What are the principal advantages to a bank of using a credit-scoring system to evaluate a loan application? Are there any significant disadvantages to a credit rating scoring?

Credit Scoring / Customer Credit Risk Rating System

Credit scoring is an internally developed assessment model of Bank, which helps the banks in achieving the following:

• - Criteria for determining initial credit limit
• - Qualitative and quantitative assessment of credit requests
• - Determines the extent of relationship with each credit customer
• - Forms the basis of limit enhancement for each credit customer
• - Maintains an overall risk profile of the entire credit portfolio of the company.

Types of Credit Risk Rating

A dual risk rating system shall be followed in the bank i.e. separate rating shall be assigned to customer, based on the general creditworthiness and rating to each facility representing the nature, tenor, security/collateral, etc. The two dimensional credit ratings increase accuracy/consistency with the Basel requirements and State Bank of Pakistan guidelines on the internal risk ratings.

A two dimensional credit rating system calculates Expected Loss (EL) as the product of obligor and facility risk characteristics. The customer risk rating is described by the probability that it will default and the facility risk by the Loss Given Default (LGD). These two elements are separately recorded and used jointly to compute an EL for a credit exposure.

Customer Risk Rating (CRR) represents the risk rating assigned to customers on a clean risk basis, i.e. without considering security and collaterals. The rating is determined by assigning score to numerous key and crucial quantitative & qualitative risk factors. The rating shall be based on the customer's expected performance, which is critically and professionally examined from the historical performance and its future prospects in the light of conditions that may occur during the tenor of the facilities. CRR determines the Probability of Default (PD).

Facility Risk Rating (FRR) is related to the recoverability under each facility extended by the Bank to customers from the underlying assets financed and from any additional security / collateral obtained by the bank. The FRR depicts LGD.

CRR and FRR will be assigned separately as required by the regulator.

Risk Rating Categories

Classification of risk rating is required to categorize the degree of risk to bank in each custorner and facility. However, if there are too many grades, assigning customer rating becomes too time consuming or subjective and cumbersome. On the other hand, if there are few grades, it is not possible to differentiate risk between customers satisfactorily.

Therefore, the bank will use a moderate-scale of twelve-point scale for CRR which is also prescribed by the SBP. The scale is divided between nine performing and three default /non-performing ratings. A descriptive snapshot of Risk Rating, mapped to SBP scale is mentioned below:

Customer Risk Rating (CRR) Categories:

 

	Customer Risk Rating		Score Range			Description Risk Rating			Risk to the Bank			Quality of Credit
	Bank	SBP
	1	1	91 -100			Superior			Minimal Risk			Investment Grade
	2	2	81 - 90			Very Good			Very Low Risk
	3	3	71 - 80			Good			Low Risk
	4	4	66 -70			Satisfactory			Moderate Risk			Sub- Investment Grade
	5	5	60 - 65			Acceptable			Acceptable Risk
	6	6	56 -59			Average			Average Risk			Marginal Credit
	7	7	51 -55			Below Average			Below Average Risk
	8	8		46 – 50			Watch			Potential for Default			Vulnerable to
	9	9		41 – 45			Border Line			Unacceptable Risk			Default
	10	10	35 – 40			Sub-Standard			Partial Loss			Classified Credit
	11	11	25 – 34			Doubtful			Fully Repayment Questionable
	12	12	upto 25			Loss			Loss

Facility Risk Rating (FRR) Categories:

Facility Risk Rating Definition	Score Range	Representation of Loss Min.    Max.
A	45 -50	0 -  05%
B	35 -44	06 - 20%
C	25 -34	21-  40%
D	15 -24	41 -  60%
E	05 -14	61 -   80%
F	Less than 5	81- 100%

FRR Risk Factors:

Description of Factors	Max. Weight	Percentage of Total Weight
a) Tenor of Facility	5	10%
b) Product	5	10%
c)  Security/Collateral	20	40%
d) Ranking of Charge	5	10%
e)  Control	5	10%
f)  Liquidity	5	10%
g) Track Record in Recovery	5	10%
Total	50	100%
Discounted Factors
h) Deficiency in Documentation	-30	-60%

CRR Risk Factors:

	Section	Risk Factors	Max. Weight
	Financial Statements         (Qualitative and Quantitative Risk Factors)	b)   Ranking of Auditing Firm	4
		c)   Types of  Financial Statements	4
		d)   Quality of Financial Statements	3
		e)   Operating History	4
		f)    Sales/Revenue Growth	4
		g)   Net Profit Margin Growth	4
		h)   Operating Cycle	5
		i)    Mark-up Coverage	4
		j)    Leverage	4
		k)   Current Ratio	4
		l)    Tangible Net Worth	5
		m)  Debt Service Coverage	5
	Sub-Total:		50
	Non-Financial Risk   (Qualitative Risk Factors)	n)Industry Risk o)Business Risk p)Quality of Management q)Track Record	10
			10
			20
			10
	Sub-Total:		50
	Total:		100

Kindly Bookmark this Post using your favorite Bookmarking service: