Designing and Implementing a Dual Risk Rating System Tailored to Your Institution: A Checklist
For decades, the value of a robust, flexible dual risk rating system has been well established as a means by which financial services organizations can better measure and manage credit risk. At a high level, a dual risk rating methodology enables institutions to quantify and assign risk to the individual credit, then see the risk profile of the entire portfolio.
Despite the proven value of dual risk rating for banks of all sizes, there is much debate over the best way to design and implement this kind of credit risk grading system to meet the needs of an individual financial institution. As such, if you’re in the midst of redesigning an existing risk rating system or even starting from scratch to develop one that overcomes previous pitfalls, you will likely find that the right solution is as unique as your bank’s innerworkings and customer base.
While there is no one-size-fits-all, turnkey solution, there are time-tested rules that should be followed to design and implement a highly reliable risk rating system that is tailored to meet your bank’s needs. With that in mind, here is a checklist to guide you!
✔ Design Your Dual Risk Rating System with Implementation in Mind
While carefully designing a dual risk rating methodology to meet your organization’s needs is paramount, never lose sight of what it will take to successfully implement the solution. Get buy-in early and often from business leaders and users alike and be prepared to educate them along the way to ensure the system is implemented as intended. From the technical side, also be ready to test, tweak, and readjust the rating system as challenges arise throughout the implementation phase.
✔ Audit Historical Data and Be Honest about Your Findings
Data is the backbone that defines the outputs of a credit risk rating system. Therefore, it is crucial that your organization be honest about the quality, cleanliness, consistency, and accessibility of the historical data that has been captured to train the system. Spend as much time as needed to consolidate and standardize this data—it will pay dividends as you utilize, test, and refactor the rating system in the future.
✔ Rigorously Test and Benchmark Every Step of the Way
The benefits of testing and tweaking the new risk rating system before, during, and after implementation include not only discovering errors before users do, but also ensuring the integrity of the ratings up front and being able to identify trends over time. Of course, more serious implications exist, such as not identifying a worsening credit or underpricing for risk.
Backtesting and benchmarking present two proven methods for testing the rating system. Backtesting means studying the real behavior of companies in established ratings categories to deduce if the companies live up to the ratings assigned to them, for example, how often they default versus the assigned probability. If back-testing using historical data is not possible, use benchmarking to compare an institution's internal ratings to those of a competitor, then examine how well that competitor has assessed credit risk over time.
✔ Prioritize Consistent Documentation to Facilitate Company-wide Alignment
Effectively applying dual risk rating in the wild relies on many factors, not least of which are the documentation and subsequent terms used to describe how the risk rating works in practice. Without alignment on how, when, and why to use the ratings; what the system measures; and what its strengths and weaknesses may be, how to use it properly will likely remain a mystery to those who aren’t afforded ample training and updates on tweaks being made. Utilize documentation to fill in these gaps and provide a tried-and-true user manual.
Similarly, misalignment over the exact definitions of terms used in the documentation can result in risk mismanagement, because definitions for “Superior” and “Strong” when rating management strength may differ by analyst. Thus, it is essential to make certain that all terms used within the rating system and subsequent documentation are clearly defined and agreed upon, and that these definitions are frequently reviewed and accessible to all users and stakeholders.
✔ Consider If and When Independent Risk Rating Decisions are Appropriate
It is likely not worth the effort to create a standardized risk rating system if independent decisions will still be allowed to rule the day. Having an expertly designed and implemented dual risk rating scale in place does not mean independent rating decisions are completely prohibited; however, it does mean that there should be an institutional standard regarding when these kinds of decisions are appropriate.
✔ Balance the Needs of Different Business Units—Within Reason
Different business units have different needs, making it difficult to design a rating system that serves them all equally. Even so, reaching out to each business unit for their input will help ensure alignment and reduce potential friction upon implementation once key stakeholders understand the need for centralized risk oversight. After all, if the business units cannot resolve to use the new rating system to attain comparable outputs, then the new ratings will not be able to serve their main purpose of effectively aggregating credit risk across your institution.
✔ Embrace Change with Open Arms
Why go through the trouble of designing or redesigning a rating system if the result is the same old status quo? Make the most of this opportunity to look at every aspect of the ratings process with fresh eyes and open ears and be prepared to embrace change as a catalyst for good, understanding that the future of the organization could be at stake.
✔ Ask for Help If You Need It
If you have made it this far, kudos. You are serious about building the best credit risk grading system possible for your institution, even if the roadmap is not as clear as you would like it to be right now. If you need some help defining this roadmap or would like to learn about how existing risk rating products can accelerate your implementation journey, the credit risk experts at RMA are here for you. Contact us today to start the conversation!