Useful Notes on Rate of Risk Involved When Loaning to SMEs?

Banks should have a comprehensive risk scoring/rating system that serves as a single point indicator of diverse risk factors of counter-party and for taking credit decisions in a consistent manner. To facilitate this, a substantial degree of standardization is required in ratings across borrowers.

The risk rating system should be designed to reveal the overall risk of lending, critical input for setting pricing and non-price terms of loans as also present meaningful information for review and management of loan portfolio.

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The risk rating, in short, should reflect the underlying credit risk of the loan book. The rating exercise should also facilitate the credit granting authorities some comfort in its knowledge of loan quality at any moment of time.

The risk rating system should be drawn up in a structured manner, incorporating, inter alia, financial analysis, projections and sensitivity, industrial and management risks. The banks may use any number of financial ratios and operational parameters and collaterals as also qualitative aspects of management and industry characteristics that have bearings on the creditworthiness of borrowers.

Banks can also weigh the ratios on the basis of the years to which they represent for giving importance to near term developments. Within the rating framework, banks can also prescribe certain level of standards or critical parameters, beyond which no proposals should be entertained. Banks may also consider separate rating framework for large corporate/small borrowers, traders, etc., that exhibit varying nature and degrees of risk.

Forex exposures assumed by corporate who have no natural hedges have significantly altered the risk profile of banks. Banks should, therefore, factor the unhedged market risk exposures of borrowers also in the rating framework. The overall score for risk is to be placed on a numerical scale ranging between 1 -6, 1-8, etc., on the basis of credit quality.

For each numerical category, a quantitative definition of the borrower, the loan’s underlying quality, and an analytic representation of the underlying financials of the borrower should be presented.

Further, as a prudent risk management policy, each bank should prescribe the minimum rating below which no exposures would be undertaken. Any flexibility in the minimum standards and conditions for relaxation and authority there for should be clearly articulated in the loan policy.

The credit risk assessment exercise should be repeated biannually (or even at shorter intervals for low quality customers) and should be delinked invariably from the regular renewal exercise. The updating of the credit ratings should be undertaken normally at quarterly intervals or at least at half-yearly intervals, in order to gauge the quality of the portfolio at periodic intervals.

Variations in the ratings of borrowers over time indicate changes in credit quality and expected loan losses from the credit portfolio. Thus, if the rating system is to be meaningful, the credit quality reports should signal changes in expected loan losses.

In order to ensure the consistency and accuracy of internal ratings, the responsibility for setting or confirming such ratings should vest with the Loan Review function and examined by an independent Loan Review Group. The banks should undertake comprehensive study on migration (upward – lower to higher and downward – higher to lower) of borrowers in the ratings to add accuracy in expected loan loss calculations.

The price of accessing credit will be influenced by risk grading and the nature and size of debt transaction. Due to higher risk awareness of the finance sector and the needs of Basel II norms many SMEs will be confronted for the first time with internal rating procedures or credit scoring systems by their banks.

The banks will require more and better quality of information from their clients and will assess them in a new way. The banks will have to communicate the relevant criteria affecting the rating of SMEs and should inform them about its assessment in order to allow SMEs to improve.

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