How to create a credit risk rating system

For credit unions, a popular tool to monitor credit risk is a standardized risk rating system, which can serve several purposes. These systems often determine credit approval processes, covenants placed on the borrower 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 OCC guidance. That said, banks and credit unions have the ability to customize a rating system to best fit the unique risk characteristics of their institution.

For most community banks and 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 borrower’s potential future payment volatility by reviewing several characteristics. For instance, when assessing the current financial health of the borrower’s business, global cash flow, global debt service coverage, global debt to equity, financial statement strength and loan to value and collateral value for the loan should be considered. In addition, financial projections for the business and industry health should be reviewed and incorporated into the grade. The important item to remember here is to focus on future performance, not just historical data.

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