December 2012 - Several years ago, FHLBank Atlanta implemented a new credit risk rating system to help it better assess the probability of default for each of its shareholders. The credit risk rating system was a significant departure from the previous credit and collateral matrix system and enabled the Bank to identify credit risk of any shareholder at a much more granular level.
The system is based on an internal model that assigns an individual financial institution a credit risk rating derived from key financial measures obtained from each shareholder’s quarterly regulatory report. The system includes a rating scale ranging from one to 10, with one representing the least amount of credit risk and 10 representing the greatest amount of risk. Shareholder risk ratings are updated quarterly.
The credit risk rating system remains one of the most critical risk management tools FHLBank Atlanta employs to help protect shareholders’ capital investments, maintain the Bank’s high credit rating, and help keep FHLBank System debt at attractive interest rates. The credit rating system has been an important asset to the Bank as it navigated the extreme volatility of the financial crisis and recession and the significant number of financial institution failures that resulted.
Importantly, FHLBank Atlanta has successfully managed all shareholder failures to date with no credit losses, which is due in large part to its ability to identify high risk financial institutions well in advance of their failure.
Today, the credit environment remains challenging and Bank shareholders continue to face financial stress. However, the trends are improving and the Bank is seeing signs of stabilization across the FHLBank Atlanta membership. As noted in Figure 1 below, the credit rating distribution has shifted to a zone of less risk over the last two years.
How the Credit Rating System Works
The credit rating system uses key financial ratios that are the highest indicators of probability of default based on actual historic financial institution failures. FHLBank Atlanta uses separate models for banks, credit unions, and insurance companies to account for unique qualities and risks of each type of institution. The models for banks and credit unions include the following ratios:
- Asset Quality Ratios: slow loans and nonperforming assets
- Capital Ratios: total risk-based and tangible common equity capital (for banks) and net worth/asset ratio (for credit unions)
- Return on Assets: average two quarters net income
- Liquidity: available liquid assets
FHLBank Atlanta uses separate models for property-and-casualty insurance companies and life insurance companies. The largest components of the models for each type of insurance company are asset size and risk-based capital.
The various financial ratios create a well balanced model. For example, if an institution has a relatively high ratio of nonperforming assets but has strong capital levels that provide a cushion against potential losses, the model will reflect that relative strength.
In addition, Bank credit analysts typically review the financial condition of approximately one third of shareholders each quarter to confirm the model’s rating or make adjustments based on other factors. These factors may include regulatory findings or risks to a shareholder’s financial strength identified in a shareholder's SEC filings or discussions with management. Shareholders subject to analyst review typically fall into higher-risk ratings or experience a significant change in their rating from one quarter to the next.
For shareholders that have acquired failed institutions, the credit risk model incorporates adjusted asset quality ratios that account for loss-sharing agreements with the FDIC.
The Bank also implemented new underwriting guidelines along with the credit rating system. At the time, these changes provided several benefits to shareholders, including the removal of certain borrowing limitations for de novo institutions, more flexibility for pledging commercial real estate loans, and fewer restrictions on accessing convertible advances. However, some restrictions do apply, depending on the shareholder’s rating.
Shareholders with credit risk ratings from one to eight have no additional restrictions beyond FHLBank Atlanta’s standard credit and collateral policies. Shareholders with ratings of nine or 10 are subject to the following:
Credit Rating 9:
- Shareholders with elevated credit risk or high exposure are required to have an annual Collateral Verification Review (CVR).
- Shareholders without high exposure or elevated credit risk may be eligible for a two-year CVR cycle.
Credit Rating 10:
- Not eligible for Loans Held for Sale Program
- Annual CVR required if total collateral exposure is not fully covered by cash and securities
- More conservative discounts applied to all loans, thus lower lendable collateral value
- Credit availability may be reduced
- Shareholder may be required to deliver loan collateral
- Shareholder may be required to collateralize prepayment fees
- Advance terms may be restricted to 36 months or less
- Monthly Qualifying Collateral Reports (or monthly loan status updates) may be required
The credit risk rating system is one of many tools FHLBank Atlanta uses to help manage the myriad risks it faces in today’s economic environment. As with any credit rating system, the Bank’s methodology is designed to help it make prudent lending decisions. Ultimately, it helps the Bank protect shareholders’ investments in the cooperative.
If you have questions about the credit risk rating system or any other credit policy, please call your FHLBank Atlanta credit analyst. Click here to access the Bank’s contact sheet for your credit analyst’s contact information.
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The Federal Home Loan Bank of Atlanta is not a registered investment advisor. Nothing herein is an offer to sell or a solicitation of an offer to buy any securities or derivative products. You should consult your own legal, financial and accounting advisors before entering into any transaction.