Best practices in risk rating policies

Vest Risk Rating Responsibility Appropriately

Risk rating assignment should be separate from loan origination in order to limit bias - both real and perceived. The credit analyst may discuss the risk rating with the lender since the lender is likely to have additional perspective on the borrower’s state. Some institutions may also use a committee structure to discuss risk ratings. However, the final responsibility should be with the credit department. This separation of responsibilities safeguards the risk rating from undue influence.

Require Additional Approval Levels and Reviews

An institution may require additional approvals in certain circumstances. Common reasons for additional approvals are large size, a change in risk rating from prior period or a final risk rating that differs from the scorecard output. Policies may further distinguish between situations that require approval before a rating is finalized and those that merit periodic monitoring. The emphasis should be on ensuring risk ratings are assigned accurately and timely.

There are a number of variants that an institution could employ. For example, an institution may allow a credit analyst to approve a final rating that differs from the scorecard by one grade and require a manager to approve any other differences. The institution would then review all differences periodically. Similarly, an institution’s policy may require a manager to approve a change of two or more grades from the prior period because this level of change should occur rarely. It would review overall migration periodically as part of portfolio monitoring.

The current environment of low defaults could easily create complacency. It is critical to maintain strong risk rating policies and use them to identify troubled credits early to maximize a lender’s recovery with swift intervention.