Loan Risk Ratings, Classification Systems, and Loss Factors

Article excerpt

The information in this "Statistical Snapshot" is from the KPMG Peat Marwick's Financial Services Practice 1993 Survey of Credit Risk Management Practices. The survey is based on 185 responses representing 535 financial institutions. Responses came from commercial banks, thrifts, and savings banks. Of the total respondents, 81 (44%) represented institutions with asset sizes less than $1 billion, 78 respondents (42%) represented institutions with assets between $1 and $10 billion, and 26 respondents (14%) represented institutions with greater than $10 billion in assets.

This excerpt presents the data from just one section of KPMG Peat Marwick's survey. The complete survey also includes information regarding forecasts of loan demand, the allowance for loan and lease losses, and commercial and consumer risk grade factors.

Who Assigns Ratings?

Of the respondents, 61% indicated that the loan officer has the primary responsibility of assigning a risk rating to a loan at origination; 22% indicated that an independent loan review function assigned a rating.

How Are Ratings Assigned?

Of total respondents to the survey, 27% indicated that the risk rater evaluated both the risk of default and the risk of loss in the event of default in determining a final risk grade. For the respondents whose loan officers did not estimate the loss in the event of default, more than half reported that the loan review department performed this analysis.

The final risk rating was based solely on the judgment of the rater in 72% of the institutions responding.

What Loans Are Rated?

Of all respondents, 35% reported using a dollar cut-off for risk rating loans on an individual basis after origination. The average cut-off for all respondents was $265,000. An interesting break between the commercial banks and the thrifts in the survey was apparent regarding the cut-off point for rating loans. The commercial banks reported an average cut-off at $115,000, while the average cut-off point for rating loans at thrifts was $435,000.

How Are Loans Rated?

Survey respondents reported using a rating scale that contained from 5 to 13 risk grades for commercial loans, with rating scales of 7 and 8 the most frequently cited. A clear majority of the survey respondents indicated using the standard set of regulatory grades for criticized and classified loans. That is, 85% use either other assets especially mentioned (OAEM) or special mention, 84% use the category substandard, and 92% use the category doubtful. …