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May 2025

The Importance of Loan Risk Rating Systems
by Andrew Giltner, Lead Examiner, Supervision and Regulation, Federal Reserve Bank of Chicago

Having a well-defined and consistently applied internal loan risk rating system, or loan grading system, is an essential component of a strong bank credit risk management framework. Accurately identifying credit risk embedded across the loan portfolio will help drive the decisions of bank management and the board of directors regarding the desired capital position and credit reserves to protect against possible future losses. Furthermore, having a clear understanding of a bank’s credit risk profile is crucial for management and the board when overseeing loan portfolio concentrations and establishing strategic initiatives regarding future lending activities. The board’s risk tolerance with respect to other risk areas also influences a bank’s strategic direction of its lending activities. This article summarizes supervisory guidance and expectations concerning internal loan grading systems, outlines the benefits of having a clear and consistently applied rating system, and discusses weaknesses commonly uncovered by examiners during bank examinations.

Supervisory Guidance and Expectations

A loan risk rating system is a method developed and used by bank management to assign an individual loan a rating or grade based on its perceived credit risk according to management’s established criteria and rating scale. The rating system should be commensurate with the size, complexity, and risk profile of a bank’s lending activities. For banks with small, noncomplex, or low-risk loan portfolios, a relatively broad risk rating system with a limited number of risk rating categories may be acceptable. In contrast, larger institutions with complex and higher-risk lending activities should have a more granular grading system with multiple risk grades reflecting more detailed categories. It is the responsibility of bank management to evaluate the scope and complexity of lending activities and develop an appropriate risk rating system. Consistent with safety and soundness standards for state member banks,¹ bank management must “establish a system of independent, ongoing credit review and appropriate communication to management and to the board of directors.” Supervision and Regulation (SR) letter 20-13, “Interagency Guidance on Credit Risk Review Systems,”² provides clarity on an effective credit risk rating framework, which includes:

• formal policies describing factors for assigning risk ratings to individual commercial loans and retail credit portfolios that reflect the risk of default and possible credit losses;
• proper identification of loans that carry higher risk and warrant close attention by management for inclusion on an internal “watch list” for more frequent in-depth monitoring;
• an explanation justifying why particular loans are assigned an adverse risk rating or warrant the special attention of management;
• an evaluation of the effectiveness of approved workout plans for problem credits;
• communication methods to ensure that bank management and the board stay abreast of the condition of, and actions taken by management to mitigate risk associated with, loans warranting special attention or adverse classification; and
• an evaluation of historical losses associated with each risk grade.

In general, individual credit ratings should be assigned to commercial and industrial loans, commercial real estate (CRE) loans, and agricultural loans above management’s established rating definitions that reflect the size, complexity, and risk profile of lending activities. For retail loans (i.e., residential real estate and consumer loans), bankers can follow the guidance in SR letter 00-08, “Revised Uniform Retail Credit Classification and Account Management Policy,”³ which outlines the agencies’ classifications for retail credit.

While bankers have some discretion in the granularity and definitions adopted for risk grades, SR letter 13-18, “Uniform Agreement on the Classification and Appraisal of Securities Held by Depository Institutions,”⁴ contains definitions for assets adversely classified for supervisory purposes as follows:

• A substandard asset is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
• An asset classified as doubtful has all the weaknesses inherent in one that is classified as substandard with the added characteristic that the weaknesses make collection or liquidation in full, based on currently existing facts, conditions, and values, highly questionable and improbable.
• Assets classified as loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be affected in the future. Amounts classified as loss should be promptly charged off.

Management’s internal definitions for adversely classified risk grades should closely mirror these regulatory definitions. Additionally, examiners also use a special mention⁵ risk rating for credits that have potential weaknesses deserving management’s close attention but do not yet warrant adverse classification. A bank’s risk rating system should also have a corresponding special mention risk grade. There are no regulatory expectations for pass or watch risk grades; rather, bankers should exercise judgment when establishing the number of pass and watch grade categories and their corresponding definitions when rating loans that are not adversely classified. Having a single pass grade and a single watch risk grade may be prudent at a smaller bank with limited complexity in its loan portfolio, whereas a larger or more complex bank may have multiple pass and/or watch grades to better refine and segment the loan portfolio based on similar risk characteristics of the underlying borrowers.

Benefits

There are many benefits associated with having a clear and consistently applied internal loan risk rating system. First, accurate risk identification is a critical step to ensure that bank management and the board of directors understand the degree of credit risk inherent in the loan portfolio. With this knowledge, management can effectively mitigate risk by developing commensurate ongoing monitoring and measurement tools to assist in decision-making processes with the goal of proactively controlling the degree of risk exposure. Second, a well-developed risk rating system facilitates consistency and reliability in evaluating credit risk across the loan portfolio and provides a stable framework for the ongoing evaluation and identification of credit risk. An effective loan grading system will properly identify loans deserving additional attention to help mitigate the risk of possible losses. An internal loan watch list should identify any loans that are risk rated as watch as well as loans internally rated as special mention, substandard, doubtful, or loss. This watch list should be frequently discussed and monitored by management and the board with routine and timely updates provided on the financial condition, debt service performance, and outlook for each borrower. In addition, management should require action plans or workout strategies for borrowers on the watch list.

Assigning individual risk ratings should generally follow a risk-based approach applying specific qualitative and quantitative criteria established by management. Banks often establish a rating matrix that captures these specific factors and applies a corresponding weighting for each factor based on its relative importance in driving the overall risk grade. The use of a rating matrix is an excellent approach to ensure that the adopted risk grading method is consistently evaluated and applied against individual loans while documenting the justification for the assigned rating. If the individual risk rating of a loan changes over time, a matrix will allow for the analysis of what specific factors are driving the rating change. Understanding aggregate risk rating changes of loans over time enables management to understand any systemic shifts in credit risk embedded within the loan portfolio and take commensurate actions to proactively minimize potential loss exposure.

Common Weaknesses in a Bank’s Risk Rating System

Inaccurate internal risk grading and risk identification can increase a bank’s credit risk profile and may hamper the ability of bank management and the board to identify credit weaknesses. Inadequate risk rating systems will lead to an inaccurate understanding of a bank’s credit risk profile. These weaknesses may also have a domino effect on the bank’s capital and allowance for credit losses. Weaknesses in risk rating systems may raise safety and soundness concerns and, depending on the severity of the deficiencies, may result in supervisory findings that require corrective action by the board or senior management.

Risk rating systems may be inadequate because of factors such as the inconsistent or untimely application of the adopted methodology; failure to assign risk ratings to all covered commercial and industrial, CRE, and agricultural loans; or failure to report all loans that are risk rated as watch and those that are adversely rated on the bank’s internal watch list for enhanced monitoring. Performing regular independent validation of the internal risk rating system helps bank management assess its accuracy and determine whether enhancements may be necessary.⁶ Regularly scheduled independent loan reviews test the effectiveness of internal risk identification. During safety and soundness examinations, examiners assess a bank’s loan review process and its internal loan grading. Frequent loan downgrades by a bank’s auditors and examiners are a clear signal of weaknesses in the established loan rating system. Loan downgrades can manifest because of a variety of factors, including:

• overreliance on payments being current and a past payment performance without an analysis of the stability of the cash flow repayment source. Even if a loan is current, an adverse classification may be warranted if the borrower is facing cash flow shortfalls, which may affect the borrower’s ability to repay the loan in accordance with the loan agreement.
• placement of too much weight on subjective factors used in a risk rating matrix, such as the borrower’s capabilities, experience, and economic conditions/outlook. Management should ensure that sufficient weight is given to market and economic factors that directly affect a borrower’s financial condition and ability to repay a loan, such as the debt-service-coverage ratio, working capital, liquidity levels, and debt-to-equity ratio.
• overreliance on the collateral position or strength of guarantees when the primary source of repayment (e.g., operating cash flow) is weak. Generally, more weight should be given to the primary source of repayment with emphasis on secondary or tertiary sources.

Conclusion

Implementing a consistent and effective internal loan risk rating system is critical to the timely and accurate identification of credit risk and has other benefits as well. A well-defined internal loan risk rating system:

• establishes clear responsibility for assigning initial ratings and their periodic review;
• promotes consistent risk identification;
• ensures sufficient capital and credit reserves relative to the bank’s credit risk profile; and
• allocates bank resources to enhance the monitoring and oversight of credits rated as watch or worse.

Credit risk is commonly the highest and most impactful risk that influences a bank’s financial performance and its long-term viability. Therefore, establishing an effective loan risk rating system is paramount to ensuring credit risk is consistently and accurately identified and monitored by a bank’s management and board.

• ¹ See 12 C.F.R. Part 208, Appendix D-1, “Interagency Guidelines Establishing Standards for Safety and Soundness,” available at www.ecfr.gov/current/title-12/chapter-II/subchapter-A/part-208.
• ² See SR letter 20-13, available at www.federalreserve.gov/supervisionreg/srletters/SR2013.htm.
• ³ See SR letter 00-08, available at www.federalreserve.gov/boarddocs/srletters/2000/SR0008.htm.
• ⁴ See SR letter 13-18, available at www.federalreserve.gov/supervisionreg/srletters/sr1318.htm.
• ⁵ See SR letter 93-30, “Interagency Policy Statements on Supervisory Initiatives Released Today,” available at www.federalreserve.gov/boarddocs/srletters/1993/SR9330.htm.
• ⁶ See SR letter 20-13.