Navigating Risk: Crafting a Sound Risk Rating Matrix

Posted on November 1, 2023 Published by

In the complex world of finance, where lending forms the bedrock of business transactions, risk assessment is a fundamental art. Risk rating matrices can be invaluable tools for evaluating borrowing relationships across various sectors, including commercial, agricultural, and investment real estate. However, before diving into the world of risk rating matrices, there are several considerations to keep in mind. Learn more below on Navigating Risk: Crafting a Sound Risk Rating Matrix.

Focus on the foundation

While a multitude of factors come into play when making a risk matrix, two should take center stage: cash flow of the primary source of repayment and collateral coverage. These two factors should represent 50% to 65% of the overall weighting of the risk rating matrix. The remaining factors could include guarantor strength, global cash flow, management experience, balance sheet strength, tenant mix, and more. It’s important to understand that the balance between these factors can vary based on your specific business context.

Be objective

Objective criteria are the foundation of an effective risk rating matrix. Unlike subjective measures that can be influenced by individual perceptions or opinions, objective criteria are clear and consistently calculated. They provide a common language for evaluating risk, ensuring everyone has a common understanding of risk across the portfolio.

Tailor for industry specificity

One size does not fit all. Depending on the composition of your loan portfolio, we recommend creating separate matrices for commercial (C&I), investment real estate, and agricultural lending. These distinct matrices should consider the unique characteristics and metrics defining each sector. This industry-specific approach enhances your ability to accurately assess the risk profiles of borrowers within each segment.

Allow for flexibility

While a risk rating matrix provides structure, it cannot capture every nuance that influences a borrowing relationship’s risk profile. It’s essential to build flexibility into your system. Allow for the override of matrix scores for factors outside the matrix’s purview. For instance, if a borrower secures a new tenant who significantly improves the primary source of repayment, this positive change should be reflected in the assessment, even if it falls outside the initial matrix.

Be cautious with proforma data

When working with proforma or budgeted cash flow figures, particularly in cases involving construction projects, business start-ups, or ownership changes, a more conservative approach is advisable. In these scenarios, consider capping the rating indicated by the risk matrix in order to account for the inherent uncertainty in these projections.

Potential Pitfalls

While you are reviewing your matrix, be aware of some of the potential pitfalls:

Artificial Cash Flow Improvements

Avoid assigning improved risk ratings solely based on structural changes rather than operational performance. A loan re-amortization, for instance, should not automatically translate to an improved risk rating if it doesn’t reflect improved operational performance.

Excessive Overrides

While some flexibility is essential, too many overrides (typically exceeding 10% of cases) might indicate a misalignment between the matrix and your risk tolerance. Consistently overriding the matrix, even when taking a conservative approach, can suggest that your risk rating methodology needs fine-tuning. Keep a vigilant eye on overrides, and regularly report them to management or the board to gain insights for matrix adjustments.

Major Changes:

When modifying your risk rating matrix, opt for gradual, incremental changes rather than a complete overhaul. Major changes can disrupt the integrity of your risk rating system and make it harder to track the effectiveness of adjustments.

A well-constructed risk rating matrix is an indispensable tool for lending institutions. By following these considerations, you can ensure your matrix aligns with your unique risk appetite and that it evolves with your organization’s changing landscape. The careful balance of these elements will allow you to make informed and precise borrowing decisions, reduce risk and enhance the overall quality of your loan portfolio.

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