The first industry comments on an important proposal to revise the supervisory framework for classifying commercial credit exposures are due June 30, 2005. RMA will comment on behalf of the industry and two working groups are drafting our response to cover reactions from community banks and large banks.

Regulators will issue a revised proposal once comments have been reviewed. The industry will then have another opportunity to comment before a final proposal is drafted. Depending on the comments received, the earliest the proposal could be adopted is perhaps June 2006, and regulators expect a "protracted implementation period" to follow. Also, a substantial training initiative will precede implementation.

So, what exactly are the regulators proposing? Figure 1 on the following page illustrates how the new classification framework might work. The new system would be a dual rating system, capturing both the borrower dimension and facility dimension. Today, institutions cannot use loan structure or collateral to help determine the regulatory classification rating. Under the new system, a rating could move up or down based on the structure of the facility.

[FIGURE 1 OMITTED]

The new facility dimension will rate the severity of possible losses after default. The four facility dimensions are:

1. Remote Risk of Loss   (Loss Severity Estimate = 0%)
2. Low                         (< = 5% Loss)
3. Moderate                (> 5% but < = 30% Loss)
4. High                        (> 30% Loss)

It is important to note that the requirement to use the facility rating would occur only at default, although institutions choosing to use the rating earlier certainly could do so.

The remote risk of loss rating would be restricted to a facility secured by cash, marketable securities, and marketable commodities. In addition, government-guaranteed loans, or portions thereof, and certain asset-based lending (ABL) transactions would be eligible for the remote classification. Loans for the purpose of financing production expenses associated with agricultural crops also could qualify for the remote loss rating if management can demonstrate that the loan will be self-liquidating at the end of the production cycle.

Figure 1 shows that the remote risk of loss rating in the Facility Dimension could move a credit's classification rating from "criticized" to "pass."

The new borrower ratings (Marginal, Weak and Default) are drawn extensively from the current framework and would replace the existing categories: special mention, substandard, and doubtful.

Borrower rating--marginal. "A marginal borrower exhibits material negative financial trends due to company-specific or systemic conditions that, if left unmitigated, threaten its capacity to meet its debt obligations. Marginal borrowers still demonstrate sufficient financial flexibility to react to and to positively address the root cause of the adverse financial trends without significant deviations from their current business strategy. They exhibit potential weaknesses that deserve close attention and warrant enhanced monitoring. Obligations of marginal borrowers do not expose an institution to sufficient risk to warrant adverse classification." (1)

Borrower rating--weak. "A weak borrower does not possess the current sound net worth and payment capacity of a creditworthy borrower. Borrowers rated weak exhibit well-defined credit weaknesses that jeopardize the borrower's continued performance. The weaknesses are of a severity that the distinct possibility of the borrower defaulting exists." (2)

Borrower rating--default. "A borrower is rated default when one or more of the institution's material exposures exhibit the following conditions: 1) the regulatory reporting definition of nonaccrual, or 2) the banking organization has made a full or partial charge-off or write-down for credit-related reasons or determined that an exposure is impaired for credit-related reasons." (3)

The complete proposal can be found in the URL listed below. Please review and forward your comments to: pmartin@rnmhq.org.

Notes

(1) www.federalreserve.gov/boarddocs/press/bcreg/2005/20050328/.

(2) ibid.

(3) ibid.

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