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Risk Insight: Five Essential Steps To A Dual Risk Rating System

Welcome to this month’s installment of the Risk Insight Monthly Video & Blog Series.

While the appropriate level of complexity of a bank's risk measurement system will vary by institution and portfolio type, we are seeing more and more banks adopting a “dual risk ratings” process.

In this dual system, the probability of default (PD) is estimated separately from the loss given default (LGD). The expected loss for a given loan is then calculated as their product.

Watch Bob Durante share five essential steps to a dual risk rating system that can provide best practices for your institution.

 Bob Durante -DualRisk

1) Understand key drivers of a dual risk system

Our best practice approach is to have separate Risk Rating Systems for PD and LGD. In Figure 1 below, we show very simply what separates a good loan from a bad loan. In other words, if LGD risk is higher than PD risk, then the focus is on verifying if the obligor risk rating is correct. If the PD risk is higher, the focus will be on the collateral value and security enforceability. Other key drivers include making sure your PD solutions are linked to historical default rates and, where possible, supporting your loss estimation with empirical data.  

Figure 1 Dual Risk Rating System for PD & LGD

Source: S&P Global Market Intelligence. For illustrative purposes only. 

2) Demonstrate the advantages of a dual risk rating approach through case studies

To take a conceptual approach and transform it into a practical application, we recommend conducting a parallel run of old vs. new scoring capabilities. This way the advantages become obvious, including:

  • Granularity -- get dispersion of loans across the rating scale;  
  • Enhanced transparency -- better understand the PD and LGD risk, or lack of risk, and, in response, price accordingly;
  • Reliability -- immediately reduce the adverse selection of low priced/high risk loans.

3) Implement separate PD and LGD credit scoring solutions

Use robust PD scorecards or LGD models based on external data, such as those provided by S&P Global Market Intelligence, which can be sampled in such a way as to represent the bank’s own portfolio data.

4) Develop a PD and LGD mapping scale

Capitalize on established approaches to develop a bank-wide dual risk rating scale that includes definition/specification of internal rating grades and assignment of appropriate PD and LGD ranges. By working together on a bank’s sample loan cases and drawing from S&P Global Ratings’ history found in our CreditPro® database, S&P Global Market Intelligence can help you also develop an expected loss (EL %) master scale.

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5) Combine dual rating scores

The dual risk rating system requires an internal risk rating on the creditworthiness of the borrower and a risk rating based on the facility of the loan. The two risk ratings are then combined using a matrix (see Figure 2) to develop an overall composite loan quality risk rating.

Figure 2 

Combining Dual Rating Grades - Expected Loss

Source: S&P Global Market Intelligence. For illustrative purposes only. 

Want to learn more about the PD Scorecards and LGD models Bob highlights in this video? Request a demo.

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