Credit Risk: Effect of Guarantor Support on Commercial Credit Risk Ratings

Summary

The Office of the Comptroller of the Currency (OCC) is issuing this bulletin to provide banks with clarification regarding the treatment of guarantor support when assigning risk ratings to commercial credits. This bulletin focuses on personal or corporate guarantees and does not address U.S. government guarantees.

Highlights

This bulletin

• provides background information about credit risk ratings.
• emphasizes that credit risk ratings are based on the specific facts and circumstances of the credit.
• emphasizes that credit risk mitigation provided by guarantor support can result in a range of outcomes depending on the circumstances.
• explains how guarantor capacity and willingness are considered when assigning a credit’s risk rating.
• discusses types of guarantees and how characteristics of each can affect the extent of credit risk that is mitigated by guarantor support.

Background

The OCC and other federal bank regulatory agencies use a common risk-rating scale. The regulatory ratings of special mention, substandard, doubtful, and loss identify different degrees of credit weakness. Credits (or portions of credits) that are not rated special mention, substandard, doubtful, or loss are rated pass. There is no formal regulatory definition for pass credits. Similarly, the OCC does not differentiate between various degrees of pass (e.g., pass/watch); however, many banks choose to further segment the pass category by additional risk characteristics.

Credit risk ratings emphasize risk of default based on the borrower’s expected performance (i.e., the likelihood that the borrower can service the debt) from the primary source of repayment. Guarantor support is generally a secondary or tertiary source of repayment.

Effect of Guarantor Support on Commercial Credit Risk Ratings

A credit’s risk rating is assigned based on the specific facts and circumstances of the credit. The extent of credit risk that may be mitigated by guarantor support similarly depends on the specific circumstances. Consequently, guarantor support does not always have the same bearing on a credit’s risk rating, and factors notwithstanding the existence of the guarantor support can also positively or negatively affect a credit’s risk rating. For example, prudent underwriting is a key consideration when assessing the risk within a credit.

Credit risk mitigation provided by guarantor support can result in a range of outcomes depending on the circumstances. Guarantor support and any credit risk mitigation it provides are assessed relative to the interagency classification definitions. For most credits with well-defined weaknesses, guarantor support alone is generally insufficient to warrant a pass rating. It is more common for guarantor support to result in a special mention rating or preclude a more severe rating (e.g., doubtful or loss) depending on the circumstances. In certain circumstances, however, a strong guarantee can mitigate the risk of default or loss and support a pass rating, despite a credit’s well-defined weaknesses. These circumstances generally involve credits with prudent underwriting and guarantors with strong financial positions that mitigate both risk of default and risk of loss.

The guarantor must exhibit the capacity and willingness to support the debt for guarantor support to enhance a credit’s risk rating. Capacity is demonstrated through analysis of current guarantor financial information and, in most cases, global cash flow analysis. Analysis of financial information generally includes verification of liquid assets. In the absence of current financial information, reliance on guarantor support as a possible risk-rating enhancement is generally precluded. Obtaining sufficient information on the guarantor’s global financial condition, income, liquidity, cash flow, contingent liabilities, and other relevant factors (including credit ratings, when available) enables banks to determine the guarantor’s financial ability to fulfill its obligation. An effective assessment generally includes consideration of whether the guarantor has the financial ability to fulfill the total number and amount of guarantees currently extended by the guarantor.

A presumption of willingness is usually appropriate until financial support becomes necessary. When financial support becomes necessary, it must be demonstrated to have a positive effect on the credit’s risk rating.

Guarantors who attempt to invalidate their obligations through litigation or protracted renegotiations impede rather than improve a loan’s collectability. Guarantor willingness to support the credit is not demonstrated in these cases.

Guarantees that are not properly authorized may not be legally enforceable and therefore do not enhance a credit’s risk rating. For example, some corporations’ bylaws prohibit the corporation from assuming contingent liabilities.

Considerations by Type of Guarantee

The type of guarantee can affect the extent of credit risk that is mitigated by guarantor support. The following are examples of common types of guarantees:

• Contingent or conditional guarantees require a specific event to occur or certain conditions to be met before the guarantor is liable.
• Continuing guarantees, or open guarantees, extend liability for an obligor’s present and future debts.
• Collection guarantees extend liability only after default and are conditioned on the creditor first exhausting legal remedies against the obligor.
• Payment guarantees extend liability based on the debt’s contractual terms. The bank does not have to first seek the primary obligor’s performance. This type of guarantee mitigates default risk.
• Irrevocable guarantees cannot be terminated without the consent of the other parties.
• Revocable guarantees can be terminated by the guarantor without any other party’s consent.
• Declining guarantees reduce the guarantor’s liability as certain conditions are met (e.g., the guarantor’s liability declines based on a project’s construction progress).

Key considerations when assessing the extent of credit risk mitigation provided by different types of guarantees include the following:

• Whether the guarantee mitigates risk of default or risk of loss. Guarantees that mitigate risk of default generally provide stronger risk mitigation.
• Whether the guarantee is irrevocable. Guarantees that are revocable by the guarantor without the bank’s consent generally do not provide risk mitigation.
• Whether the guarantee is unconditional. Conditional guarantees generally provide less risk mitigation than unconditional guarantees. For conditional guarantees, examiners should assess the effect the guarantee would likely have on the credit once the conditions are met.
• The amount of the guarantee. Guarantees that are limited in amount generally only provide risk mitigation up to the amount of the guarantee.

For example, an unconditional, irrevocable payment guarantee would generally be the strongest guarantee because it mitigates risk of default, is not conditioned on certain events, and cannot be unilaterally revoked by the guarantor.

Further Information

Please contact Credit Risk Division at 202-649-6670.

James M. Gallagher
Senior Deputy Comptroller and Chief National Bank Examiner