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| | Credit Risk Rating at Large U.S. Banks by William F. Treacy of the Federal Reserve Board of Governors, and
Mark S. Carey of the Board of Governors November 1998 Beginning: Internal credit ratings are becoming increasingly important in credit risk management at large U.S. banks. Banks' internal ratings are somewhat like ratings produced by Moody's, Standard & Poor's, and other public rating agencies in that they summarize the risk of loss due to failure by a given borrower to pay as promised. However, banks' rating systems differ significantly from those of the agencies (and from each other) in architecture and operating design as well as in the uses to which ratings are put. One reason for these differences is that banks' ratings are assigned by bank personnel and are usually not revealed to outsiders.
For large banks, whose commercial borrowers may number in the tens of thousands, internal ratings are an essential ingredient in effective credit risk management. Without the distillation of information that ratings represent, any comparison of the risk posed by such a large number of borrowers would be extremely difficult because of the need to simultaneously consider many risk factors for each of the many borrowers. Most large banks use ratings in one or more key areas of risk management that involve credit, such as guiding the loan origination process, portfolio monitoring and management reporting, analysis of the adequacy of loan loss reserves or capital, profitability and loan pricing analysis, and as inputs to formal portfolio risk management models. Banks typically produce ratings only for business and institutional loans and counterparties, not for consumer loans or other assets.
In short, risk ratings are the primary summary indicator of risk for banks' individual credit exposures. They both shape and reflect the nature of credit decisions that banks make daily. Understanding how rating systems are conceptualized, designed, operated, and used in risk management is thus essential to understanding how banks perform their business lending function and how they choose to control risk exposures. The specifics of internal rating system architecture and operation differ substantially across banks. The number of grades and the risk associated with each grade vary across institutions, as do decisions JEL Classification: G20, G21. Keywords: Ratings, Credit risk, Risk management, Bank risk. Published in: Federal Reserve Bulletin, (November 1998), pp. 987-921. Republished in: "Credit risk rating systems at large US banks", Journal of Banking & Finance, Vol. 24, No. 1-2 , (January 2000), pp. 167-201. Download paper (142K PDF) 25 pages
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