March/April 2011 Wire Preview: A Two-Factor Loan Rating Framework is a Necessity

April 07, 2011 at 12:51 PM
For lenders, the future industry environment will be characterized by higher capital and greater regulatory scrutiny.  To ensure accurate allocation of capital and to pass regulatory muster, we at CPG believe that commercial bankers should consider transitioning from a single-factor risk rating methodology to a (more robust) two-factor framework. 
 
A two-factor loan risk rating framework (also commonly referred to as a dual risk rating framework) can help to both improve risk adjusted returns on capital as well as provide an objective basis for justifying pricing differentiated by risk.  It includes risk ratings for both the borrower and the facility.  By explicitly capturing both of these elements, it provides management with a better sense of the true risk in the loan portfolio.  This can serve a basis for risk-based pricing and more accurate allocation of capital.  The single-factor risk rating methodology employed by many institutions is not robust enough to serve as a true measure of credit risk.
 
Any two-factor rating framework that is adopted should reflect the institution’s credit policies, credit culture, and risk management objectives.  To be truly effective, the factors that are considered when assigning risk to the borrower must be explicit and objective.  In addition to meeting regulatory expectations, this will help to reduce uncertainty between the lenders and credit personnel about what constitutes a specific risk grade.  The factors to be considered will differ by type of lending.  The facility rating should account for the type of collateral, the degree of control exercised over the collateral, and the loan-to-value ratio.
 
In short, a two-factor loan rating framework can serve as a foundation upon which to build risk-based pricing strategies, improved accuracy in provisioning, and build more robust analysis and reporting capabilities. Questions or comments? Please contact Claude Hanley.
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