What it means
A risk grade turns a messy judgement into a single, easy-to-read rating. Banks grade their loans, insurers grade policyholders, and credit rating agencies grade bonds, all using a scale that runs from very safe to very risky.
The scale might be letters (AAA down to D) or numbers (1 to 10), but the idea is the same. For a non-finance professional, the key point is that a grade is a shortcut for a lot of analysis underneath.
Behind a grade of 4 there might be a review of the borrower's cash flow, debt levels, industry outlook and payment history. The grade summarises all of that so that managers, auditors and regulators can read a portfolio at a glance.
Grades drive real decisions. A lender may approve low-risk grades automatically, send middle grades to a credit committee, and decline the worst ones.
Interest rates, collateral demands and the amount of capital set aside for losses all tend to rise as the grade worsens. Grades are also linked to numbers.
Each grade is usually tied to a probability of default, which is the chance the borrower fails to repay within a set period, often one year. Over time a lender checks whether its grade 3 borrowers really default at the rate that grade promised, and adjusts the scale if they do not.
One nuance is that grades are only as good as the process behind them. Different institutions use different scales, so a 3 at one bank is not necessarily a 3 at another.
Grades also lag reality, since a company can deteriorate faster than its rating is reviewed.
In practice
Real-world examples.
Example
A regional bank grades each commercial customer from 1 to 10 every year. Loans graded 1 to 3 are approved by a branch manager, while grades 8 to 10 are placed on a watch list and reviewed monthly.
Example
A wholesaler grades its customers A, B and C before offering credit terms. Grade A customers get 60 days to pay, grade B get 30 days, and grade C must pay cash on delivery.
Example
An insurance company grades restaurants by fire risk after inspecting kitchens and sprinkler systems. A restaurant with modern extraction equipment gets a low-risk grade and a cheaper premium than one with an old deep fryer setup.
Formula
Calculation
Grades feed into the expected loss on a loan:
Expected Loss = PD x LGD x EAD
PD is the probability of default for the grade, LGD is the loss given default (the share of the exposure lost if the borrower fails), and EAD is the exposure at default (the amount owed at that moment).
Worked example: A bank lends $500,000 to a company graded 4 on its internal 1 to 10 scale. Grade 4 carries a PD of 2%, and the bank expects to lose 40% of the balance after selling collateral.
Expected Loss = 0.02 x 0.40 x $500,000
Expected Loss = 0.008 x $500,000
Expected Loss = $4,000
If the same loan were graded 7 with a PD of 8%, the expected loss would be 0.08 x 0.40 x $500,000 = $16,000, four times higher for the same loan size.Case study
Seen in the real world.
Harbourline Finance is a fictional lender that wrote loans to small manufacturers using a five-grade scale. In an illustrative review, the credit team found that their grade 2 borrowers were defaulting at nearly the same rate as grade 3 borrowers, so the two grades were not really telling them apart.
The team rebuilt the scale with ten grades and added cash flow cover and customer concentration to the scoring. Pricing was then tied to the new grades, so the safest borrowers paid less and the riskiest paid more. Within two years the lender's loss rates matched the expectations of each grade much more closely, which made its capital planning easier.
Watch out
Common mistakes.
- Assuming all grading scales are the same. A grade 3 at one lender, or a BBB from one rating agency, may not mean the same as a 3 or BBB elsewhere.
- Treating a grade as permanent. Borrowers change, so a grade set two years ago may be badly out of date.
- Believing a top grade means zero risk. Even the safest grade carries some chance of loss, and a low-risk grade can still default.
Questions
People also ask.
Who sets risk grades?
Banks and insurers usually set them internally, while credit rating agencies publish grades for bonds and companies.
Are risk grades the same as credit scores?
Not quite. A credit score is usually a number for an individual consumer, while a risk grade is a broader band used for companies, loans or portfolios.
How often should grades be reviewed?
Most lenders review them at least annually, and sooner if the borrower misses a payment or its financial results change sharply.
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