Change sought to US credit exposure classification
WASHINGTON - Four federal US bank regulatory agencies announced in March that they are seeking comment on proposed changes to the supervisory framework for classifying commercial credit exposures.
The current classification system is used both by regulators and banks to measure the level of credit risk in commercial loan portfolios, and to benchmark credit risk across institutions, as well as assess the adequacy of a bank's capital to meet loan and lease losses.
This classification system dates back to 1938 with only minor revisions made over the last seven decades. The joint proposal from the agencies would replace the current commercial credit classification categories (special mention, substandard, and doubtful) with a two-dimensional framework: one dimension would measures the risk of a borrower defaulting on his or her obligations (borrower rating), and a second focused on the loss severity the bank would likely incur in the event of the borrower's default (facility rating).
The joint proposal would increase consistency among agencies and clarify issues that have historically led to rating differences between bankers and examiners and among the regulatory agencies. Such differences have sometimes resulted in split ratings (facilities that are assigned multiple ratings). In addition, the proposal would provide a clearer methodology for rating asset-based lending facilities.
Differing applications of the current classification can occur because the existing classification system focuses primarily on borrower weaknesses and the possibility of loss without specifying how factors that mitigate the loss, such as collateral and guarantees, should be considered in the rating assignment. Risk mitigants such as collateral and the facility's structure can, however, reduce the institution's risk of incurring a loss.
The existing classification system does not adequately address how (when rating an asset) to reconcile the risk of the borrower's default with the estimated loss severity of the particular facility. As a result, the system dictates that transactions with significantly different levels of expected loss receive the same rating. This limits the effectiveness of the current classification system in measuring an institution's credit risk exposure, say the agencies.
The two-dimensional rating framework that the agencies now propose would considers a borrower's capacity to meet its debt obligations separately from the facility characteristics that influence loss severity. By differentiating between these two factors, a more precise measure of an institution's level of credit risk should be achieved. The proposal includes three borrower rating categories, "marginal," "weak" and "default." Facility ratings would be required only for those borrowers rated default (i.e. borrowers with a facility placed on non-accrual or fully or partially charged off).
Typically, this is a very small proportion of all commercial exposures. For borrowers not rated default, institutions would have the option of assigning the facility ratings along the lines proposed in the framework. The agencies believe that this flexibility will allow institutions with both one-dimensional and two-dimensional internal risk rating systems to adopt the proposed framework. Under the current classification system, institutions with two-dimensional internal credit rating systems have encountered problems translating their internal ratings into the supervisory categories.
Comments on the notice of proposed changes, which was published in the Federal Register on March 28, 2005, will be accepted through June 30, 2005.
