GET MORE OUT OF RISK RATING

Risk management depends on good risk rating data ... and I am betting that yours is not nearly as good as it could be.

Risk ratings have become our industry standard for quantifying the risk associated with each credit in the portfolio. They even capture a certain amount of subjective judgment, along with a lot of hard numbers, to express a level of confidence in that credit's repayment.

Risk ratings should be rich sources of information about the current risk profile and about how credits move to higher or lower levels of risk over time. Used as originally designed, they are enormously powerful contributors to meaningful portfolio analysis and effective risk management.

But are there banks out there that are not getting the full benefit of their risk rating systems? Are the banks where the data that their risk ratings provide falls short of what is needed for optimal risk management?

Yes, just about every bank's risk rating system falls short these days, in my opinion!

Take the Test

Here's a simple quiz that reveals a lot about how efficiently your bank monitors asset quality:

1. How many categories (numbers, bins, however you think of it) are there in your risk rating system?
2. If you counted up all the ratings actually assigned to credits in your portfolio, what would that number be?

I'm going to guess that #2 is a much smaller number than #1. And the farther apart these numbers are, the less efficiently you are using your risk rating system.

The truth is that many, if not most, banks describe one risk rating system in their policy, but actually implement quite a different system. They lump all credits of acceptable quality into one rating, or maybe two.

So what's wrong with that?

Consider the A-B-C-D-F scale you followed in most of your high school and college classes. Your teachers, your parents, and even your future employers used those ratings both as a record of recent performance and as an indicator of probable future performance. Your grades allowed others to determine where extra attention was needed to improve outcomes.

How helpful would those grades have been to you and the school if your teachers had only assigned a "C" or an "F" to every student, ignoring the other possible grades? Wouldn't a lot of information have been lost that could have been used to achieve better results?

In the same way, a risk rating system that really only uses a couple of categories is wasteful in several ways:

• It throws away a ton of valuable information that could help you hit the ALLL/Capital sweet spot. Just as getting only a C or an F tells you little about a student's performance, getting only a Pass or Fail provides little information for your portfolio analysis program. More importantly, it clouds movement within the portfolio. It is pretty hard to decipher trends when you can only move from one point to another on a two-point scale.
• It wastes resources. One objective of your original risk rating system design was to help distribute resources more efficiently. A bank that uses the full spectrum of risk ratings can give more attention to credits that need closer monitoring and they can apply fewer scarce resources to manage the lowest risk credits. Without finer granularity in your risk descriptions, you can be sure you are using banker, analyst, and administrative time inefficiently.
• It undermines culture, policy, communication, and audit/review functions. There's a pretty good chance that the full risk rating system is covered in your policy and your training, but staff quickly learn that the policy is not always followed, that what they were taught is not what they are supposed to do. Saying one thing and doing another is rarely a good thing in any business, much less one, like banking, that is focused on managing risk!
• It leaves little room for actively managing loan pricing. In particular, if all the “good” loans are in a single bucket, there’s not much room for pricing according to the risks and merits of individual credits.

Harvest the Benefits of Your Risk Rating System

It takes awareness, commitment, and some hard work to harvest the benefits of a fully-utilized risk rating system.

After all, most banks have simply drifted into a more compressed system. Without an explicit review of how you use risk ratings, you probably do not even know the extent of the problem.

Add to that the fact that regulators like the FDIC prefer simple systems, and there's a temptation to just take the path of least resistance and follow their lead. But your bank and the FDIC have very different perspectives on your portfolio, and very different goals. The FDIC's thinking makes sense for them, because the FDIC is basically an insurance agency. They are interested in whether or not they will have a "claim" to pay

You are interested in protecting the bank while deploying resources as efficiently as possible, according to the true distribution of risk in your portfolio. And that takes a range of risk ratings, not just a couple of slots.

Jeff Judy & Associates can help you get more out of your risk rating system. Contact me for help with:

• a review of your current system and how it is really being used. My team can tell you how you are using your system now, and make recommendations for getting more information, and more efficiency, out of your system in the future.
• crafting credit policy that truly reflects how you actually run your credit business. I work with banks to craft relevant, living credit policy that reflects their strategies, their values, their standards, and their approved practices, one that reflects the culture of the institution and the vision of the leadership. In short, a policy that directly contributes to the bank's success.
• Supporting risk rating practices through training and curriculum development, and by assessing and enhancing the culture.
• Helping you develop portfolio analysis approaches that make the most of your risk rating data, and guiding you through the data preparation process to make sure you have the best possible information with which to optimize your risk management practices.

If you're not sure your risk rating system is doing the job, please contact me to explore next steps to a more productive risk rating system.

Continue on for a discussion of Portfolio Analysis Options ...

Are you confident that your risk rating practices are doing all they could to help you be successful and to manage risk?