Current Risk Ratings Assumption Guidance

This article will cover guidance for Annual Loss, Credit Capital and Guarantor Factors.

 

In this Article

• Background
• Guidance Overview
• Methodology
• 2020 Recommendations
• Scope

 

Background

Among PrecisionLender clients, we’ve found that the the most successful banks and credit unions review and update their Risk Rating assumptions on an annual basis. This regular review helps ensure that Andi’s insights are impactful, accurate, and aligned with your profitability and growth goals.

Many of our clients provide their unique portfolio migration data annually to PrecisionLender so we can perform a credit migration study. The results of this study are then used to determine  recommendations and updates to that specific client’s economic capital input factors.  

PrecisionLender will continue to review migrations, the resultant credit capital suggestions, and the risk groupings annually.

We invite you to request a credit migration analysis for your bank.  Please contact Support to request the credit migration template and to start the conversation.  

However, some of our clients have found it difficult to provide migration data on an annual basis and have asked if we could share “Industry” data as an alternative. To meet this need we have compiled credit migrations performed over the past several years to create “industry wide” groupings and migration patterns/results. The grouping specific to a client’s situation can be used as an alternative to client-specific credit migration results.  

 

Guidance Overview

To support our clients, in this annual review, PrecisionLender provides industry-based guidance for the three key inputs used to calculate economic capital. These factors are:  

1. Annual Loan Loss Percentage (sometimes referred to as Probability of Default)
2. Economic Capital Percentage
3. Guarantor Factor Percentage

PrecisionLender presents eight categorizations of risk rating groups. Our research indicates that the key drivers of the migration-based credit risk assumptions are, by commercial & agricultural loan count:

• The most common risk rating used
• The first “watch” category 

You may determine which of the eight standard categorizations is best suited to your bank by looking at a distribution of your loan portfolio — a point-in-time count of active commercial loans summed by each of your risk ratings. The most common rating carries the highest loan count.   

PrecisionLender generally defines a watch loan as a performing loan in which the lending institution has credit or operational concerns about the borrower. If this watch loan were a new borrower with no existing relationships, that bank would typically deny the loan based on these concerns. Watch loans can carry several different risk rating descriptions, including: internal watch, special mention, OAEM, or watch.

After reviewing the data, we have organized industry credit migration results into templates that may assist you in updating your credit risk assumptions.

PrecisionLender notes the recommendations are based on a sample of over 40 financial institutions. These institutions have a median asset size of approximately $3.6 billion and are located across the United States. 

 

Methodology

This guidance is derived from the Basel III best practice methods. 

For each of the eight standard risk rating sets, PrecisionLender used commercial loan migration data as the foundation. Next, we bundled migration data into the appropriate standard framework in order to create a migration table for each standard. 

We analyzed the migration results, determined 1-year PDs, and used Basel III methodology to determine the Credit Capital, Annual Loss and Guarantor Factor results across durations and risk ratings. This approach allowed us to ensure consistency across the credit risk results. PrecisionLender aligned common risk rating meanings across the data set.

 

2020 Recommendations

PrecisionLender recommends that the credit risk assumptions follow the term structure from 12 months to 120 + months.  For the purposes of input in to the solution, we display the 12, 60, and 120+ month categories and interpolate for points in between, using the interpolation method you have previously selected in your instance of PrecisionLender.  You may always add duration points to the assumption tables.

A sample recommendation set and the UGD recommendations are presented below. Click here for an appendix that includes our full 2020 Risk Rating guidance. 

 

The Usage Given Default factors apply to committed funds when the payment type field is either LOC (Line of Credit), Letter of Credit, Scheduled Draws or  Scheduled Draws and Repays.  This factor, when populated, can increase the amount of annual loss provision and the economic credit capital amount in cases where the instrument is not fully drawn or funded. 

PrecisionLender guidance is shown in the table below.  It aligns with the standard risk rating sets (columns).  The UGD factors decrease as credit risk increases (rows) as shown in the table.  For more information on how the calculation works, please see the How To Determine Capital–Line of Credit Multifactor example. 

 

 

 

Scope

This article does not address any other assumptions beyond the three key inputs listed above. PrecisionLender also provides guidance for Minimum Capital and Minimum Annual Loss amounts. 

Unmitigated Capital factors - to cover market and operational risk - can be determined by publicly available Call Report information. For most of our community bank clients an Unmitigated Capital factor of 1% of asset balance is our usual recommendation. 

However, PrecisionLender provides Usage Given Default (UGD) recommendations across the various risk rating templates. 

If you need any assistance updating your risk ratings, check out this Setting up and Managing Risk Ratings article.