A well-designed loan risk-rating system is a critical component of a bank’s risk management program. These systems help management accurately and consistently identify and monitor credit risk in a bank’s loan portfolio, which in turn drives various strategic decisions. So, it’s a good idea for banks to review their loan risk-rating systems periodically to ensure they’re appropriate for the bank’s current lending activities. 

Regulatory overview 

Under guidance from the federal banking agencies, banks should “establish a system of independent, ongoing credit review and appropriate communication to management and to the board of directors.” According to Interagency Guidance on Credit Risk Review Systems, an effective credit risk-rating framework should include: 

• Formal policies describing the factors (such as default risk and possible credit losses) used to assign risk ratings to individual loans and retail credit portfolios or portfolio segments with similar risk characteristics, 

• Identification or grouping of higher-risk loans that warrant close management attention or inclusion on management loan “watch lists,” 

• A clear explanation of why particular loans received adverse risk ratings or warrant special attention from management, 

• An evaluation of the effectiveness of approved workout plans, 

• Communication methods to inform senior management and the board about the status of loans identified as warranting special attention or adverse classification, including the actions management has taken to strengthen the credit quality of those loans, and 

• An evaluation of the institution’s historical loss experience for each segmented group of loans with similar risk characteristics. 

A bank’s rating system should be commensurate with the size, complexity and risk profile of its lending activities. Banks with small, less complex or low-risk loan portfolios generally can get by with just a few risk-rating categories. On the other hand, larger banks with more complex or higher-risk lending activities generally require a more granular approach — that is, a greater number of more detailed risk-rating categories. 

Risk-rating categories 

Bank management has some discretion in defining risk-rating categories and establishing the level of granularity. However, for adversely classified risk grades, the definitions should closely mirror the federal banking agencies’ asset classifications, which are: 

Substandard. This means “inadequately protected by the current sound worth and paying capacity of” the borrower. 

Doubtful. This indicates an asset “has all the weaknesses inherent in one that is classified as substandard” and “the weaknesses make collection or liquidation in full … highly questionable and improbable.”  

Loss. Assets with this classification are “considered uncollectible and of such little value that their continuance as bankable assets is not warranted.” 

Examiners also expect banks to use a “special mention” risk rating for “credits that have potential weaknesses deserving management’s close attention but do not yet warrant adverse classification.” For loans that aren’t adversely classified, the number of “pass” and “watch” grades is left to bank management’s judgment. For example, it may be appropriate for a smaller, less complex bank to have one pass grade and one watch grade. A larger, more complex bank will likely need several pass and watch grades. 

Protect your bank’s financial health 

Given the significant impact of credit risk on a bank’s financial health, it’s critical to maintain an effective loan risk-rating system that enables management to identify and monitor credit risk. Banks should review their rating systems regularly to ensure that the level of detail continues to reflect the size, complexity and risk profile of their lending activities.