Credit Risk Grading (CRG) - Importance and components
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.
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.
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.
Importance of Credit Risk Grading:
1. Well-managed credit risk grading systems promote bank safety and soundness by facilitating informed decision-making.
2. Grading systems measure credit risk and differentiate individual credits and groups of credits by the risk they pose. This allows bank management and examiners to monitor changes and trends in risk levels.
3. The process also allows bank management to manage risk to optimize returns.
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.
Business/Industry risk: The risk related to the inability of the firm to hold its competitive position and maintain stability and growth in earnings. It is generally measured by the variability of the firm’s operating income over time.
Management Risk: The risks associated with ineffective destructive or under-performing management, which hurts shareholders and the company or fund being managed.
Security risk: Security risk mainly depends on the potential owners or other source. There is some Security risks are given below:
- Perishability,
- Enforceability/Legal structure, and
- Forced Sale Value.
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.
How to Compute Credit Risk Grading
- Identify all the Principal Risk Components.
- Allocate weight to Principal Risk Components.
- Establish the Key Parameters under each risk components.
- Assign weight to each of the key parameters.
- Add all the weight of the key parameters to have an overall score.
- Assign a grade based on the total weights. The grading method assumes simple weighted average addition of the risk criteria.
Category: Credit Risk Grading (CRG), DAIBB Tutorial, Lending Operations and Risk Management, LRM Tutorial
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