Risk Rating

A risk rating is a grade a lender gives each loan to show how likely it is to be repaid as agreed. Most lenders use a numbered scale. The top grades mean little risk, and the bottom grades mean serious trouble or an expected loss.

In the US, bank regulators use standard categories for loans, and most lenders' scales map to them:

• Pass. No notable weakness. Lenders usually split pass loans into several grades.
• Special mention. A potential weakness that could hurt repayment if nobody corrects it.
• Substandard. A well-defined weakness, such as poor cash flow or weak debt coverage, with a real chance of some loss if it isn't fixed.
• Doubtful. Full collection is highly unlikely, but the exact loss isn't known yet.
• Loss. Uncollectible, and should be charged off.

Loans rated substandard, doubtful or loss are together called "classified" loans.

Why it matters for lenders

Risk ratings turn a portfolio into something a lender can manage. US bank examiners say ratings should shape who may approve a loan, how it's priced and how it's structured. Ratings also feed the loan loss reserve. Under current expected credit loss (CECL) accounting, many lenders group loans by rating to estimate future losses.

Ratings only work if they're current. Examiners expect ratings to change when the borrower's condition changes, not just once a year. A loan still rated "pass" after two failed covenant tests misleads management, the board and investors. Downgrades should also trigger action, such as closer monitoring, a workout plan or a larger reserve.

Smaller lenders, including community development financial institutions (CDFIs) and private lenders, use risk ratings for the same reasons. Investors and funders often ask to see the portfolio broken down by grade.

How it works in practice

A CDFI uses a seven-grade scale. The underwriter proposes a grade at approval, based on cash flow, collateral, credit history and management strength, and the credit memo explains it. The approver confirms or changes it.

After closing, the rating is reviewed each year when the borrower sends financial statements, and any time something changes. Eight months in, a restaurant borrower falls 35 days past due, and sales have dropped. Under the lender's policy, delinquency of more than 30 days triggers a formal review. The loan officer downgrades the loan to special mention and sets up monthly check-ins.

Many lenders keep ratings in a spreadsheet updated each quarter, so downgrades lag behind reality. Keeping the rating, its history and the reason for each change on the loan record gives a current view. It also shows examiners that ratings respond to events.