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Sound Credit Risk Management and the Use of Internal Credit Risk Ratings at Large Banking Organizations

by the Federal Reserve Board, Division of Banking Supervision and Regulation, SR 98-25

September 21, 1998

Introduction and Summary: Techniques, practices, and tools for credit risk management are evolving rapidly, as are the challenges that banking organizations face in their business lending activities. For larger institutions, the number and geographic dispersion of their borrowers make it increasingly difficult for such institutions to manage their loan portfolios simply by remaining closely attuned to the performance of each borrower. As a result, one increasingly important component of the systems for controlling credit risk at larger institutions is the identification of gradations in credit risk among their business loans, and assignment of internal credit risk ratings to loans that correspond to these gradations. The Federal Reserve believes that the use of such an internal rating process is appropriate and, indeed, necessary for sound risk management at large institutions.

This SR letter describes certain elements of internal rating systems that are necessary to support sophisticated credit risk management. This letter also underlines the need for supervisors and examiners, both in their onsite examinations and inspections and in their other contacts with banking organizations, to emphasize the importance of development and implementation of effective internal credit rating systems and the critical role such systems should play in the credit risk management process at sound large institutions. In part, this SR letter expands upon issues raised in SR letter 98-18 (Lending Standards for Commercial Loans).

This SR letter should be disseminated to the large and complex banking organizations (both foreign and domestic) supervised by the Federal Reserve, as well as other institutions for which Reserve Bank staff believes it would be beneficial. A suggested transmittal letter is attached for your use.

Internal rating systems are currently being used at large institutions for a range of purposes. At one end of this range they are primarily used to determine approval requirements and identify problem loans, while at the other they are also an integral element of credit portfolio monitoring and management, capital allocation, pricing of credit, profitability analysis, and detailed analysis to support loan loss reserving. Internal rating systems being used for the latter purposes should be significantly richer and more robust than systems used for the former purposes.

As with all material bank activities, a sound risk management process should adequately illuminate the risks being taken and apply appropriate controls to allow the institution to balance risks against returns and the institution's overall appetite for risk, giving due consideration to the uncertainties faced by lenders and the long-term viability of the bank. Accordingly, large banking organizations should have strong risk rating systems. These systems should take proper account of gradations in risk and the overall composition of portfolios in originating new loans, assessing overall portfolio risks and concentrations, and reporting on risk profiles to directors and management. Moreover, such rating systems also should play an important role in establishing an appropriate level for the allowance for loan and lease losses, conducting internal bank analysis of loan and relationship profitability, assessing capital adequacy, and possibly performance-based compensation.

For their part, examiners should evaluate the adequacy of internal credit risk rating systems, including ongoing development efforts, when assessing both asset quality and the overall strength of risk management at large institutions. Recognizing that a strong risk rating system is an important element of sound credit risk management for such institutions, examiners should specifically evaluate the adequacy of internal risk rating systems at large institutions as one factor in determining the strength of credit risk management. In doing so, examiners should be cognizant that an internal risk identification and monitoring system should be consistent with the nature, size and complexity of the banking organization's activities. In this context, those institutions with significant involvement in relevant secondary market credit activities, such as securitization of business loans or credit derivatives, should have more elaborate and formal approaches for managing the risks associated with these activities. Whether or not they are active in such secondary market credit activities, however, larger and complex institutions typically would require a more structured and sophisticated set of arrangements for managing credit risk than smaller regional and community banks. In performing their evaluation, examiners should also consider whether other elements of the risk management process might compensate for any specific weaknesses attributable to an inadequate rating system.

In addition, examiners should review internal management reports to determine whether the portion of bank loans in lower-quality pass grades has grown significantly over time, and whether any such change might have negative implications for the adequacy of risk management or capital at the institution. Examiners should also consider whether a significant shift toward higher-risk pass grades, or an overall large proportion of loans in a higher-risk pass grade, should have negative implications for the institution's asset quality rating, including the adequacy of the loan loss reserve. To some extent such reviews are already an informal part of the current examination process.

Examiners should also continue the longstanding practice of evaluating trends in categories associated with problem assets. Examiners should discuss these issues, including plans to enhance existing credit rating systems, with bank management and directors and should incorporate comments on the adequacy of risk rating systems and the credit quality of the pass portfolio in examination reports, noting deficiencies where appropriate.

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