In the past several years, the financial services industry has been improving its credit-risk grading systems, gathering extensive data to increase the objectivity and granularity of the ratings by incorporating the following concepts:

* Probability of default.

* Loss given default.

* Usage given default.

But beyond these additional facets of measurement, risk grading has become a management driver for pricing, profitability, and capital allocation. Moreover, it has become a way to communicate risk tolerance via a metric to the executive management and, indeed, throughout a highly diverse organization.

As they apply fresh approaches to risk measurement and management, community bankers are incorporating the leading risk-grading and capital tenets into their organizations. In a recent RMA audioconference, three senior bankers discussed the challenges and opportunities institutions face when they adopt a fresh approach to risk gradings.

The bankers quoted in this article are C. Michael Stanberry, SVP, and Tobin Armstrong, SVP and credit portfolio risk manager, Southwest Bank of Texas; and David Keim, chief risk and credit officer, Susquehanna Bancshares, Pennsylvania.

After operating with one grading system since its founding 13 years ago, Southwest Bank of Texas decided last year to review its system. The $6 billion, Houston-based bank had expanded into the Dallas market, making it increasingly more difficult to review the portfolio on a loan-by-loan basis. Meanwhile, senior officers could no longer be as close to the credits as they had been.

"When we began our review, we found a significant concentration in one loan grade," said C. Michael Stanberry, senior vice president at Southwest Bank. "We also found that the loan grade definitions offered little differentiation between the grades."

So, in March 2004, Southwest Bank committed the resources to redefine the grades, hiring a consultant knowledgeable about industry best practices. "We also decided to increase granularity by expanding to a two-grade system," said Stanberry. He added that such a system would allow the bank to develop criteria for an obligor grade, which would be a measure of a credit's potential or probability of default.

The two-grade system would allow the bank to measure:

* The strength of the credit.

* Its likelihood of default based on its inherent characteristics.

* The structure surrounding that credit. (Is it secured? Does it have a strong guarantor?)

"We also knew that the dual system would allow us to look at the credit enhancement characteristics that surround a credit and determine an appropriate facility grade," said Stanberry. "And in so doing, we would get an estimate on what loss we would incur should the credit default--the loss given default.

"And finally, we understood that implementing these changes would take significant internal resources. We wanted a simple, yet effective tool our lenders can use to better determine the risk characteristics of their credits. It had to be intuitive to make the training task manageable. Developing a system that the line wouldn't support would serve no purpose."

When it's completed in September 2004, the more granular, sophisticated grading system will allow the bank to review loans from a portfolio perspective and to identify higher-risk credits that need review. Currently, Southwest does the traditional scope review of its various lines of business and reviews each loan annually. Stanberry said the bank would continue doing that after the new grading system is in place.

The New System's Short-Term Benefits ...

Tobin Armstrong, senior vice president and credit portfolio risk manager at Southwest Bank, explained that the new dual grading system offered both short-and long-term benefits.

"In the short term, we hope to draw more lender attention to risk grading and make it easier for them to make a more precise grading assignment to each credit," said Armstrong. "It'll facilitate better communication of risks because lenders can discuss a loan as, say, a '5/2,' easily conveying the borrower's financial strength and the quality of collateral."

In addition, Southwest enhanced its allowance for loan and lease loss methodologies last year and established loan migration methodologies. "More precise loan grading will enhance those methodologies and allow us to price more accurately," said Armstrong.

In addition, Southwest improved upon its allowance for loan and lease methodologies and introduced more robust migration methodologies. "More precise loan grading will enhance those methodologies and allow us to price more accurately," said Armstrong.

... and its Long-Term Benefits

"With improved loan pricing, we expect to eventually turn to a RAROC (risk-adjusted return on capital) method of pricing," continued Armstrong. "As Southwest has grown and offered more products, it has become necessary to gather more profitability information from a broader set of product offerings. We currently have a companion project under way that will improve our profitability model, improving our margins and, more importantly, reducing loan losses. Finally, we expect to employ an economic capital allocation methodology as many large banks have done."