WHY COMPUTE CREDIT RISK GRADING(CRG)
Credit Risk Grading (CRG)
Credit Risk Grading (CRG):
The risk that an issuer of debt securities or a borrower may default on his or her obligations or that the payment may not be made on a negotiable instrument that is called credit risk. The use of a discriminate equation to classify the credit risk is called credit risk grading.
Credit risk grading is the process which helps the sanctioning authority to decide whether to lend or not to lend, what should be the lending price, what should be the extent of exposure, what should be the appropriate credit facility, what are the various facilities, what are the various risk mitigation tools to put a cap on the risk level. It Provides detailed and formalized credit evaluation process risk identification, measurement, monitoring and control Define target markets, risk acceptance criteria, credit approval authority, maintenance procedures and guidelines for portfolio management .
The Credit Risk Grading system should define the risk profile of borrower’s to ensure that account management, structure and pricing are adequate with the risk involved. Risk grading is a key measurement of a Bank’s asset quality, and as such, it is essential that grading is a robust process. All facilities should be assigned a risk grade. Where deterioration in risk is noted, the Risk Grade assigned to a borrower and its facilities should be immediately changed.
CRG is an important tool for credit risk management as it helps the banks and financial institutions to understand various dimensions of risk involved in different credit transaction. It provides a better assessment of the quality of credit portfolio of a bank.
Components of credit risk grading:
Financial risk:
The uncertainty of future incomes due to the company’s financing. Financial risk management refers to the practices used by corporate finance managers and accountants to limit and control uncertainty in the firm’s total portfolio. Financial risk management aims to minimize the risk of loss from unexpected changes in the prices of currencies, interest rates, commodities, and equities.
Financial risk is the principal components of credit risk grading. Two sets of financial ratio helps measure financial risk: 1. Balance sheet ratios 2. Earnings or cash flow available to pay fixed financial charges.
Business/Industry risk:
The risk related to the inability of the firm to hold its competitive position and maintain stability and growth in earnings. The uncertainty of income caused by the firm’s income. It is generally measured by the variability of the firm’s operating income over time. The Lending Guidelines should clearly identify the business/industry sectors that should constitute the majority of the bank’s loan portfolio. For each sector, a clear indication of the bank’s appetite for growth should be indicated (as an example, Textiles: Grow, Cement: Maintain, Construction: Shrink
Management Risk:
The risks associated with ineffective, destructive or under performing management, which hurts shareholders and the company or fund being managed. This term refers to the risk of the situation in which the company and shareholders would have been better off without the choices made by management. Management risk is another principal component of credit risk grading. There is some Management risk is given below:
1. Experience/relevant background
2. Track record of management in see through economic cycles
3. Succession
4. Reputation
Security risk:
Security risk mainly depends on the potential owners or other source. Future is always uncertain, can take any step to minimize uncertain situation to the potential owner. Security risk is another principal component of credit risk grading. There is some Security risks are given below:
- Perishablilty
- Enforceability /Legal structure
- Forced Sale Value (calculations of force sale value should be at least guided by
- Bangladesh Bank guidelines)
Relationship risk:
Relationship risk mainly based on supplier and customer relation to the entrepreneur. If the entrepreneur can make a good relation to the customer or supplier he or she also get the loan at a lower rate.
Importance for an entrepreneur Credit Risk Grading
Importance for an entrepreneur
1. It helps the entrepreneur to get the loan easily from a bank. If an entrepreneur know the credit risk grading very well. And grading score is good for him or her. He or she will get the loan from a bank. Credit risk grading indicates the Good Financials situation, Valuable and operating business franchises, stable operating environment adequate liquidity and earnings. Acceptable management. So it helps the entrepreneur to get the loan easily from a bank.
2. It helps the entrepreneur to understand the various risks which is involved with his or her business. The entrepreneur can understand the key risk component factors which may be broadly categories under Quantitative and Qualitative factors. When an entrepreneur compute his or her credit risk grading. He or she can identify financial risk, business risk, management risk, security risk.
HOW TO COMPUTE CREDIT RISK GRADING
1. Identify all the Principal Risk Components:
2. Allocate weight to Principal Risk Components
3. Establish the Key Parameters under each risk components:
4. Assign weight to each of the key parameters.
5. Add all the weight of the key parameters to have an overall score:
6. Assign a grade based on the total weights:
