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What Is Loan Grading?
Let me explain loan grading to you directly: it's a classification system where I assign a quality score to a loan based on the borrower's credit history, the quality of the collateral, and the likelihood that the principal and interest will be repaid. You can also apply this score to an entire portfolio of loans. As part of a lending institution's loan review or credit risk system, loan grading fits right into the credit underwriting and approval processes.
There are several reasons why a loan review system matters. It helps identify loans with credit weaknesses so banks can act to minimize credit risk. It also spots trends that could affect the collectability of the loan portfolio, and it's essential for financial and regulatory reporting.
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 usually an aspect of the credit underwriting and approval processes.
- The score takes into account not only the borrower's credit score but also a combination of several indicators of credit risk from the credit report and loan application, such as the level of 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, so you need a loan grading system that accurately evaluates credit risk—the probability of loss if a borrower fails to make payments. The processes banks use for grading loans assist examiners and management in making sound lending decisions. There's no single correct system for grading loans, but the Federal Deposit Insurance Corporation (FDIC) requires all lending institutions to have a loan review system. Larger institutions might even have dedicated departments for loan reviewing.
Banks develop different approaches based on their size and complexity. Community banks often rely on broader factors to judge loan risk, while larger, more complex institutions use quantitative methods to measure and monitor credit risk. When assigning a score, the examiner reviews the loan documentation, collateral, and the borrower's financial statements. The score considers not just the borrower's credit score but a mix of credit risk indicators from the credit report and loan application—these could include guarantor support levels, repayment history, cash flow, projected yearly expenses, and more.
For smaller institutions, an expert judgment system is common, where a loan officer assigns a grade based on their own judgment and knowledge. Other banks might use quantitative scorecards or modeled approaches that allow for qualitative adjustments. Since regulators don't mandate a specific structure for loan grading systems, it's up to each bank to create one that fits their size and complexity.
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