When an institution decides it will engage in commercial/business lending, it is required they have a firm grasp of the risk involved in this type of lending. How the risk in these loans is classified is unique, but universally applied throughout the commercial lending world.
When a loan has manageable risk and is generally considered an acceptable asset, the loan has a risk classification of “Pass.” A loan classified as Pass is one which is structured appropriately, pays on time, and likely has acceptable collateral margins. Often institutions will have several subcategories within their Pass classification to indicate a more precise amount of risk. These will range from a high Pass rating, which could be an excellent or superb loan to have, down to low Pass which is fair or minimally adequate.
The next classification of risk is the Watch List. These are loans that require continual monitoring, because there are problems that have arisen or foreseeable problems which may impact the loan’s ability to be repaid appropriately. Generally speaking, a Watch List loan is not a loan the institution would originate under the prevailing conditions. These loans will be reviewed every quarter, unless they are upgraded to Pass because conditions improve.
If a loan suffers deterioration in quality, it may be labeled Substandard. A Substandard loan is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected. In this way, a Substandard loan does not mean a loss will occur, but the likelihood is substantially elevated.
If a loan does deteriorate to the point where a loss is imminent, the loan will be classified as Doubtful. Loans classified Doubtful have all the weaknesses inherent in those classified Substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions and values, highly questionable and improbable. Simply put, a loss will occur, but the magnitude of the loss is generally unknown.
The last and worst classification a business loan can have is a Loss classification. Loans classified Loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value; but rather, it is not practical or desirable to defer writing off this basically worthless asset, even though partial recovery may be possible in the future. Any loan or portion of a loan classified as Loss must be charged down to $0 within 90 days.
When a loan is classified Watch List or worse, an institution needs to reserve additional capital in a special Loan Loss Reserve. This capital must be set aside to absorb potential losses and cannot be used to leverage new loans. An institution needs to carry enough capital to remain both adequately capitalized based on its leverage, and have enough capital set aside in reserves to protect against loan losses. Regulators check both capital requirements, and they also check the risk rating classifications to see if the institution is accounting for their risk accurately.
As with any business decision, balancing risk is both an art and a science. Every institution wants as many high Pass loans as possible, and nobody wants Watch List loans or worse. Often the challenge is to grasp how strong the Pass loan can remain in stressed conditions, so that it won’t deteriorate to a point where the loan would ever slip below the Watch List rating.--Trevor Plett