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Credit Risk Rating at Large U.S. Banks - The Fed - …

Credit Risk Rating at Large BanksWilliam F. Treacy, of the Board s Division of BankingSupervision and Regulation, and Mark S. Carey, ofthe Board s Division of Research and Statistics, pre-pared this Credit ratings are becoming increasingly im-portant in Credit risk management at Large internal ratings are somewhat like ratingsproduced by Moody s, Standard & Poor s, and otherpublic Rating agencies in that they summarize the riskof loss due to failure by a given borrower to pay , Banks Rating systems differsignificantly from those of the agencies (and fromeach other) in architecture and operating design aswell as in the uses to which ratings are put. Onereason for these differences is that Banks ratings areassigned by bank personnel and are usually notrevealed to Large Banks , whose commercial borrowers maynumber in the tens of thousands, internal ratings arean essential ingredient in effective Credit risk the distillation of information thatratings represent, any comparison of the risk posedby such a Large number of borrowers would beextremely difficult because of the need to simulta-neously consider many risk factors for each of themany borrowers.

Credit Risk Rating at Large U.S. Banks William F. Treacy, of the Board’s Division of Banking Supervision and Regulation, and Mark S. Carey, of

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Transcription of Credit Risk Rating at Large U.S. Banks - The Fed - …

1 Credit Risk Rating at Large BanksWilliam F. Treacy, of the Board s Division of BankingSupervision and Regulation, and Mark S. Carey, ofthe Board s Division of Research and Statistics, pre-pared this Credit ratings are becoming increasingly im-portant in Credit risk management at Large internal ratings are somewhat like ratingsproduced by Moody s, Standard & Poor s, and otherpublic Rating agencies in that they summarize the riskof loss due to failure by a given borrower to pay , Banks Rating systems differsignificantly from those of the agencies (and fromeach other) in architecture and operating design aswell as in the uses to which ratings are put. Onereason for these differences is that Banks ratings areassigned by bank personnel and are usually notrevealed to Large Banks , whose commercial borrowers maynumber in the tens of thousands, internal ratings arean essential ingredient in effective Credit risk the distillation of information thatratings represent, any comparison of the risk posedby such a Large number of borrowers would beextremely difficult because of the need to simulta-neously consider many risk factors for each of themany borrowers.

2 Most Large Banks use ratings in oneor more key areas of risk management that involvecredit, such as guiding the loan origination process,portfolio monitoring and management reporting,analysis of the adequacy of loan loss reserves orcapital, profitability and loan pricing analysis, and asinputs to formal portfolio risk management typically produce ratings only for business andinstitutional loans and counterparties, not for con-sumer loans or other short, risk ratings are the primary summaryindicator of risk for Banks individual Credit expo-sures. They both shape and reflect the nature of creditdecisions that Banks make daily. Understanding howrating systems are conceptualized, designed, oper-ated, and used in risk management is thus essential tounderstanding how Banks perform their businesslending function and how they choose to control specifics of internal Rating system architectureand operation differ substantially across Banks .

3 Thenumber of grades and the risk associated witheach grade vary across institutions, as do decisionsabout who assigns ratings and about the manner inwhich Rating assignments are reviewed. In general,in designing Rating systems, bank management mustweigh numerous considerations, including cost, effi-ciency of information gathering, consistency of rat-ings produced, staff incentives, the nature of thebank s business, and the uses to be made of central theme of this article is that, to a consider-able extent, variations across Banks are an example ofform following function. There does not appear to beone correct Rating system. Instead, correctness depends on how the system is used. For example, abank that uses ratings mainly to identify deterioratingor problem loans to ensure proper monitoring mayfind that a Rating scale with relatively few grades isadequate.

4 In contrast, if ratings are used in computing1. For example, bonds rated Aaa on Moody s scale or AAA onStandard & Poor s scale pose negligible risk of loss in the short tomedium term, whereas those rated Caa or CCC are quite For additional information about the internal Rating systems oflarge and smaller Banks , see Thomas F. Brady, William B. English,and William R. Nelson, Recent Changes to the Federal Reserve sSurvey of Terms of Business Lending, Federal Reserve Bulletin,vol. 84 (August 1998), pp. 604 15; see also William B. English andWilliam R. Nelson, Bank Risk Rating of Business Loans (Board ofGovernors of the Federal Reserve System, April 1998).For information about the Rating systems of Large Banks and aboutcredit risk management practices in general, see Robert Morris Asso-ciates and First Manhattan Consulting Group,Winning the CreditCycle Game: A Roadmap for Adding Shareholding Value ThroughCredit Portfolio Management(1997).

5 For a survey of the academic literature on ratings and Credit risk,see Edward I. Altman and Anthony Saunders, Credit Risk Measure-ment: Developments over the Last 20 Years, Journal of Banking andFinance,vol. 21 (December 1997), pp. 1721 See the Federal Reserve s Supervision and Regulation LetterSR 98-25, Sound Credit Risk Management and the Use of InternalCredit Risk ratings at Large Banking Organizations (September 21,1998), which stresses the importance of risk Rating systems forlarge Banks and describes elements of such systems that are nec-essary to support sophisticated Credit risk management (p. 1).SR Letters are available on the Federal Reserve Board s web site, Credit risk can arise from a loan already extended, loan commit-ments that have not yet been drawn, letters of Credit , or obligationsunder other contracts such as financial derivatives.

6 This article followsindustry usage by referring to individual loans or commitments as facilities and overall Credit risk arising from such transactions as exposure. internal profitability measures, a scale with a rela-tively Large number of grades may be required toachieve fine distinctions of Credit with the decision to extend Credit , the ratingprocess almost always involves the exercise of humanjudgment because the factors considered in assigninga Rating and the weight given each factor can differsignificantly across borrowers. Given the substantialrole of judgment, Banks must pay careful attentionto the internal incentives they create and to internalrating review and control systems to avoid introduc-ing bias. The direction of such bias tends to be relatedto the functions that ratings are asked to perform inthe bank s risk management process. For example, atbanks that use ratings in computing profitability mea-sures, establishing pricing guidelines, or setting loansize limits, the staff may be tempted to assign ratingsthat are more favorable than Banks use statistical models as an element ofthe Rating process, but Banks generally believe thatthe limitations of statistical models are such thatproperly managed judgmental Rating systems delivermore accurate estimates of risk.

7 Especially for largeexposures, the benefits of such accuracy may out-weigh the higher costs of judgmental systems. Incontrast, statistical Credit scores are often the primarybasis for Credit decisions for small lending exposures,such as consumer form generally follows function in thesystems used to rate business loans, our impression isthat in some cases the two are not closely example, because of the rapid pace of change inthe risk management practices of Large Banks , theirrating systems are increasingly being used for pur-poses for which they were not originally a bank applies ratings in a new way, such as inrisk-sensitive analysis of business line profitability,the existing ratings and Rating system are often usedas-is. It may become clear only over time that thenew function has imposed new stresses on the ratingsystem and that changes in the system are conditions appear to magnify such stresseson bank Rating systems.

8 The conceptual meaning ofratings may be somewhat unclear, Rating criteria maybe largely or wholly maintained as a matter of culturerather than formal written policy, and corporate data-bases may not support analysis of the relationshipbetween grade assignments and historical loss experi-ence. Such circumstances make ratings more difficultto review and audit and also require loan review unitsin effect to define, maintain, and fine-tune ratingstandards in a dynamic article describes internal Rating systemsat Large Banks , focusing on the relationshipbetween form and function, the stresses that are evi-dent, and the current conceptual and practical barriersto achieving accurate, consistent ratings . We hope topromote understanding of this critical element of riskmanagement among the industry, supervisors, aca-demics, and other interested parties and therebypromote further enhancements to risk article is based on information from internalreports and Credit policy documents for the fiftylargest bank holding companies, from interviewswith senior bankers and others at more than fifteenmajor holding companies and other relevant institu-tions, and from conversations with Federal Reservebank examiners.

9 The institutions we interviewedcover the spectrum of size and practice among thefifty largest Banks , but a disproportionate share of thebanks we interviewed have relatively advanced inter-nal Rating OFBANKINTERNALRATINGSYSTEMSIn choosing the architecture of its Rating system, abank must decide which loss concepts to employ, thenumber and meaning of grades on the Rating scalecorresponding to each loss concept, and whetherto include watch and regulatory grades on suchscales. The choices made and the reasons for themvary widely, but on the whole, the primary determi-nants of bank Rating system architecture appear to bethe bank s mix of Large and smaller borrowers andthe extent to which the bank uses quantitative sys-tems for Credit risk management and profitabilityanalysis. In principle, Banks must also decide whetherto grade borrowers according to their current con-dition or their expected condition under the Rating agencies employ the latter, through the cycle, philosophy, almost all bankshave chosen to grade to current condition (seethe box Point-in-Time vs.)

10 Through-the-CycleGrading ).Loss Concepts and Their ImplementationThe Credit risk of a loan or other exposure over agiven period involves both theprobability of default(PD) and the fraction of the loan s value that is likelyto belost in the event of default(LIED). LIED isalways specific to a given facility because it depends5. Internal Rating systems are typically used throughout bank-ing organizations. For brevity, we use the term bank to refer toconsolidated banking organizations, not just the chartered Reserve BulletinNovember 1998on the structure of the facility. PD, however, is gener-ally associated with the borrower, the presumptionbeing that a borrower will default on all obligations ifit defaults on product of PD and LIED istheexpected loss(EL) on the exposure in a statisticalsense. It represents an estimate of the average per-centage loss rate over time on a group of loans allhaving the given expected loss.


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