Credit Risk Grading is an important tool for credit risk management as it helps banks and financial institutions understand the risk involved in a different credit transaction.
Let’s learn credit risk crading (CRG):
What is Credit Risk?
Credit risk refers to the risk that an issuer of debt securities or a borrower may default on his or her obligations or that the payment may not be made on a negotiable instrument.
What is Credit Risk Grading (CRG)?
Credit risk grading is the process that helps the sanctioning authority to decide whether to lend or not to lend, what should be the lending price, what should be the extent of exposure, what should be the appropriate credit facility, what are the various facilities, what are the various risk mitigation tools to put a cap on the risk level.
It provides a detailed and formalized credit evaluation process for risk identification, measurement, monitoring and control, risk acceptance criteria, credit approval authority, maintenance procedures, and guidelines for portfolio management.
It provides a better assessment of the quality of the credit portfolio of a bank.
Internal Credit Risk Rating (ICRR)
Internal Credit Risk Rating (ICRR) is a collective definition based on the pre-specified scale and reflects the underlying credit risk for a given exposure. ICRR deploys a number of risk rating as a primary summary indicator of risks associated with a credit exposure.
ICRR is the module for developing a credit risk management system. Well-managed credit risk rating systems will promote bank safety and soundness by facilitating informed decision-making.
Rating systems will measure credit risk and differentiate individual credits and groups of credits by the risk they pose. This will allow bank management and examiners to monitor changes and trends in risk levels. The process also allows bank management to manage risk to optimize returns.
The Risk Rating matrix will allow application of uniform standards to credits to ensure a common standardized approach to assess the quality of individual obligor, credit portfolio of a unit or line of business.
As evident, ICRR outputs would be relevant for individual credit selection, wherein either a borrower or a particular exposure/facility is rated. The other decisions would be related to pricing (credit spread) and specific features of the credit facility.
These would largely constitute obligor-level analysis. Credit risk rating would also be relevant for surveillance and monitoring, internal MIS, and assessing the aggregate risk profile of a Bank. It is also relevant for portfolio-level analysis.
All Banks should adopt an Internal Credit Risk Rating system. The system should define the risk profile of borrower’s to ensure that account management, structure and pricing are commensurate with the risk involved.
Risk grading is a key measurement of a bank’s asset quality, and as such, it is essential that grading is a robust process.
All facilities should be assigned a risk rating.
Where deterioration in risk is noted, the risk rating assigned to a borrower and its facilities should be immediately changed. Borrower risk rating should be clearly stated on credit applications.
5 Components of Credit Risk Grading
Financial risk
The uncertainty of future incomes due to the company’s financing. Financial risk management refers to the practices used by corporate finance managers and accountants to limit and control uncertainty in the firm’s total portfolio.
Financial risk management aims to minimize the risk of loss from unexpected changes in currencies, interest rates, commodities, and equities.
Business/Industry risk
The risk is related to the inability of the firm to hold its competitive position and maintain stability and growth in earnings. It is generally measured by the variability of the firm’s operating income over time.
Management Risk
The risks associated with ineffective destructive or under-performing management, which hurt shareholders and the company or fund being managed.
Security risk
Security risk mainly depends on potential owners or another source. There is some Security risks are given below:
- Perishability,
- Enforceability/Legal structure, and
- Forced Sale Value.
Relationship risk
Relationship risk is mainly based on supplier and customer relation to the entrepreneur.
If the entrepreneur can make a good relation with the customer or supplier, he or she also gets the loan at a lower rate.
How to Compute Credit Risk Grading
- Identify all the Principal Risk Components.
- Allocate weight to Principal Risk Components.
- Establish the Key Parameters under each risk component.
- Assign a weight to each of the key parameters.
- Add all the weight of the key parameters to have an overall score.
- Assign a grade based on the total weights. The grading method assumes the simple weighted average addition of the risk criteria.
