Dual Asset Quality Ratings - The Next Generation: Abridged Version
October 18, 2011 at 12:10 PM
Earlier this year, we argued that a two-factor loan rating framework has become a necessity for banks of all sizes. Claude Hanley, Partner, and two CPG Consulting Associates, John Barrickman and Christine Corso, recently published a step-by-step guide to applying this type of framework in the November issue of The RMA Journal.
The single-factor framework currently in use at many institutions too often are based on narrative guidance that incorporates only subjective factors – and which can be applied in ways that vary from lender to lender. The dual-factor framework aims to increase objectivity and provide a clearer picture of the risk of individual transactions through the incorporation of two metrics: the probability of default and the loss given default.
The probability of default is defined as the risk presented by the borrower. This “borrower rating” is influenced by quantitative factors, qualitative factors, and borrower/sponsor factors. These vary by type of loan – a C&I borrower’s probability of default will be determined by a different set of variables than that of an agricultural borrower, for example (though there may be some overlap). Loss given default addresses the risk in the transaction and is a function of the type of collateral, the loan to value in the collateral, and the control exercised over the collateral. This “facility rating” helps to differentiate risk associated with different loans (and types of loans) to the same borrower. A dual factor risk rating can facilitate portfolio monitoring, risk-based pricing, and assessments of the adequacy of ALLL.
As borrower relationships become larger and more complex, it is critical that banks have the ability to objectively assess risk. To learn more about how to apply the dual-factor framework, read the full article here.