Bank Risk-Ratings, what are they and why you should care
Bank insider information! Take a peek behind the banking curtain.
Within the bank every business lending client has a risk-rating assigned to it. This risk-rating represents; a) the probability of loan default, and b) the potential loss given loan default. Simply put, the higher the risk-rating the more likely the loan goes bad in some way, shape or form. Banks are comfortable lending where the risk-rating is in an acceptable range. What goes into risk-ratings? Things like;
Financial position
Management ability and experience
Security position
Adherence to loan terms, conditions, and covenants.
Industry risk and current industry conditions
Environmental, Legal and Reputation risk
OK, why should I care about all this? I’ll tell you why. Banking industry regulations require that banks set aside capital for each loan that they make. For any particular loan the amount of capital to be set aside is driven by the risk-rating. The higher the risk-rating the more capital must be set aside by the bank. If the bank has to set aside a larger amount of capital, then they need to charge a higher interest rate to make their minimum profit target on the loan – which is actually the return on the amount of capital set aside.
The inverse is also true, if the bank has to set aside a smaller amount of capital for the loan, then they can charge a lower interest rate and still make their profit target.
What is your current risk-rating? Ask the bank. This should not be a secret. Also have a conversation about if or how the risk-rating can be improved, with cost savings to you in the form of reduced interest rates and fees. Also, a low risk-rating can reduce or eliminate the burden of certain business & personal financial reporting and eliminate or relax loan covenants.
Can your loan be structured to reduce the risk rating and provide you better loan terms? This is a win-win situation, lower borrowing costs for you and lower loan risk for the bank. How to achieve this? Let’s talk.
