Victor’s Insider Scoop on How Bank Assets are Classified* …
November 15th, 2008 | top of page
Like every other aspect of a bank’s operation, directors have responsibility for keeping abreast of their bank’s asset quality. Bank examination reports, internal and external loan review data and ongoing loan reports are key information sources in assessing a bank’s asset quality and credit risk.
During their review, examiners assess the inherent credit risk in a sample of a bank’s interest bearing assets—loans and securities. An asset will be assigned either a pass or classified rating. Pass assets are those where there is a reasonable prospect for the bank to receive principal and interest according to the asset’s contractual terms. Those assets not rated pass are designated as classified assets.
All the bank regulatory agencies use the same asset classification categories. There are three adverse classification categories, each representing a different degree of the risk of nonpayment:
A point to remember is that the categories are progressive: each of the categories has all of the characteristics of the previous one, plus additional factors. For example, substandard assets have some well-defined weakness that could lead to loss if action is not taken. In comparison, doubtful assets, a more serious problem classification, have some loss in them that cannot be determined at the time the evaluation is made.
Substandard - Substandard assets have a well-defined weakness that may jeopardize collection of principal and interest. These weaknesses include inadequate net worth, paying capacity and collateral. There is a distinct possibility that the bank will sustain some loss if the deficiencies are not corrected.
This does not mean that every classified asset has loss exposure. The loss exposure occurs in the aggregate of all substandard assets. In many cases, the loss may not appear for some time.
Doubtful - Doubtful assets have all the weaknesses of substandard assets, plus the characteristic that collection in full is highly questionable and unlikely. There will be some loss in the asset, but the amount is unknown at the time the asset is being reviewed.
Typically, an asset will not be classified as doubtful at more than one examination. As a result, bank management should make every effort to determine the value of any collateral or how much they can reasonably expect to receive. Any remainder would then be charged-off.
Loss - Assets classified as loss are considered to be uncollectible and of so little value that maintaining them as a bank asset is not warranted. If any portion were eventually repaid, it would be considered a recovery. Loss assets should be charged-off at the time they are determined to be uncollectible.
Examination Ratios and Rating Guidelines
Asset review is used by examiners to construct summary ratios that serve as a starting point for an overall assessment of a bank’s asset quality rating.
Two useful ratios that show the ability of bank capital and the allowance for loan and lease losses to absorb problem loans are the total and weighted classification ratios.
The Total Classification Ratio
The total classification ratio is the ratio of a bank’s classified assets to its Tier 1 Capital (the capital adequacy of a bank; core capital including equity capital and disclosed reserves) plus reserves.
• The calculation is Total Adversely Classified Items divided by Tier 1 Capital and ALLL (Allowance for Loan and Lease Losses).
• This ratio measures the volume of classified assets relative to the “cushion” of capital that may be used to absorb inherent losses in classified assets.
• Values for this ratio above 40 to 50 percent often represent less than satisfactory asset quality.
The Weighted Classification Ratio
Another useful ratio is the weighted classification ratio, an asset quality measure used only by the Federal Reserve System. Other agencies, such as the FDIC and Office of the Comptroller of the Currency, only use the total classification ratio.
• The ratio is Weighted Classifications (the sum of each category total multiplied by its weighting factor) divided by Tier 1 Capital and ALLL.
• The numerator for this ratio is the bank’s classified assets, weighted by the severity of their classification. The weights used are 20 percent for loans classified substandard, 50 percent for loans classified doubtful and 100 percent for loans classified loss.
• This ratio measures the severity of classifications relative to capital and the ALLL.
• Weighted classification ratio values above 15 percent often represent unsatisfactory asset quality.
A bank with a large amount of loans that are classified as substandard will have a higher total classification ratio, but a smaller weighted ratio than a bank with more loans in the doubtful and loss categories.
Classification Category (by volume) Weighting Factors
Total of Substandard Assets Total of Substandard Assets x 20%
Total of Doubtful Assets Total of Doubtful Assets x 50%
Total of Value Impaired Assets Total of Value Impaired Assets x 100%
Total of Loss Assets Total of Loss Assets x 100%
Total Adversely Classified Items Total Weighted Classifications
Divided by Tier 1 + ALLL Divided by Tier 1 + ALLL
= Total Classification Ratio = Total Weighted Classification Ratio
A total classification ratio less than 40 percent and a weighted classification ratio less than 15 percent are often thought of as cutoff values for satisfactory asset quality. However, keeping ratios below these values will not necessarily result in a satisfactory asset rating for a bank. Factors such as a trend in problem assets, ability to satisfactorily administer the loan portfolio and management’s ability to successfully work through problem loans are also taken into account in assessing asset quality.
Loan review information is another data source used to judge bank asset quality. Loan review is a bank’s assessment of the inherent risk in its loan portfolio. This review may be done by the bank itself or by someone hired by the bank. Loans that pose normal credit risk receive a pass. Those that pose a greater-than-normal credit risk receive a classified grade.
Bank loan grading systems often have more pass and criticized loan grades than the system used by bank examiners. For instance, one survey indicated that loan grading systems of community banks on average had three pass grades and three nonpass grades. Some banks who answered the survey had 10 pass and 10 nonpass grades. Regardless of the number of grades, the information included in a bank’s loan grading system must be translatable into the grades used by banking supervisors. As a result, internal and external loan review information can be used to assess bank asset quality and calculate the asset quality ratios used by the banking agencies during the interim period between bank examinations.
Other Sources of Asset Quality Information
Beside examination and loan review data, a summary picture of asset quality can be obtained from other sources. One particularly good information source is the Uniform Bank Performance Report (UBPR). Two useful ratios to check in the UBPR are the past-due ratio and net losses to average total assets ratio.
1. The past-due ratio reflects all loans over 30 days past due (loans that are 30 to 89 days past due, plus loans that are 90 days or more past due, plus nonaccrual loans) as a percentage of total loans. Values approaching 4 percent may need further investigation with management.
2. Net losses to average assets. Net losses are loan charge-offs for the current period less recoveries of prior period charge-offs (charge-offs – recoveries). Since some losses are an inevitable part of the banking business, it can be expected that a bank will experience some loan losses.
However, a loss ratio (net losses/average total assets) greater than 1 percent indicates that losses may be becoming excessive. Consequently, you may want to work with management to investigate the reasons behind the losses and determine if corrective action is needed.
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