What is Loan Grading?
Loan grading is a classification system that involves assigning a quality score to a loan based on a borrower's credit history, quality of collateral and likelihood of repayment of the principal and interest. A score can also be applied to a portfolio of loans.
How Loan Grading Works
Banks often develop their own rating scales comprising as many as 12 categories ranging from "prime," indicating little to no risk, to "substandard" or "doubtful," indicating a high probability that the loan will be uncollectible—and "loss," indicating little or no recovery is likely.
Bank examiners use a classification system when conducting a bank examination and will assign their own scores to a sample of the bank's loan portfolio. In assigning a score to a loan, the examiner will review the loan documentation, collateral and the borrower's financial statements.
Banks may develop their own loan grading scales with as many as a dozen categories ranging from "prime," for which there is little or no risk, to "loss," which indicates that little or no recovery is likely.
A standardized loan classification system published by three Federal supervisory agencies in 1949 included three primary categories for loans considered weak:
- Substandard loans were those carrying higher-than-normal risk due to the financial health or unfavorable history of the borrower, inadequate collateral, or other factors.
- Doubtful loans were those for which collection was doubtful, but the loss was not determined.
- Loss referred to loans considered uncollectible.