Risk Grade: a Worked Example

Every bank builds its own scale, so a 5 at one bank tells you nothing about a 5 at another. Most start from a financial model fed with the borrower's accounts, then add judgement on the industry, the owners and how the account has been run. An analyst's view can move the model's answer, and a sound system records when it did: the international standard for banks using internal models requires overrides to be identified and their performance tracked.

The same standard requires that a grade be completed or approved by someone who does not directly stand to benefit from the lending, that it be refreshed at least annually, and that it be reset when material information arrives. Banks outside the models regime commonly run similar disciplines of their own. In Australia the prudential standard requires an internal grading system where that suits the institution's scope, scale and complexity. Who confirms the grade is a matter of each bank's design, though it often sits with a credit function rather than the relationship manager.

Capital needs a caution. It moves with the grade mainly at a bank accredited to use its own models, the internal-ratings approach used by the largest banks in each of the three markets. A bank on the standardised approach generally takes its risk weight from the regulator's table, by exposure class and features such as an external rating, loan-to-value ratio or the size of the business, so a move between internal grades does not by itself change the requirement. There is one exception. For unrated corporates, Australia's standard (above its small-business size line) and the UK's from January 2027 let a bank with regulatory approval sort borrowers into investment grade or below on its own assessment, so a downgrade across that line can move the weight. Such a bank still uses the grade for price, authority and monitoring.

A distributor of welding gases and equipment, constructed for this page like every figure in it, has a US$15m term loan at a margin of 2.30 per cent, fixed for the three-year facility, with a bank that uses its own models. Earnings have fallen and the last two sets of accounts arrived late. At the annual review the bank moves the borrower from grade 5 to grade 7 on its scale. Loss given default stays at 40 per cent because the security has not changed. The bank holds capital of 11 per cent of risk-weighted assets and looks for a 12 per cent return on it. All of these belong to the example and are not market norms.

Nothing in the facility moved, because the agreement fixes the margin until it ends. Inside the bank, the loan now needs US$0.41m more capital and has almost stopped paying for its funding premium and upkeep. The renewal that could be signed by two senior credit officers at grade 5 goes, under this bank's matrix, to credit committee at grade 7. The file returns every six months, not every twelve. The next time the bank can reset the price, it will know exactly what the loan has been costing it. At a bank on the standardised approach the capital line would usually stay flat; the other three would still move.

A credit rating from an agency is published, is usually paid for by the company rated, and can be compared across issuers. Most mid-market borrowers do not have one. The grade is a private opinion on the bank's own scale. A bureau credit score is different again, built from payment and filing data by a third party, and may be one input to a grade without being the grade.

The grade also differs from what it maps to. Probability of default is the estimated number behind a grade, and it describes the borrower. For corporate exposures the internal-models standard requires a second dimension for the transaction, so better security can lower loss given default without improving the borrower's grade at all. A watch list is a management list; a downgrade may put a name on it, but the two are separate records.

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The grade is settled before the argument starts. It fixes who will read the paper and the price the proposal has to reach, so an analyst who thinks a grade is wrong has to deal with it first. A borrower's visible signals feed it: tightening covenant headroom, a falling trend in cover, and information that arrives late or thin.

A serious downgrade can also change the provision. Under IFRS 9 and its local equivalents, a significant increase in credit risk moves a loan from a twelve-month to a lifetime measure of expected loss, and a grade movement is commonly one of the indicators a bank uses. For the borrower, the useful question at a review is what changed since last year and what would change it back, because the answer identifies which of its numbers and habits the bank is reading.