Credit Risk Assessment of Bank Investment Portfolios, Part 2: Is that Investment Still “Investment Grade”?

12/12/2013

 By Suzanne Storm, Senior Consultant for Credit Policy and Risk Management

As Ardmore Banking Advisors discussed in our June 14 article, banks may no longer depend solely on external credit ratings to determine the quality of a security held for investment.  Banks must now perform a pre-purchase and an ongoing credit analysis. A qualified individual must now monitor and grade a security’s credit risk based upon the repayment capacity of the issuer and the structure of the instrument.

On October 29, 2013, the FDIC announced (FIL-51-2013) a joint issuance of the Uniform Agreement on the Classification and Appraisal of Securities Held by Depository Institutions (Agreement). This replaces the agreement from 2004, and specifies how the existing regulatory definitions of classified assets (those graded Substandard or worse) should be applied to investment securities. The Agreement emphasizes that external rating agency ratings are not to be relied on by the bank.  The bank must analyze securities to determine (a) if the timely payment of principal and interest is certain, and (b) if the security has ever sustained credit losses in the past.

Depository institutions should persistently assess whether securities meet the investment grade standard and grade each security to accurately reflect its credit risk profile. General principles to consider:  
 
  • A security is investment grade under recent rules if the risk of default is low, and the full and timely repayment of principal and interest is expected.  An appropriate credit analysis documenting the investment grade quality, and ongoing analyses that demonstrate continued repayment capacity, support a “pass” rating in a regulatory exam 
  • If payment of the obligation in full is in question, it is no longer investment grade and management should classify the security 
  • Generally, assets that defer payments, even if allowed for in the instrument’s contract, do not meet the “full and timely” repayment standard for investment grade and should be classified.
  • If impairment is taken, but all payments are received as due, the security may be eligible for future upgrade to regain its investment grade status
  • If a credit loss is incurred (i.e., payments are missed), the security may be eligible for future upgrade to pass, but may never regain its investment grade status, unless it has been through a court-approved restructuring
(Note that none of this applies to securities held in a trading account and regularly marked-to-market.  It is only for those securities held in the  investment portfolio.)  
 
If a security is adversely classified but circumstances improve and there is no longer a risk of non-payment in full, the security may be upgraded after a period of sustained performance.  However, if credit losses occur that may not ever be recovered, that security may not be considered “investment grade” again.
 
The Agreement contains a table of examples that cover each potential scenario of deterioration and whether a security subject to such scenario is subsequently eligible to be upgraded or purchased.
 
If Ardmore Bank Advisors may help you in any way please contact Louis Dunham at ldunham@ardmoreadvisors.com, or by phone at 847-687-7353.