Explain the benefits of a credit risk grade system
Introduction
Grade or rating refers to the degree of credit risk that will be assigned to the borrower, after the competition of the credit evaluation process. The grades should be updated continuously for continued load or credit risk review process, especially in the banks and the financial institutions. The accurate and consistent risk rating is essential in risk monitoring and management of credit risk. The benefits of the credit risk grading system are discussed below.
Benefits of Credit Risk Grade System
The various benefits of credit risk grading system include the provision of an essential framework for the credit decision-making process, facilitating judgment on obligor’s creditworthiness, used in the reporting purposes, used in statistical analysis, highlighting the credit quality of the clients, and lastly used in credit pricing and allocation of capital.
Provision of an essential framework for the credit decision-making process
According to Joseph (2013) a well-established credit rating system provides an essential framework for credit decision making.
Facilitates distinguishing between the credit risk of different credit assets in the portfolio
According to Joseph (2013), a good credit rating system will facilitate distinguishing between the credit risk of different credit assets in the portfolio. It also helps the management in facilitating judgment on obligors’ creditworthiness.
Credit risk grading is used for reporting purposes
According to Joseph (2013) credit risk grades are highly used for reporting purposes, internally or externally. Implying that, the grades can also be used when external reports are made to the regulators, for instance reporting to the central bank. Reporting may include portfolio breakdown by credit grade and various sub-segments in the portfolio (such as sectors, regions, etc.). This would also facilitate segment-wise trend and migration analysis and reporting.
Statistical analysis
Credit risk grading is also used in statistical analysis, which enables analyses for several portfolios or sub-portfolios.
Checking the credit quality
Credit risk grading can also be used in the checking of the credit quality of the portfolio and thus also helps in the monitoring of the high-risk customers.
Credit pricing and allocation of capital
According to Joseph (2013), credit risk grading can also benefit the financial institutions through the calculation of the PD’s which to a larger extent can also be used in the credit pricing and allocation of capital.