Risk Rating Improvements for the ALLL in Banks and Credit Unions
3 likes1,148 views
The document outlines the importance and methodology behind credit risk rating systems used by financial institutions for loan portfolio management. It covers components such as the probability of default, loss given default models, and the implications of risk ratings on credit approval, strategic planning, and regulatory compliance. Additionally, the presentation highlights the need for transparency, objectivity, and appropriate staffing in the risk rating process to ensure accurate assessments of portfolio risk.
Risk Rating Improvements for the ALLL in Banks and Credit Unions
- 1. P R E S E N T E D B Y Rob Ashbaugh Sr. Risk Management Consultant Sageworks
- 2. • Ask questions throughout the session using the GoToWebinar control panel • We will answer as many questions as we can at the end of the presentation 2
- 3. • Financial information company that provides loan portfolio and risk management software solutions to thousands of financial institutions • Trusted by more financial institutions for the ALLL than any other solution • Awards » Named to Inc. 500 list of fastest growing privately held companies in the U.S. » Named to Deloitte’s Technology Fast 500 » NC Tech Awards: Excellence in Customer Service 3
- 4. Sr. Risk Management Consultant Sageworks 4 ROBERT ASHBAUGH
- 5. I. Function of a Credit Risk Rating System II. Approaches to Risk Rating Systems » Internal Systems » Probability of Default/ Loss Given Default Models III. Implications for Examinations » Credit Analysis » Loan Review » Strategic Planning and Lending Policies IV. Impact on Your Risk Management » Using Risk Ratings in Your ALLL » Stress Testing » CECL & the Future 5 RISK RATINGS
- 6. 6
- 7. 7
- 8. • Often determines credit approval process and price for the loan; incorrect ratings could lead to undue risk in the portfolio • Equips lenders to determine how and how often to review and analyze the relationship • Forms the basis for broader risk management including setting the reserve, stress testing, capital and strategic planning • Gives the management team, board, auditors a more accurate measure of portfolio risk and trends in risk levels 8 WHY IT DESERVES ATTENTION
- 9. • Appropriate for most institutions • Usually based on an internally generated scorecard • Can be made more sophisticated as needed, including different templates for loan types or loan sizes 9 PROBABILITY OF DEFAULT & LOSS GIVEN DEFAULT MODEL • More commonly used at larger institutions • More accurate measure of default and loss • Requires more data and modeling within the institution INTERNAL SYSTEMS
- 10. 10
- 11. • Assess the borrower’s potential future payment volatility • Characteristics to consider include » Current financial health of the business (5 Cs of Credit) • Conditions: Global cash flow • Capacity: Global debt service • Capital: Global debt to equity • Character: Financial statement strength • Loan to value and Collateral value for the loan » Underwriting agreements » Financial projections for borrower business » Borrower’s industry and its health • Focus on future performance not just historical data There is no one, right matrix 11 WHAT ARE YOU MEASURING?
- 12. 1. Granular – number of ratings will depend on the institution’s portfolio, but should be sufficiently granular that loans do not pool in one or two ratings. 2. Transparent – personnel and examiners should be able to review and distinguish between risk ratings. Both parties should be able to risk rate a loan independently and arrive at the same rating. 3. Objective – the risk rating matrix will only be valuable if the personnel responsible are external to the lending process (someone other than the lender, for example). 12 SYSTEM REQUIREMENTS
- 13. • Number of ratings will vary, anywhere from 5 to 10 grades 13 DETERMINING RISK RATING SCALE PASS SPECIAL MENTION SUB- STANDARD DOUBTFUL LOSS 1 2 3 4 5 6 7 8 9 Largely risk free Minimal risk Modest risk Bankable Addition- al review Criticized Classified Classified Classified Typically the ratings that differ by institution – depending on the level of granularity needed in Pass loans
- 14. • Special Mention – the loan has a potential weakness that could lead to future credit deterioration without appropriate monitoring by the institution • Substandard – the loan has identified weakness(es), including reduced payment capacity, that will likely lead to loss without appropriate action • Doubtful – the loan has identified weakness(es) that makes full repayment unlikely; placed on nonaccrual • Loss – the loan is uncollectible, usually because the member has declared bankruptcy, discontinued payments or closed the business 14 DEFINITIONS
- 15. 15 Capacity Debt Service Coverage (Proposed & Historical) Interest Coverage Sensitivity of the Business to Change in Income Sensitivity to Interest Rate Risk Business Credit Score Lease Terms / Customer Base Capital Current Ratio Debt to Equity Tangible Net Worth Collateral Loan to Value Collateral Quality (variability of value, easy to liquidate) Conditions Member’s Skills Industry Performance (Current ratio, DSC, NPM) Comparison to Industry (Financial & Product Line) Character Member’s Financing Alternatives Management of the Business Guarantor's Credit Score (and others?) Tangible Net Worth of Guarantors Dimensions Factors ESTABLISHING 5 C’S OF CREDIT
- 16. • Financial performance • Product line considerations (i.e., does the business’s product keep pace with industry) • Comparability of data: » Recent » Industry fit » Objective » Regionalized 16 INDUSTRY PERFORMANCE DATA
- 17. • Certain risk dimensions are more closely tied to loan performance • Gives the institution more levers to pull after backtesting to make the model fit actual risk » Capacity often given highest priority » Capital next in priority » Conditions and Character are lower priority » Then Collateral, which really factors in only when the collateral has to be liquidated • In addition to 5 Cs, the factors used for each dimension are weighted • Show priority for objective criteria (financial performance) over subjective criteria (evaluation of management) 17 WEIGHTING
- 18. 18 Capacity 35% Proposed Debt Service Coverage 20% Historical Debt Service Coverage 20% Sensitivity of the Business to Change in Income 10% Sensitivity to Interest Rate Risk 10% Business Credit Score 10% Lease Terms / Customer Base 30% Capital 15% Current Ratio 40% Debt to Equity 40% Tangible Net Worth 20% Collateral 10% Loan to Value 25% Collateral Quality 75% Conditions 15% Member’s Skills 20% Industry Current Ratio 20% Industry DSC 20% Industry NPM 20% Comparison to Industry 20% Character 25% Member’s Financing Alternatives 25% Management of the Business 25% Guarantor's Credit Score 25% Tangible Net Worth of Guarantors 25%
- 19. • Define thresholds to be used in rating loans • Example for Historical Global Debt Service Coverage Ratio 19 THRESHOLDS PASS SPECIAL MENTION SUB- STANDARD DOUBTFUL LOSS 1 2 3 4 5 6 7 8 9 Largely risk free Minimal risk Modest risk Bankable Addition- al review Criticized Classified Classified Classified >2.5x >1.75x >1.4x >1.2x >1.0x <1.0x <1.0x <1.0x <1.0x
- 20. • Each factor has a score, weighted • Each dimension has a score, weighted • Adds up to Risk Rating for the loan 20 CALCULATING THE SCORE CAPACITY RISK SCORE WEIGHT RAW SCORE Current DSCR 4 X 20% = 80 Historical DSCR 3 X 20% = 60 Income Sensitivity 3 X 10% = 30 Rate Sensitivity 4 X 10% = 40 Bus. Credit Score 3 X 10% = 30 Customer Base/Lease 2 X 30% = 60 CAPACITY = 300
- 21. 21 RAW SCORE WEIGHT RAW SCORE CAPACITY 300 X 35% = 105 CAPITAL 100 X 15% = 15 COLLATERAL 400 X 10% = 40 CONDITION 160 X 15% = 24 CHARACTER 210 X 25% = 53 Final Raw Score = 237 1 2 3 4 5 6 7 8 9 <151 151- 230 231- 310 311- 380 381- 450 451- 500 501- 540 540- 571 >570
- 22. 22 Example matrix through an automated system
- 23. 23
- 24. • Not one size fits all – will take into consideration the size/complexity of loans and businesses being evaluated • Thresholds may be different institution to institution » Look for consistency of application » Look at performance versus realized loan performance » Don’t just use a certain system “because XYZ bank does” • For historical DSC, is the institution considering an average for the previous years? How should that be weighted? How many years should be included? 24 REFLECTIVE OF THE PORTFOLIO
- 25. • Different matrices will be used to rate different types of loans » Industry-specific templates – more/less weight on industry comparison or specific metrics • Taxi Industry (individual versus a minifleet medallions, consider governing taxi authority’s revenue regulations) • Agricultural Loans (commodity pricing in your region) » Small business template – more weight on guarantor, management team strength » Commercial real estate template – emphasis on vacancy rates instead of sales 25 DEVELOPING DIFFERENT TEMPLATES
- 26. • Risk rating policies should be transparent and staff appropriately trained on: » Data to collect » Calculations » Threshold analysis » Grey areas • Risk rating function should be independent from lending, but needs shared data and rich credit files • Employee performance based on accuracy of risk ratings? • For commercial risk rating, look for staff experienced in commercial lending (and not just in an upswing economy) • In credit unions, look for MBL experience in staff. CUSOs may increase costs and risk 26 APPROPRIATE STAFFING
- 27. 27
- 28. • Methodology gaining popularity after mentions in Basel II, Basel III and FASB CECL guidance • Currently used by larger institutions, primarily • PD (probability of default): the average percentage of borrowers that default over a certain time period • LGD (loss given default): the percentage of exposure to a bank if the borrower defaults • EAD (exposure at default): an estimate of the outstanding amount, or exposure to the bank, in the event a borrower defaults 28
- 29. • Produces risk ratings for both the borrower (PD) and the facility (LGD) – a dual rating • Probability of Default (PD) » % likelihood a member will NOT make full and timely repayment of their credit obligations over a given time horizon » Assigned to each segment, usually based on loan balance • Loss Given Default (LGD) » Loss amount if there is a default (%) » Variable (5) assigned to each loan that reflects losses within the loan’s industry or product • Expected Loss » The product of PD * LGD is the expected loss 29 DUAL RISK RATINGS
- 31. 31
- 32. 32
- 33. • Data quality and accuracy of credit analysis » Integrity of financial data used » Global cash flow analysis » Quality of business projections » Use of appropriate industry benchmarks » How credit analysis output is used to establish risk rating • Rationale of risk rating system » Using the right factors for Capacity and Capital? Thresholds seem appropriate? • Consistency across the institution • Relation to risk » Factored into loan prices, covenants, other strategic decisions? 33
- 34. • Data quality and accuracy of reviews » Consistency with which updated statements are collected » Quality and timeliness of appraisals » Quality of market data collected from Tax Authority • Rationale of risk rating system » Risk ratings updated often enough to reflect risk for the institution? • Organization of loan review responsibility • Consistency across the institution • Relation to risk » Are loans being re-priced or restructured based on new risk ratings? 34
- 35. • Volume of credits where ratings changed more than one grade • Seasoning of ratings (the length of time credits stay in one grade) • Velocity of rating changes • Default and loss history by rating category • Ratio of rating upgrades to rating downgrades • Rating changes by line of business, loan officer and location 35
- 36. • Re-evaluation of risk appetites and concentration limits for the institution • Identification of portfolio segments with increased risk • Optimization of loan pricing and loan covenants » Adequately compensated for risk » Provides defensible measures to justify pricing changes and avoid charges of discriminatory pricing • Employee performance management » Application of risk rating system – following rules? » Performance of loans by employee 36
- 37. 37
- 38. • Identifying loans as performing or nonperforming (ASC 450 vs ASC 310) • Relation of risk rating to the reserve » Do risk rating migrations appear in the reserve balance • Migration analysis as loss rate methodology • Portfolio reporting – disclosure for Credit Risk Grade by Segment • Additional qualitative analysis • Consistency across the institution 38
- 42. 42 Source: Managing Financial Risks Strategically In Light of Emerging Regulation, Ridgway & Bayer MIGRATION ANALYSIS
- 43. 43 Historical Loss Concentration Loan Balance Historical Loss Rate ALLL Provision MBL $409,250 9% $36,833 Migration Analysis Risk Grade Loan Balance Loss Rate ALLL Provision MBL Pass $378,000 7% $26,460 MBL Special Mention $18,000 12% $2,160 MBL Substandard $11,250 22% $2,475 MBL Doubtful $2,000 48% $960 TOTALS $409,250 $32,055
- 44. • BASEL III – more focus on credit risk / overall risk management and need for more objective assessment of risk • CECL will require more granular calculation » E.g., Migration, PD/LGD, vintage analysis » These types of calculations will rely on risk ratings • CECL will require frequent review of loans » Access to accurate loan-level detailed data will be essential • Risk ratings are critical for institutions to accurately measure performance in their portfolios • Risk ratings are a core element of your credit risk management process • Big & small banks can develop risk rating systems that work for them 44
- 45. 45
- 46. 46 ROBERT ASHBAUGH Sr. Risk Management Consultant rob.ashbaugh@sageworks.com 919.851.7474 ext. 2521 RISK MANAGEMENT SOLUTIONS Save significant time – up to 80% – on each ALLL calculation Quickly access, store loan-level data for reporting and to prepare for requirements anticipated with the FASB’s CECL model
- 47. • ALLL.com – Everything ALLL, including news articles, whitepapers, and peer discussions • ALLL Forum for Bankers – LinkedIn group for ALLL news & discussion • CECL Post-release webinar - panel-style webinar with thought leaders from top accounting firms • FASB’s CECL Prep Kit - complimentary toolkit, to help you better prepare • Sageworksanalyst.com – Learn about Sageworks’ risk management suite • Interested in talking with a specialist? » Email us now: sales@sageworks.com 47