Stressing its concerns about credit risk management, the Federal Reserve Board on Monday told its examiners to scrutinize bank loan rating systems.
In an eight-page supervisory letter, the Fed said large banks need sophisticated systems to assess the risks posed by individual loans. Examiners should factor the effectiveness of a bank's system into their assessment of the bank's capital adequacy, the Fed said.
"We're stepping up the pressure, or the tension, on this issue," said Jim Houpt, a deputy associate director in the Fed's bank supervision division. "There is quite a range (among banks) as far as the rigor, value, and usefulness" of credit risk systems.
"If you're not evaluating risk properly, then you're not pricing it properly either," he explained.
According to the letter, some banks are applying their credit risk ratings too narrowly, assigning grades only to troubled credits. "Such systems contribute little or nothing to evaluating the bulk of loans in the portfolio-that is, loans for which no specific difficulties are present or foreseen," the Fed said. Other common problems include risk grades assigned inconsistently or not validated independently.
Two Fed staffers spent much of this year studying the credit risk systems used by the 50 largest bank holding companies, according to Mr. Houpt. Relying on this research, the Fed letter describes for examiners what the best systems look like.
Credit risk ratings identify gradations in risk among business loans. Most banks use the systems to approve loans and recognize problem credits, but the Fed said more sophisticated institutions use internal ratings systems to price credit, analyze profits, allocate capital, and set loan- loss reserves.
The Fed said it sent the letter to its examiners in part to encourage innovations in credit risk management and to urge more banks to improve their loan rating systems.
Following the drumbeat that U.S. regulators have sounded over the last two years, the Basel Committee on Banking Supervision on Monday issued the first internationally accepted framework for evaluating the effectiveness of a bank's internal controls