Magazine article The Journal of Lending & Credit Risk Management

The CUP Approach to Bank Loan Risk Grading

Magazine article The Journal of Lending & Credit Risk Management

The CUP Approach to Bank Loan Risk Grading

Article excerpt

This article offers workable definitions relative to credit quality and financial strength by focusing on "CUP," with each letter containing three very basic aspects of finance that combine to affect loan risk. "C" relates to the customer (borrower); "U" relates to the money itself; and "P" concerns the return of the money. Together, these three encompass all of the basic aspects of credit risk. For the past two years, Roetz has reviewed commercial loan portfolio risk grades at American Bank of Hollywood, Florida, using the approach and review format presented in this article.

Successful banks are profitable because they measure risk accurately, and the key to accurate risk management is a well-defined risk-rating system. Definitions are the heart and soul of bank loan risk grading and every bank's board of directors is ultimately responsible for defining its loan risk grades. Of course, the best definitions render meanings that are easy to understand and simple to use.

As a direct result of the reaction of the U.S. Congress to the banking problems of the 1980s, bank regulators are now obliged to require each bank to have formal procedures for internal loan risk grading. As recently as September 1998, the Fed asked its bank examiners to pay close attention to how U.S. banks measure the credit risks in their business loans. A letter from Fed officials advised banks to develop and maintain internal tools, such as ratings systems, that could reduce risk exposure in business lending.

The exact content of a bank's procedures is not dictated by the regulations. Thus, a wide variety of definitions exist among the various sizes of banks. Smaller banks often focus on loan collateral as the basis for risk grade definitions. This is essentially a classification rather than a risk evaluation and causes high-quality unsecured credits to be graded lower than might be warranted. This also tends to obscure the real meaning of the word "loan." Even when the grade definitions include unsecured loans at all levels, the definitions may use words like "credit quality" and "financial strength" without defining these terms. Figure 1 was compiled from the grading guidelines of several banks.

The CUP approach, presented in this article, takes three essential parts of risk assessment and integrates them into risk grade review of commercial portfolios. It is easy to find fault with a simplistic approach unless one is willing to accept and apply a very general and broadly inclusive meaning for each of the nine segments - identified here as character, capacity, capital, gift, investment, loan, profits, proceeds, and placement. In this instance, these segments are divided equally into the three letters of "CUP." Genesis 44:17 tells us, "...the man in whose hand the cup is found, he shall be my servant...." Isn't the banker with cup in hand expected to serve his customers? The acronym CUP is defined as follows:

1. "C" is comprised of the time-honored C's of credit - character, capacity, and capital, also known as integrity, cash flow, and net worth of the borrower. Obviously, arguments can be made about the importance of conditions (economic and political) as well as collateral and any other "C" words that can affect the ability of a borrower to perform as contracted. Nonetheless, these three are of paramount importance in determining the degree of risk in every credit situation. Because the three C's form the foundation of credit quality, some lenders ignore "U" and "P."

2. "U" refers to the three uses of money. In the most general sense, all money usage fits within one or more of only three possible uses. We can give it away, invest it, or lend it. If we overpay for clothing or food, the first two uses are involved. If we do not use the clothing or food, the price paid becomes a gift. Buying stock in a company is clearly an investment as there is no other source of return for the funds used. Therefore, the necessity of having more than one source of return of the money becomes the very essence of the real definition of a loan. …

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