As you know, SBA requires an independent loan review be performed every two years by a person who is not directly or indirectly responsible for loan making or by outside contractors. At JRB, we’re often engaged to perform these loan reviews since we are independent of loan making. Also, some CDCs engage us to advise them on issues their independent contractor discovered in their loan review. So we’ve become well versed on SBA’s “Independent Loan Review Guide” and on the Uniform Classification System that the guidance references, “Classifying Assets Using the UCS.”
The UCS Includes 5 Classes of Loans: Acceptable; Special Mention; Substandard; Doubtful and Loss. Loans are classified based on a thorough analysis of the five primary credit factors: The good old “5 C’s of Credit” we learned as little lenders. The UCS guides a lender through identifying the risks and creditworthiness of a borrower, defining credit factor characteristics associated with each classification, and key considerations in assessing the 5 C’s of Credit.
Rating by the Numbers. Yet as good and as thorough the UCS analysis is, lenders are not required to use it. Instead, many lenders assign a loan grade based on a numeric score they develop. How it works: The lender identifies the characteristics it wishes to risk rate. Say, the lender identifies eight characteristics it wishes to use in assessing the risk of each loan and develops a grading system for each characteristic. Management might be one such characteristic and compliance with loan covenants like monthly payments might be another.
Under its grading system, the CDC has determined that 10 years of management experience rates a grade of “10” and one year might rate a “1.” The borrower has eight years of management experience, so it gets an “8” for management. But this borrower failed to make two payments on time last year. That’s a very big deal and more important than management experience. The lender has determined that missing two payments is a sure sign of trouble and according to its risk rating system, it assigns a grade of “2” to payment performance.
But which factor is more important: management experience or payment performance? The lender believes that payment performance is more important and so the grade of “2” for payment performance should weigh more than the grade of “8” for management experience. If every factor were equally important, each factor would have a weight of 12.5. But since payment performance is more important, the lender gives it a weight of 0.20 and gives management a weight of 0.05. The lender will assess other factors similarly and the sum of the weighted average will determine the risk grade.
Essential to Note: Every lender determines its own loan grading system. SBA expects that the loan grading system will conform to the lender’s written Policies & Procedures. Each lender has its own Policy & Procedures, approved by its board and submitted to SBA. And so each lender has its own loan grading system. And if the lender chooses, it adjusts its risk rating software to follow its risk rating policy. The software does not determine the grade. The lender’s policy does.
Still, many clients ask me what “grade” to give a certain loan. They are very confused when I tell them that the assignment of loan grades is part of their internal control Policies & Procedures. They tell me how Ventures weighted the loan.
Now, I like Ventures very much indeed. But the risk factors in Ventures are examples and were never intended to be determinant. The CDC uses its policy and procedures to develop its risk factors in Ventures. Once management has determined the factors, it determines how much weight is given to that factor. The cumulative weight of the factors determines the loan grade.
AI is helpful but it has not taken over risk rating. Not yet anyway.