With balance sheets returning to strength after years ofrecession and restricted lending, there are two main issues thatcredit unions have to address — low interest rates and increasedregulation — which show no sign of letting up.

These two challenges pull credit unions in opposite directions.Historically low interest rates have led to a razor-thin spread,pushing credit unions to take on more risk in search of growth.Meanwhile, the heightened regulatory environment often hasprecisely the opposite effect — reigning in risk to ensure balancesheets are capable of withstanding stress tests and economicshocks. Credit unions looking to actively expand have the addedchallenge of competing in a crowded market.

Navigating this dilemma — growing the portfolio whilequantifying and managing risk — is thus emerging as a key challengethat credit unions face in the post-crisis era.

It is in response to this challenge that having a comprehensiveand precise risk rating system becomes absolutely crucial. Thoughmany credit unions have a process in place for generating riskratings, in many cases it is plagued by several well-knownissues.

Risk ratings aren't templated or standardized.The most fundamental problem is not having a standard risk ratingmodel in place. In practice, this may mean that risk ratings areset by the whims of lenders based on perceived risk or pastbehavior. That may be part of the risk rating, but it doesn'tobjectively capture or predict future risk. Instead there should bedefined risk criteria and thresholds.

Risk rating policy isn't consistently applied.Even credit unions that have a formal risk rating model in placeoften struggle with its inconsistent application: Some lenders mayuse it but only for certain members or they don't use the propertemplates.

These faults then impact a number of critical functions in thecredit union — from accurately pricing the loan, to loanadministration and finally to calculating the ALLL.

Why should credit unions care about risk rating?

The short answer is because the NCUA and auditors do. Indeed, ina handbook on credit risk published by the Office of theComptroller of the Currency, regulators begin by stating:

Credit risk is the primary financial risk in the bankingsystem and exists in virtually all income-producing activities. Howa bank selects and manages its credit risk is critically importantto its performance over time; indeed, capital depletion throughloan losses has been the proximate cause of most institutionfailures. Identifying and rating credit risk is the essential firststep in managing it effectively.

There are also non-regulatory reasons to care about having aneffective risk rating process: Risk rating is the primary toolfor quantifying and managing, not restricting, risk.

Each credit union has a particular risk appetite — the amount ofrisk that it is willing to take on given a host of considerations:The desire to grow, the current make-up of the portfolio, theircapital cushion and the interest rate and general economicenvironments. Risk rating is thus not necessarily a means ofrestricting, but rather calibrating and optimizing risk.

There is another added benefit: With a risk rating, the creditunion distills hours of analysis and research into a figure thatcan be readily compared. By giving every credit a numerical riskrating, credit unions can meaningfully compare the riskiness of onedeal to the rest of its portfolio without having to re-analyzespreads and key metrics. In other words:

• It can be tracked over time, to see both the evolution of asingle credit
• It allows for portfolio-wide reporting, showing how riskratings “migrate” through risk levels over time
• It is a consistent and easy way to talk about credit riskthroughout the life of the loan, from underwriting to calculatingALLL

In short, credit unions should take their risk rating processseriously not only because their regulators and auditors do, butalso because it serves as an efficient management tool tocalibrate, track and manage risk.

In today's competitive, low rate environment, where membersoften have more than one option, accurately gauging risk can makethe difference between winning and losing new business. It likewisehelps credit unions guard against taking uncompensated risks,accurately calculate their reserves and conduct a comprehensivestress test. This is why risk rating is the “common language” ofcredit risk management.

KeithPulling is a credit risk consultant at Sageworks. He can be reachedat [email protected].