Grading Classifications and Appropriateness for Downgrading vs. Upgrading
Banks, in general, are in the business of making money through extending credit to their customers to generate income through the interest charged on the loans, as well as the fees associated with providing the loans. One important piece within the process of the bank's loan management is centered around the bank's loan classifications or how the loans are graded. This can have a dramatic impact on the income generated for the bank through their loans.
Banks, in general, are hesitant to downgrade a loan or relationship at times, as it can affect the perception of the overall portfolio and asset quality of the bank. But grading the credit accurately should be the bank's primary goal in any circumstances.
Typically, banks have several different grades within their loan policy; Pass (1-4), Pass / Watch (5), Special Mention (6), Substandard (7), Doubtful (8), and Loss (9). Now, not all banks need or have these classifications or grades. The classifications should cater to the bank's size and complexity, which is determined and approved by the Board of Directors. Understanding the current grading system is very valuable, but knowing when to downgrade a credit is vital to a bank's performance and asset quality.
Typically, when analyzing business and commercial loans, certain factors are heavily scrutinized when considering grading those credits. These factors are not the only basis for assigning grades, but they are the top characteristics. Deterioration in the cash flow, collateral, or liquidity is a good indicator that a credit may be struggling and a couple of factors when determining the correct grade. Additionally, timeliness of the payments is also another strong characteristic of how a credit is performing.
Loans can move through all of the different grades when a credit is deteriorating and can move from Pass to Pass / Watch to Special Mention and then to Substandard when being downgraded. However, the process for upgrading credits is not the same as downgrading. For example, a credit which is graded Substandard and has shown signs of improvement with the characteristics above, cannot just be upgraded to Special Mention. For a credit to be upgraded, the credit has to show significant improvements to where the credit can go from Substandard to Pass / Watch, which would be the lowest category of Pass that a Substandard credit could be upgraded to.
Special Mention credit is defined as a Potential Weakness where a Substandard credit indicates a Well-Defined Weakness. Therefore, for a credit to move from Substandard to Special Mention would not be appropriate as that would suggest that the Well-Defined Weakness has been evaluated to a Potential Weakness. If there is a potential weakness, then the weakness hasn't been eliminated and therefore, cannot be upgraded. The rule of thumb is if the weakness hasn't been eliminated, then the credit should not be upgraded.
The last grading category that has not been discussed is Non-Accrual and is directly associated with Substandard credits, which has a direct impact on the bank's ability to generate income from these types of loan relationships. Non-Accrual credits are identified by the bank where the bank is just trying to get the money that they lent back and are not concerned with the interest income for some time. This is typically the last line of defense prior to downgrading the credit further (Doubtful and Loss) and reviewing the process for foreclosure or repossession of the collateral. Banks do not like to assign a credit a Non-Accrual status, but sometimes it's imperative to minimize the risk to the bank and recoup as much from the loans as possible.