For credit unions, a popular instrument for monitoring credit risk is a standardized risk rating system, which can serve several purposes. These systems often determine credit approval processes, covenants placed on the member business and how loans should be priced. They can also form the basis for broader risk management practices – for instance, setting the reserve, stress testing the loan portfolio, setting risk appetites and strategic planning. Unfortunately, there are no specific requirements for credit risk rating systems, though there are several expectations outlined in the NCUA Examiners Guide. That said, credit unions have the ability to customize a rating system to best fit the unique risk characteristics of their institution.

For most credit unions, internally-developed risk rating systems are used. These systems typically use a scorecard rating based on level of risk in Pass and Criticized categories. Some institutions may have one system for all loan types, while others may have different templates for various loan types.

The goal of a risk rating system should be to assess a member business’ potential amd future payment volatility by reviewing several characteristics. For instance, when assessing the current financial health of a member’s business, global cash flow, global debt service coverage, global debt to equity, and financial statement strength should be considered. To measure a particular loan – proposed or existing – the credit union may look at loan to value or quality of the collateral. In addition, financial projections for the member business and industry health should be reviewed and incorporated into the grade. If the member is in a declining industry, it suggests that the future of that business and its ability to repay debt may be problematic. The important item to remember here is to focus on future performance, not just historical data.

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