Effective: Credit Risk-Rating Systems. (Internal Risk Ratings)

Article excerpt

This conclusion of a two-part article presents a case study of a regional bank's initiative to upgrade its credit risk management process.

The first part of this article (September 2001) described how an effective credit risk system should be designed and what issues should be resolved for successful implementation. This concluding section presents a detailed case study of the design stage in implementing such a system at SunTrust Banks, Inc.

In September 2000, SunTrust began a thorough and methodical redesign of its entire credit risk-rating system. Despite its strong reputation as one of the industry leaders in credit quality, the bank decided that the substantial costs associated with initiating an even more effective credit risk system were justified. The improvements would facilitate the implementation of Basel II in 2005 and would strengthen the bank's position at the forefront of the lending industry. Oliver, Wyman & company (OWC) was asked to assist SunTrust in accelerating the implementation of the new system with minimal disruption to the bank's daily business and ensure that, once in place, the system would be consistent with industry best practices. Though projects of this type can vary in scope and timing, SunTrust's experiences should be helpful to other institutions involved in similar projects.

Priorities and Specifications

SunTrust's first step was to identify design specifications that would become the risk-rating system's foundation. Because the redesign of a bank-wide credit rating system is always a major undertaking, demanding many internal resources, consensus among the key players was a prerequisite. After discussions throughout the bank that included line managers, credit officers, and senior management, four strategic imperatives were identified for the new ratings system to support:

1. Loan approval. The correct assessment of the level of credit risk is a key component to a successful loan approval system.

2. Loan pricing. A proper differentiation of credit risk is necessary for a competitive loan pricing model, both to fully exploit potential opportunities and to avoid adverse selection problems in client relationships.

3. Risk-Adjusted Return on Capital (RAROC). Accurate capital management and performance measurement require consistent risk measures across all lines of business (LoB).

4. Portfolio monitoring and control. Effective monitoring and control rely on timely, accurate measurement of credit risk.

The challenge was to support these critical applications while moving the bank closer to compliance with anticipated changes in regulatory guidelines. Based on the priorities of SunTrust management and expectations regarding the Basel II regulatory guidelines, OWC identified five key improvements to the current system:

1. Two-dimensional credit ratings--independent obligor and facility ratings to increase accuracy and be consistent with Basel II requirements.

2. Additional granulariry in the "pass" obligor ratings--a necessary component of certain systems, such as a RAROC model currently in development, that use credit risk ratings as an input.

3. Explicit separation of the assignment of risk ratings and the use of the given ratings. In many credit risk-rating systems, such management decisions as "reduce risk" can influence credit risk ratings by leading people to assign harsh ratings. The new system should assign grades based solely on the risk of the credits.

4. Bankwide consistency in ratings, both within and across LoBs. In the old system, each LoB had its own ratings scale, and it was difficult to compare these ratings.

5. Increased resources and capabilities for data capture and analysis. The proposed requirements of Basel II make this particularly important.

A Master Credit Risk Scale for All Credit Exposures

Risk-rating systems should measure the credit risk consistently throughout the entire organization. …