequately support all the functions that require a credit risk rating. Obligor ratings often support deal structuring and loan administration, while facility ratings support ALLL and capital estimates (which affect loan pricing and portfolio management decisions).
It is a sound practice for a credit union’s credit risk rating system to address both the ability and willingness of an obligor to repay, the adequacy of the loan structure, and sufficiency of collateral. Such rating systems may assign a single rating or dual ratings. Whichever approach is used, a credit union’s risk rating system should accurately convey the risks the credit union undertakes and should reinforce sound risk management.
Automated Scoring Systems
While statistical models that estimate borrower risk have long been used in consumer lending and in capital markets, commercial credit risk models have only recently begun to gain acceptance. Increasing information about credit risk and rapid advances in computer technology have improved modeling techniques for both consumer and commercial credit. Models can confirm internal ratings, assign finer ratings within broad categories, and supplement judgmentally assigned ratings.
A credit union should carefully evaluate and periodically validate any automated commercial credit scoring systems. These systems should be balanced and supplemented by the judgement and objectivity of experienced credit professionals. An effective rating process ultimately relies on a combination of quantitative and qualitative factors. The quantitative measures augment the professional judgment of credit professionals, whose objective is to rank the relative degree of credit risk in a systematic, transparent, and consistent manner.
Risk Rating System Process Controls
Board and Senior Management Oversight
The board and senior management must ensure that a suitable framework exists to identify, measure, monitor, control, and report credit risk. Board-approved policies should guide the risk rating procedures and process. The board should be kept apprised of the level of, and changes in, risk associated with the commercial loan portfolio by receiving regular reports and an analysis of risk trends.
Reviewing and Updating Credit Risk Ratings
The overarching principles that govern the frequency of review are the materiality of new information and the relative risk of the loan relationship. A credit union should review and update credit risk ratings whenever relevant new information is known.
In general, loans should be formally reviewed once a year, upon the timely receipt of the year-end financial statements, to ensure risk ratings are accurate and up-to-date. Large loans, new loans, higher-risk loans, problem loans, and complex loans should be reviewed more frequently.
To gain efficiencies, smaller, performing loans may be excluded from periodic reviews and reviewed by exception. This provision is reserved for smaller, less complicated relationships that have paid as agreed for a reasonable period of time and that have had the financial condition of the borrower confirmed as healthy before a “review by exception” status is designated. Such loans tend to pose less risk, transaction by transaction. A smaller, performing loan may have its assigned risk level reviewed only when there is a known change in risk (for example, payment default, insurance lapses, or real estate taxes remain unpaid, or other changes).
Management Information Systems
Credit union management information systems are an important control because they provide feedback about a credit risk rating system’s performance. In addition to static data, the MIS should generate, or allow a user to calculate:
- The volume of loans whose ratings changed more than one grade (“double downgrades”)
- Seasoning of ratings (length of time loans stay in one grade)
- The velocity of rating changes (how quickly are they changing)
- Default and loss history, by rating category
- Ratio of rating upgrades to rating downgrades
- Rating changes by line of business, loan officer, and location
MIS reports should display information by both dollar volume and number count, because some reports can be skewed by changes in one large account.
Credit Risk Rating Categories
Banking supervisory agencies use a common risk rating scale to identify problem loans. These are used for both commercial and retail loan relationships. Although these ratings are not required by the NCUA, an effective credit risk rating system requires granularity in recognizing the degree of weakness in troubled loan relationships. The ratings assigned to these loans are referred to as adverse credit risk ratings.
Credit unions should have ratings that identify the potential for loss. Examples of such ratings include:
- Special mention
- Substandard
- Doubtful, and
- Loss
In addition to the ratings above, the NCUA recognizes a “pass” rating. A credit union should have sufficient granularity in its pass ratings to distinguish and quantify the level of risk. Adverse trends in pass rating with loans moving from lower risk to higher risk grades may be an early sign of distress that should be immediately addressed by the credit union.
For more information about rating categories, see the OCC Rating Credit Risk handbook.
Split Ratings
At times, more than one rating is necessary to describe a credit risk exposure. When one or more parts of an exposure require a separate rating, it is called a split rating. Split ratings are usually assigned when collateral or other structural protection supports only part of a loan.
For more information about split ratings, see the OCC Rating Credit Risk handbook.
Watch List
There are circumstances in which a credit union’s risk rating system may require “pass” loans to be included on a watch list as a result of imminent or recent events that may adversely impact the risk associated with the loan. Such events may include changes in a borrower’s industry or the market, operational changes for a borrower, receipt of current financial information, and the impact of changes to a borrower’s operations.
Such loans require enhanced monitoring and oversight. The watch list assessment period should be relatively short, and include clear triggers to upgrade or downgrade a loan. A loan’s credit risk rating should be adjusted when concerns are resolved. The purpose of a commercial loan watch list is to keep the board of directors and management informed of loans that are not adversely classified but which require special attention or monitoring.
A credit union should place commercial loans with an adverse credit risk rating on the watch list. In addition to ensuring adequate loan loss reserves for these loans, a credit union should monitor them more closely than less risky loans.
Enhanced monitoring includes developing a detailed action plan for each loan relationship and providing the board and senior management with regular status reports that address a loan’s compliance with the established plan.
If a loan was placed on a watch list as a result of well-defined weaknesses in a borrower or credit structure, credit unions should normally await correction of the weaknesses and a period of sustained performance under reasonable repayment terms before upgrading the risk rating. A plan for improvement, by itself, does not warrant an upgrade.
Examination Considerations
exam staff evaluate a credit union’s internal risk rating process by considering whether:
- Individual risk ratings are assigned accurately, consistently, and in a timely manner, and
- The overall risk rating system effectively supports the risk profile and complexity of a credit union’s portfolio
As part of the loan review, an examiner should validate a credit union’s risk grades by evaluating a reasonable sample of loans by assigning ratings to commercial loans in the credit union’s portfolio based on the credit risk rating system a credit union uses. To quantify and communicate the results of loan classifications, an examiner must decide which loans are subject to criticism or comment in the examination report.
While examiners should be most concerned when rating inaccuracies understate risk, any significant inaccuracy should be criticized because it will distort the portfolio’s risk profile and diminish the effectiveness of the portfolio management processes. Accurate risk ratings are critical to sound credit risk management, especially in the determination of the allowance for loans and lease loss (ALLL) account and capital adequacy levels.
Examiners must investigate to determine the root causes of significant risk rating inaccuracies and decide whether to expand their loan review sample. Determining factors include:
- The nature and pattern of rating inaccuracies
- The severity of inaccuracy
- The adequacy of ALLL and capital, and
- Whether inaccurate risk ratings distort overall portfolio risk and the credit union’s financial statements
A borrower’s expected performance is generally based on:
- Their financial strength as reflected in their historical and projected balance sheet and income statement
- Current payment performance, and
- Future prospects in light of conditions that may occur during the term of a loan
The main consideration in a credit risk assessment is the strength of the primary repayment source. A primary repayment source is a sustainable source of cash. This cash must be under a borrower’s control and must be reserved, explicitly or implicitly, to cover the debt obligation. As the primary repayment source weakens and default probability increases, collateral and other protective structural elements have a greater bearing on the rating.
Almost all credit transactions are expected to have secondary or even tertiary sources of repayment (collateral, guarantor support, third-party refinancing, etc.). Even when secondary support is available, generally the rating assessment is based on the expected strength of the primary repayment source, the operations of the borrower, until default has occurred or is highly probable.
In some instances, a poorly structured loan may require a lower classification even though the likelihood of default is low. Examples of this include loans with deferred interest payments or no meaningful amortization as the loan balance may not be reducing in line with the depreciation of the asset purchased with the loan proceeds.
Examiners will evaluate the rating for each loan that they review based on the quality and accuracy of the risk assessment performed by the credit union. Examiners should address loans they have determined have not been accurately risk rated or the risk rating is not adequately supported with the credit union. When recommending a credit union downgrade a rating, examiners should support their position by stating the reason for the downgrade or deficiencies in the process.
An examiner’s analysis should be limited to what is necessary to support his or her conclusion. Examiners should not underwrite a loan to determine the exact level of risk in a portfolio. The in-depth assessment of risk should be performed by the independent loan review.
Examiners reviewing the risk rating process will also determine:
- Whether there is a sufficient number of ratings to distinguish between various types of credit risk a credit union assumes
- The effectiveness of risk rating process controls
- Whether lenders, management, and key administrative and control staff understand and effectively use and support the risk rating process, and
- The effectiveness of the risk rating system as a part of the credit union’s overall credit risk management process
For more information on examining risk rating systems see Federal Reserve SR 98-25.
Accounting
Accounting issues are intertwined with credit risk ratings. This is particularly the case at the classified level, in which a credit risk rating often dictates accounting treatment.
Nonaccrual
A commercial loan that is on nonaccrual or about to be placed on nonaccrual has severe problems that make the full collection of interest and principal highly questionable. Nonaccrual loans will almost always be classified. For the treatment of non-accrual loans, see 13-CU-03, Supervisory Guidance on Troubled Debt Restructuring.
Impairment
When financial results show that a borrower is not able to repay a loan as structured and the loan is considered collateral-dependent, the loan must be reserved for in accordance with ASC 310-10-35.
Appropriate ALLL Level
Credit union management is responsible for maintaining the ALLL at an appropriate level and for documenting its analysis according to the standards set forth in NCUA’s IRPS No. 02-3.
Last updated November 25, 2016
