Credit risk management has long relied on the implementation and use of rating systems that help lenders quantify, assign, and manage the risk level of credits. Traditionally, these systems have varied in complexity and sophistication depending on a bank’s portfolio size, industries served, customer needs, and, often most importantly, the overall budget and appetite for investing in a customized risk rating system.
Regardless of a bank’s budget or portfolio size, there is no denying the need for long-term accuracy and improved granularity in a risk rating system’s output, especially with the economic uncertainty many obligors are now experiencing in the COVID-19 period. With the goal of improving probability of default (PD) accuracy and minimizing loss given default (LGD) top of mind, many banks are making the switch from a single risk rating system to a dual risk rating system.
If your bank is in the process of deciding which kind of credit risk rating system is the right fit, you can start by unpacking the key differences between single and dual risk rating. Let us examine the differences between the two systems:
Single Risk Rating Defining Characteristics
- Commonly an 8- or 10-point scale that approximates expected loss
- Risk grades based on regulatory loan classification definitions
- May lead to increased concentration among pass-rated credits
- Tendency for ratings to be assigned using written definitions and thus less defensible
Dual Risk Rating Defining Characteristics
- Dual scale that provides a mechanism to separate borrower creditworthiness and facility riskiness
- Rating configuration, for example, consists of a 14-point borrower rating scale, indicative of probability of default (PD), combined with a 10-point facility rating score, indicative of loss given default (LGD)
- Framework of evaluating credits promotes consistency in the assessment of risk
- Offers additional granularity when reporting on portfolio trends
Why the Time is Right for Dual Risk Rating
Once in place, a dual risk rating system can strengthen underwriting and improve the overall risk management capabilities of a bank, as well as increase the effectiveness of other risk management processes. While the benefits over single risk rating are clear, there have historically been hurdles preventing small- and mid-sized banks from adopting a dual risk rating approach. Recently, a few things have happened to heighten the need for dual risk rating as well as eliminate former roadblocks:
- Economic pressures stemming from the COVID-19 crisis have forced banks relying on a single risk rating system to reevaluate their loan portfolios and reckon with a high concentration of pass-rated credits (usually 4s and 5s on the scale) that lack differentiation, making it difficult to predict the probability of default (PD) and act accordingly
- The Current Expected Credit Losses (CECL) standard introduced in 2016 has motivated banks to make the shift by requiring multiple risk rating elements over the life of a loan, such as probability of default (PD), loss given default (LGD), and expected loss (EL)
- Necessary data gathering and management technologies to support dual risk rating have become less costly and more sophisticated and widely available to banks
To meet the demand caused by these and other factors, the RMA has introduced Dual Risk Rating, an affordable, flexible solution designed for banks looking to enhance their risk management process. If you are considering making the shift from single to dual risk rating or even implementing a credit risk rating system for the very first time, contact us today.