Why credit risk rating systems matter

Ashbaugh

Low market rates and intense competition have been hallmarks of the lending environment in recent years, and regulators have taken notice that this can lead to weaker discipline around pricing and structuring of loans.

Indeed, the Office of the Comptroller of the Currency in its latest Semiannual Risk Perspective noted, “Competitive pressures from banks and nonbanks contribute to easing in underwriting and to the risk that sound pricing structures and practices may be compromised.”

Loan pricing and the importance of pricing as it relates to managing risk in the portfolio are subjects that Robert Ashbaugh, senior risk management consultant at Sageworks, know well. Ashbaugh recently led a session on effective loan pricing at Darling Consulting Group’s Balance Sheet Management Conference in Boston.  He is among several Sageworks consultants and executives who speak regularly on a variety of topics, including loan-growth practices, credit risk, global cash flow analysis, the allowance for loan and lease losses (ALLL) and stress testing.

During the session, Ashbaugh provided an overview of key components of effective pricing models. He also shared insights on current pricing trends and how changes such as CECL may impact pricing decisions going forward.

Surveys by Sageworks in recent years have found that bankers worry about issues of subjectivity with risk ratings, and many believe they can improve upon current risk rating systems. Ashbaugh explained that one of the challenges with the risk rating process is that it forms the basis of so much of what financial institutions know about risk management, and yet the risk rating process itself can be imperfect.

Why credit risk rating systems are important

During the session, Ashbaugh described four reasons why credit risk rating systems deserve attention by financial institutions:

1. Credit risk rating systems often determine the approval process for credits, as well as the price for the loan. Without a reliable and consistent way of providing a risk rating, it is difficult to have an accurate read on the borrower’s ability to repay, which can lead to undue risk in the portfolio.
2. Credit risk rating systems equip lenders to determine how to review and analyze the borrower relationship and how often to do so. Risk rating systems define the loan review and watch list process, as well as the workout process. A risk rating can also help the lender plan ahead to determine if repricing or restructuring the loan will be preferable when it comes times for renewal.
3. Credit risk rating systems form the basis for financial institutions’ broader risk management efforts, including stress testing, setting the reserve and capital and strategic planning. If risk information for individual loans is incorrect, risk information for the overall portfolio might also be inaccurate, so it is crucial to have accurate risk ratings for every single loan.
4. Credit risk rating systems give financial institutions’ management teams, boards and auditors a more accurate measure of portfolio risk and the trends in risk levels. Management teams armed with better information can make decisions that minimize risk and grow profitably.

“The risk rating touches so many parts of the bank,” Ashbaugh says. “Whether it’s the loan pricing strategy, the review process or, at the end of the day, the allowance process. Risk rating is critical to each of these components.”

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