This post was authored by Alison Trapp, Director of Client Education at Abrigo.
When a lending institution establishes its risk rating system it has to decide whether it will require analysts to risk rate the borrower or the loan -- or both. Said another way, it has to decide between a single or dual rating system. There are benefits to each. On one hand, a single rating system is simple. On the other, the dual rating system allows for more distinction in risk grades, which could be beneficial to the institution. The answer to the question as to which is better for a lending institution is the same as many questions in credit risk: it depends.
A dual rating system has one rating that captures the overall creditworthiness of the borrower and a second at the facility level. Differences between the two ratings are generally because of secondary support factors such as collateral, guarantees or letters of credit that would impact a single facility and not the borrower’s overall condition. In other words, being secured by a building is not likely to change whether a borrower defaults but it does mitigate the chargeoff. Often loans that are unsecured or structured as cash flow loans will have a facility rating equal to the borrower rating because there is limited hard collateral or additional credit support to improve the facility rating. A concordance table maps the risk ratings to the regulatory risk classification system of Special Mention and classified asset levels.
The OCC and NCUA explain that while many institutions have moved to a dual rating system over the last 15-20 years, the regulatory agencies do not require institutions to do so. Smaller, less complex institutions may find that a single rating system is sufficient. What is important is that the risk rating system capture consistently, accurately, and timely “the ability and willingness of the obligor to repay and the support provided by structure and collateral.”
