A TYPICAL CREDIT RATING SYSTEM
Category: Risk Management in Banking
(TABLE 1)
The following are definitions of the risk levels of Borrowing Facility:
1. Substantially Risk Free
Borrowers of unquestioned credit standing at the pinnacle of credit quality. Basically, governments of major industrialized countries, a few major world class banks and a few multinational corporations.
2. Minimal Risk
Borrowers of the highest quality. Almost no risk in lending to this class. Cash flows over at least 5 years demonstrate exceptionally large and/or stable margins of protection and balance sheets are very conservative, strong and liquid. Projected cash flows (including anticipated credit extensions) will continue a strong trend, and provide continued wide margins of protection, liquidity and debt service coverage. Excellent asset quality and management. Typically large national corporations.
3. Modest Risk
Borrowers in the lower end of the high quality range. Very good asset quality and liquidity; strong debt capacity and coverage; very good management. The credit extension is considered definitely sound; however, elements may be present which suggest the borrower may not be free from temporary impairments sometime in the future. Typically larger regional or national corporations.
4. Below Average Risk
The high end of the medium range between the definitely sound and those situations where risk characteristics begin to appear. The margins of protection are satisfactory, but susceptible to more rapid deterioration than class 3 names. Some elements of reduced strength are present in such areas as liquidity, stability of margins and cash flows, concentration of assets, dependence upon one type of business, cyclical trends, etc., which may adversely affect the borrower. Typically good regional or excellent local companies.
5. Average Risk
Borrowers with smaller margins of debt service coverage and where definite elements of reduced strength exist. Satisfactory asset quality and liquidity; good debt capacity and coverage; and good management in all critical positions. These names have sufficient margins of protection and will qualify as acceptable borrowers; however, historic earnings and/or cash flow patterns may be sometimes unstable. A loss year or a declining earnings trend may not be uncommon. Typically solid local companies. May or may not require collateral in the course of normal credit extensions.
6. Management Attention Risk
Borrowers who are beginning to demonstrate above average risk through declining earnings trends, strained cash flow, increasing leverage, and/or weakening market fundamentals. Also, borrowers which are currently performing as agreed but could be adversely impacted by developing factors such as, but not limited to: Deteriorating industry conditions, operating problems, pending litigation of a significant nature, or declining collateral quality/adequacy. Such borrowers or weaker typically require collateral in normal credit extensions.
Borrowers generally have somewhat strained liquidity; limited debt capacity and coverage; and some management weakness. Such borrowers may be highly leveraged companies which lack required margins or less leveraged companies with an erratic earnings records. Significant declines in earnings, frequent requests for waivers of covenants and extensions, increased reliance on bank debt, and slowing trade payments are some events which may occasion this categorization.
7. Potential Weakness
Borrower exhibits potential credit weakness or a downward trend which, if not checked or corrected, will weaken the asset or inadequately protect the bank’s position. While potentially weak, the borrower is currently marginally acceptable; no loss of principal or interest is envisioned. Included could be turnaround situations, as well as those previously rated 6 or 5, names that have shown deterioration, for whatever reason, indicating a downgrading from the better categories. These are names that have been or would normally be criticized “Special Mention” by regulatory authorities.
8. Definite Weakness; No Loss
A borrower with well defined weakness(es) that jeopardize the orderly liquidation of the debt. Borrowers that have been or would normally be classified “Substandard” by regulatory authorities. A substandard loan is inadequately protected by the current sound worth and paying capacity of the obligor. Normal repayment from this borrower is in jeopardy, although no loss of principal is envisioned. There is a distinct possibility that a partial loss of interest and/or principal will occur if the deficiencies are not corrected.
9. Potential Loss
A borrower classified here has all weaknesses inherent in the one classified above with the added provision that the weaknesses make collection of debt in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Serious problems exist to the point where a partial loss of principal is likely. The possibility of loss is extremely high, but because of certain important, reasonably specific pending factors, which may work to the advantage and strengthening of the assets, its classification as an estimated loss is deferred until its more exact status may be determined. Pending factors include proposed merger, acquisition, or liquidation, capital injection, perfecting liens on additional collateral, and refinancing plans.
10. Loss
Borrowers deemed incapable of repayment of unsecured debt. Loans to such borrowers are considered uncollectible and of such little value that their continuance as active assets of the bank is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be effected in the future.