Management Risk

Enterprise Risk Solutions:

Commercial Risk Ratings Redefinition

Challenge “spacing” between each of the grades in the scale, is customized

Banks are faced with some compelling business reasons for to the bank’s portfolio of exposures. The key criteria that will

upgrading their commercial risk ratings systems. These systems guide the redefinition of the Obligor Rating scale are

are intended to assist financial institutions in estimating the differentiation capability, distribution, and usefulness, e.g. as an

Probability of Default (PD) of loans at the time of their input into loan pricing decisions.

underwriting. Having an accurate estimate of PD is important so

banks can: Figure 1 illustrates differentiation capability. A good system

shows meaningful changes in the Probability of Default (PD) as

Improve the balance between risk assumed and pricing ratings get worse, whereas a poor system shows little

More effectively use their capital differentiation between the highest and lowest grades.

Address the changing regulatory climate

Avoid missing out on business because of crude

yes/no underwriting

Good System Poor System

Avoid getting cherry-picked by competitors with more

sophisticated ratings systems Default

Default

Rate

Rate

Some institutions have attempted to address these issues with

stopgap measures such as subjectively “splitting” the existing risk

grades or segregating out collateral effects from risk ratings.

These approaches are not consistent with credit risk management

best practice or the Basel II Advanced Internal Ratings Based Rating

Rating

approach. Banks struggle to come up with a solution because

they are unable to address the fundamental challenges: Figure 1

How many risk rating grades should I have?

For distribution, ideally we would want to distribute borrowers

What is an appropriate distribution of loans across grades?

across the entire range of risk ratings instead of having them

How do I get underwriter and account officer buy-in for the

bunched together into a single or few ratings. This allows for a

revised system?

fuller use of ratings “bandwidth” and results in enhanced

granularity. However, creating a wider distribution of ratings will

Solution

be balanced with the first objective of differentiation.

ERisk has found that a more comprehensive approach that

redefines risk ratings, rather than just adding categories,

The final criterion is usefulness, illustrated in Figure 2. For the

produces better results and creates a much more useful system

commercial risk rating scale to be incorporated into applications

for measuring, managing, and pricing credit risk. The first task in

such as pricing models, the change in default rate from one pass

redefining the risk rating framework is to construct the Obligor

rating to the next should be small enough so that a single rating

Rating scale. The number of ratings in the scale, as well as the

Figure 2 Poor System

Good System

Pricing Spread by Rating

Pricing Spread by Rating

Size of increment too big

Typical range of

Spread

Spread

- you won’t do any 6’s

market pricing

Size of increment

reflects meaningful Too small

Too small

difference in price to matter

to matter

1 2 3 4 5 6 7 1 2 3 4 5 6 7

Rating Rating

All below market – no real

All below market - no

difference between these ratings

real difference between

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ERisk Consulting Services

email ****@*****.***, or call 212-***-****

change does not have a drastic impact to the final result, but is

large enough for meaningful differences in risk and pricing. There

Figure 3

need to be enough pass grades in the typical range of “market”

prices and the system needs to be intuitive to underwriters and

account officers.

LGD Rating

Collateral

The second task is to construct the Transaction Rating scale Type

A B C … F

based upon Loss Given Default (LGD). The Transaction Rating

Cash …

> 100% 90-100% 80-90% <50%

scale adjusts for loss mitigation mechanisms built into the

transaction - in most cases collateral type and amount that is Property …

> 150% 120-150% 100-120% <70%

provided, as well as whether or not the transaction is

Inventory …

> 200% 150-200% 125-150% <80%

subordinated or not. ERisk analyzes the range of products and

… … … … …

…etc.

collateral types in the bank’s portfolios and uses that as the

basis for constructing the range of the LGD scale. Figure 3 is an

illustration of a Transaction Rating scale.

The final task is a well-designed process for rolling out the

redefined commercial risk ratings scale. This includes both

training for underwriters and account officers and a conversion

strategy for migrating existing loans to the new ratings scale.

Why ERisk?

Benefits

As the leading provider of integrated risk management solutions to

Commercial risk ratings redefinition can be completed in as little

the financial services industry, ERisk offers a number of unique

as 8-10 weeks. The results and benefits ERisk’s clients have

qualifications to assist organizations meet their most critical risk and

achieved through this process have been impressive, including:

capital management challenges:

Greater accuracy in estimating credit risk

We have deep expertise in developing credit risk metrics and

Ability to more aggressively price lower risk borrowers, or early warning systems – our experts are among the most

credits with better structures and collateral experienced credit risk management professionals in the world.

Improved margins and better pricing for credit risk We deliver “best-in-class” risk management analytics that are

available from no other source.

A more accurate calculation of Economic Capital for credit

risk, which requires PD and LGD as separate inputs We are particularly skilled in translating complex analytical

analyses into useful insights that can support real decisions.

Consistency with the Basel II Advanced Internal Ratings

Based approach for credit risk We deliver on time and on budget – with a reputation of “over

delivering” relative to client expectations.

Banks are finding that as those institutions that have already

made the investment in more rigorous approaches compete with

them for their commercial business, they need a risk rating scale

that is fine tuned to their market and the credits they compete

for. Banks are choosing ERisk to assist them in redefining their

commercial risk ratings scale to ensure they realize the business

benefits of increased margins, better risk and relationship

profitability management, and a smooth rollout of the revised

ratings scale.

For More Information

About ERisk

ERisk is the leading provider of integrated software and Main Phone: 212-***-****

ERisk

consulting solutions that enable financial organizations to

Fax: 212-***-****

1500 Broadway

enhance their performance through better risk and capital

Worldwide Web: www.erisk.com

New York, New York

management. Our mission is to help senior executives to

Email: ****@*****.***

10036

transform their risk management processes to improve

management effectiveness, reduce losses and increase

shareholder value.

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