Adjusting Your Risk Rating System to Combat COVID-19 Uncertainties
At the beginning of June 2020, RMA released “Guidelines for Risk Rating Loans in the COVID-19 Period,” a whitepaper that summarized the findings of the Risk Ratings Working Group, which is made up of 13 RMA member institutions ranging from $25 billion to $450 billion in assets. These institutions contributed their expertise and forward-looking strategies to help RMA members and, more broadly, credit risk professionals navigate risk ratings in the context of this current pandemic.
One of the key topics we covered in that whitepaper was how to approach the use and outputs of risk rating models during a time when the economic data used to build them has been turned on its head. As a member bank put it in the paper, “the quantitative portion of risk rating models is not expected to be a significant differentiator of forward-looking risk.”
While risk rating models have never been expected to predict the future with complete accuracy, they have been relied on for their ability to accurately risk rate loans based on historical trends and quantitative benchmarking. As we know, however, the current economic situation created by the COVID-19 pandemic does not follow any historical trends that could be expressed in the modern data used to train risk rating systems.
With so many models breaking, it's time for a different approach.
Adjusting Your Current Risk Rating Approach
How much should your bank trust its risk rating models and system as a whole? The short answer is “less than usual,” but that doesn’t mean you should completely stop relying on a risk rating system.
With economic disruption expected to continue as we eagerly await a vaccine for COVID-19, your bank should consider making dramatic changes to how it utilizes the existing risk rating system. Here are some guidelines to follow as you adjust that approach:
- Monitor the reasonableness of risk rating outputs and be on the lookout for unintuitive results that may require additional adjustments or overrides
- Ensure the ratings analysts and approvers consistently apply overrides and document the logic behind them for all to use as guidance
- Gather and analyze as much alternative information as possible, and take a closer look at metrics like liquidity, cash burn rate, and cash runway to gauge the degree to which you should override an unintuitive system output
- Track the Loss Given Default of existing loans closely to ensure that expected loss measures are still reasonable under current market conditions
- Use care when you consider building anomalous data from Q1 and Q2 2020 into your system, as this information may remain an outlier and may not be substantive enough to adjust your models or scorecards appropriately
As useful as risk rating models have been for banks in recent decades, it’s clear that today’s landscape calls for a more measured, less automatic approach to risk rating. This does not mean, however, that banks should turn back to or continue to rely on rudimentary single risk rating systems that lack granularity and consistency during this credit crisis.
Considering a Risk Rating Overhaul?
Depending on the success you’re having with your current risk rating approach, you might be ready to overhaul or upgrade the system in favor of something new. If that’s the case, RMA can help.
For a modern yet measured approach to risk rating, RMA Dual Risk Rating increases the granularity of risk ratings without employing a model-based approach that creates outputs in an algorithmic black box. Instead of relying on models, RMA Dual Risk Rating employs an expert judgment-based scorecard system that outputs reliable ratings in fluid economic situations.
To provide additional flexibility, RMA Dual Risk Rating enables methodology adjustments and rating overrides as needed while making it easy to capture subsequent documentation to maintain consistency. Furthermore, you can report on credit quality at the client and portfolio level to monitor and act upon recent or anticipated loan performance.
If you’re interested in seeing RMA Dual Risk Rating in action, we encourage you to contact us today to schedule a complimentary demo. And remember, whatever risk rating system your bank uses, RMA will be there to help you manage risk effectively, just as we have been for the past 100 years.
John has served RMA for 22 years in relationship management and strategic roles. He is currently responsible for all of RMA’s credit risk round tables. John was previously a commercial and corporate banker and holds the RMA Credit Risk Certified (CRC) professional designation.