May 10, 2017
How Risk Ratings Can Enable Optimal Growth for Financial Institutions
By Elise Hauser, Product Marketing Manager, Sageworks
Today’s banking industry is defined by tight interest margins and increased regulatory oversight. At the same time that banks and credit unions are facing these challenges, threats from alternative lenders and mega banks make it imperative that institutions grow in order to achieve economies of scale and remain competitive and profitable. These opposing pressures mean that community banks and credit unions must optimize their opportunities to grow profitably while mitigating risk.
One way to increase profitability is to reduce the costs associated with managing risk. Banks and credit unions with efficient risk management processes will spend less time analyzing and evaluating risk in their portfolios, and thus will lower the cost of doing business. For many institutions, a best practice is a comprehensive risk-rating system, that -- when properly applied -- streamlines risk management across the institution.
Assigning a Number
A risk-rating system is deceptively straightforward: a reduction of the unique combination of risk factors on each individual loan down to one number, for example, a 3. Once a loan has been risk-rated as a 3, the institution is able to use that information to make decisions about that loan and the portfolio. This risk rating can also be used at nearly every stage of the credit process to lower the cost of managing risk. Developing, implementing and maintaining a risk-rating methodology that accurately and consistently measures risk can be challenging, but it offers tremendous payout.
Risk ratings are also useful in that they allow the bank or credit union to talk about risk in a standardized language across departments and across the life of the loan. Under a given risk-rating methodology, “a 3 is a 3,” meaning that everyone from the lending department to loan administration to those determining the ALLL have the same understanding of the risk level of a loan that is risk-rated as a 3. Distilling the credit risk of a loan into a single metric also allows the institution to track it over time and to see both the evolution of a single credit, as well as the portfolio as a whole.
One important note about risk ratings is that they are not in and of themselves a risk-reducing tool. They simply function to identify and categorize risk so that the institution can make informed decisions on pricing, terms and reserves based on its individual risk appetite. A strong risk-rating system allows the institution to optimize the balance of risk and reward that is right for them.
Ultimately, the single most important reason to make sure your risk-rating methodology is up to snuff is because risk ratings come into play at every stage of the life of the loan. If your risk-rating methodology is comprehensive and standardized, you have a powerful tool. If it is inconsistently applied or has gaps in coverage, then at best you aren’t able to use risk ratings when evaluating risk; at worst, you are making decisions based on faulty data.
How Ratings Help
To get a sense of just how crucial risk ratings are to every part of the credit process, consider a few different ways risk ratings are used at various points in the life of the loan:
Risk ratings come in handy even before a loan is booked. By assigning a risk rating to a loan during the initial spreads for a proposed loan, the analyst is able to see a holistic picture of the risk of that loan, and make a lending recommendation based on that information.
An important consideration when pricing loans is the level of risk the institution is taking on with that credit. Especially with pressures to price competitively, it is important that when the institution makes a pricing decision, it is adequately compensated for that risk. By risk-rating proposed loans, the loan officer or lending committee can make an informed decision about what price to set, or whether to walk away from the deal entirely.
Throughout the life of any loan, it is important that the loan is risk-rated at regular intervals, such as annual reviews. The loan administration department plays a critical role in making sure that updated risk ratings are reflected in the management of the loan. For example, if a loan were to receive a worse risk rating at annual review, the institution may want to begin collecting additional documentation, update the terms of the covenants or make other changes to the way the loan is managed. These changes are implemented through the loan administration department, so they are also able to leverage the risk-rating on a loan to reduce risk through loan management.
ALLL and Stress Testing
When it comes to managing the risk of the entire portfolio, risk ratings come in handy in a variety of ways. Beyond just grouping loans by risk rating to stress test a particular segment, some ways risk ratings can be helpful in portfolio risk management include:
Migration of risk ratings by segment
Exposure in watch, special mention or substandard ratings
Changes in risk ratings under stress scenarios
Risk rating by loan officer
In today’s banking environment of tight margins and ever-increasing regulatory oversight, it is crucial that community banks and credit unions find ways to grow without compromising the desired risk levels of their portfolios. Risk ratings are crucial to accomplishing risk-managed growth. By implementing a robust risk-rating methodology, banks and credit unions can make credit risk management easier and more effective at every stage of the life of the loan.
Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.
About the Author
Elise Hauser, Product Marketing Manager, Sageworks
Elise Hauser is a product marketing manager at Sageworks, where she manages new product marketing for Sageworks banking solutions.