how loan grading works
being able to manage their lending capacity effectively is central to the success of a bank so banks must come up with a loan grading system that accurately evaluates credit risk or the probability of loss due to a borrower s failure to make payments the processes that banks use to grade loans help examiners and management make good lending decisions there is no one correct system for grading loans although the federal deposit insurance corporation fdic requires that all lending institutions have a loan review system larger institutions may maintain separate departments specifically for loan reviewing depending on the size and complexity banks develop different approaches community banks often use more broad factors to judge the risk of a loan whereas larger more complex institutions may rely on more quantitative approaches to measure and monitor credit risk when assigning a score to a loan the examiner will review the loan documentation collateral and the borrower s financial statements the score takes into account not only the borrower s credit score but also a combination of several indicators of credit risk from the credit report and loan application these factors may include the level of guarantor support repayment history cash flow projected yearly expenses etc smaller institutions typically use an expert judgment system in this system a loan officer is entrusted with assigning a grade based on their judgment and knowledge other banks may use quantitative scorecards or other modeled approaches that allow for adjustments based on qualitative judgments since there are no regulatory requirements that mandate how a loan grading system is structured it is up to banks to develop a system that is suitable for their size and complexity 