Loan grading is a classification system that involves assigning a quality score to a loan based on a borrower’s credit history, quality of the collateral, and the likelihood of repayment of the principal and interest. A score can also be applied to a portfolio of loans. Loan grading is part of a lending institution’s loan review or credit risk system and is typically a facet of the credit underwriting and approval processes.
There are many purposes for a loan review system, such as identifying loans with credit weaknesses so banks can take steps to minimize credit risk, identifying trends affecting the collectability of the loan portfolio, and meeting financial and regulatory reporting requirements.
Key Takeaways
- Loan grading is a classification system that involves assigning a quality score to a loan based on a borrower’s credit history, quality of the collateral, and the likelihood of repayment of the principal and interest.
- Loan grading is part of a lending institution’s loan review or credit risk system and is typically an aspect of the credit underwriting and approval processes.
- The score considers the borrower’s credit score along with several other indicators of credit risk from the credit report and loan application, such as guarantor support, repayment history, cash flow, projected yearly expenses, etc.
How Loan Grading Works
Managing lending capacity effectively is crucial for a bank’s success. Consequently, banks must develop a loan grading system that accurately evaluates credit risk, or the probability of loss due to a borrower’s failure to make payments. These processes help examiners and management make well-informed lending decisions. While there is no universally accepted system for grading loans, the Federal Deposit Insurance Corporation (FDIC) mandates that all lending institutions have a loan review system. Larger institutions may even have separate departments dedicated to loan reviewing.
Depending on size and complexity, banks employ diverse methodologies. Community banks might use broader factors to evaluate loan risk, whereas larger institutions might rely on quantitative approaches to monitor credit risk. When assigning a score to a loan, an examiner will review the loan documentation, collateral, and the borrower’s financial statements. The score integrates not only the borrower’s credit score but also several indicators of credit risk from the credit report and loan application. These indicators might include the level of guarantor support, repayment history, cash flow, projected yearly expenses, etc.
Smaller institutions typically use an expert judgment system, where a loan officer assigns a grade based on their experience and knowledge. On the other hand, some banks use quantitative scorecards or other modeled approaches that allow for adjustments based on qualitative judgments. As there are no regulatory mandates dictating the structure of a loan grading system, banks have the freedom to develop a system suited to their size and complexity.
Related Terms: Credit History, Collateral, Credit Score, Loan Portfolio, Repayment Risk.
