DEPARTMENT OF THE TREASURY 

Office of the Comptroller of the Currency 

[Docket No. 05-08] 

FEDERAL RESERVE SYSTEM 

[Docket No. OP-1227] 

FEDERAL DEPOSIT INSURANCE CORPORATION 

DEPARTMENT OF THE TREASURY 

Office of Thrift Supervision 

[No. 2005-14] 

Interagency Proposal on the Classification of Commercial Credit Exposures 

AGENCIES: Office of the Comptroller of the Currency, Treasury, (OCC); Board of 

Governors of the Federal Reserve System (Board); Federal Deposit Insurance 

Corporation (FDIC); and Office of Thrift Supervision, Treasury, (OTS). 

ACTION: Joint notice and request for comment. 

SUMMARY: The OCC, Board, FDIC, and OTS (the agencies) request comment on their 

proposal to revise the classification system for commercial credit exposures. 

The proposal will replace the current commercial loan classification system 

categories “special mention,” “substandard,” and “doubtful” with a two-dimensional 

based framework. The proposed framework would be used by institutions and 

supervisors for the uniform classification of commercial and industrial loans; leases; 

receivables; mortgages; and other extensions of credit made for business purposes by 

federally insured depository institutions and their subsidiaries (institutions), based on an 

assessment of borrower creditworthiness and estimated loss severity. The proposed 

framework would not modify the interagency classification of retail credit as stated in the 

“Uniform Retail Credit Classification and Account Management Policy Statement,” 

issued in February 2000. However, by creating a new treatment for commercial loan 

exposures, the proposed framework would modify Part I of the “Revised Uniform 

Agreement on the Classification of Assets and Appraisal of Securities Held by Banks and 

Thrifts” issued in June 2004. 

This proposal is intended to enhance the methodology used to systematically 

assess the level of credit risk posed by individual commercial extensions of credit and the 

level of an institution’s aggregate commercial credit risk. 

DATES: Comments must be received by June 30, 2005. 

ADDRESSES: Interested parties are invited to submit written comments to any or all of 

the agencies. All comments will be shared among the agencies. 

ADDRESS: Comments should be directed to: 

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OCC: You should include OCC and Docket Number 05-08 in your comment. You may 

submit comments by any of the following methods: 

• Federal eRulemaking Portal: http://www.regulations.gov. Follow the 

instructions for submitting comments. 

• OCC Web Site: http://www.occ.treas.gov. Click on "Contact the OCC," scroll 

down and click on "Comments on Proposed Regulations." 

• E-mail address: regs.comments@occ.treas.gov. 

• Fax: (202) 874-4448. 

• Mail: Office of the Comptroller of the Currency, 250 E Street, SW., Mail Stop 1-

5, Washington, DC 20219. 

• Hand Delivery/Courier: 250 E Street, SW., Attn: Public Information Room, 

Mail Stop 1-5, Washington, DC 20219. 

Instructions: All submissions received must include the agency name (OCC) and 

docket number or Regulatory Information Number (RIN) for this notice of proposed 

rulemaking. In general, OCC will enter all comments received into the docket 

without change, including any business or personal information that you provide. 

You may review comments and other related materials by any of the following 

methods: 

• Viewing Comments Personally: You may personally inspect and photocopy 

comments at the OCC's Public Information Room, 250 E Street, SW., 

Washington, DC. You can make an appointment to inspect comments by calling 

(202) 874-5043. 

• Viewing Comments Electronically: You may request e-mail or CD-ROM 

copies of comments that the OCC has received by contacting the OCC's Public 

Information Room at regs.comments@occ.treas.gov. 

• Docket: You may also request available background documents and project 

summaries using the methods described above. 

Board: You may submit comments, identified by Docket Number OP-1227, by 

any of the following methods: 

• Agency Web Site: http://www.federalreserve.gov. Follow the instructions for 

submitting comments on the 

http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm. 

• Federal eRulemaking Portal: http://www.regulations.gov. Follow the instructions 

for submitting comments. 

• E-mail: regs.comments@federalreserve.gov. Include docket number in the 

subject line of the message. 

• FAX: 202-452-3819 or 202-452-3102. 

• Mail: Jennifer J. Johnson, Secretary, Board of Governors of the Federal Reserve 

System, 20th Street and Constitution Avenue, N.W., Washington, DC 20551. 

All public comments are available from the Board’s web site at 

www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as submitted, except as 

necessary for technical reasons. Accordingly, your comments will not be edited to 

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remove any identifying or contact information. Public comments may also be viewed 

electronically or in paper in Room MP-500 of the Board’s Martin Building (20th and C 

Streets, N.W.) between 9:00 a.m. and 5:00 p.m. on weekdays. 

FDIC: You may submit comments by any of the following methods: 

• Agency Web Site: http://www.fdic.gov/regulations/laws/federal/propose.html. 

Follow instructions for submitting comments on the Agency web site. 

• E-mail: Comments@FDIC.gov. 

• Mail: Robert E. Feldman, Executive Secretary, Attention: Comments, Federal 

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Deposit Insurance Corporation, 550 17 Street, N.W., Washington, D.C. 20429. 

th

• Hand Delivery/Courier: Guard station at the rear of the 550 17 Street Building 

(located on F Street) on business days between 7:00 a.m. and 5:00 p.m. 

Instructions: All comments received will be posted without change to 

http://www.fdic.gov/regulations/laws/federal/propose.html including any personal 

information provided. 

OTS: You may submit comments, identified by No. 2005-14, by any of the 

following methods: 

• Federal eRulemaking Portal: http://www.regulations.gov. Follow the 

instructions for submitting comments. 

• E-mail: regs.comments@ots.treas.gov. Please include No. 2005-14 in the 

subject line of the message, and include your name and telephone number in the 

message. 

• Fax: (202) 906-6518. 

• Mail: Regulation Comments, Chief Counsel’s Office, Office of Thrift 

Supervision, 1700 G Street, NW., Washington, DC 20552, Attention: No. 2005-

14. 

• Hand Delivery/Courier: Guard’s Desk, East Lobby Entrance, 1700 G Street, 

NW., from 9:00 a.m. to 4:00 p.m. on business days, Attention: Regulation 

Comments, Chief Counsel’s Office, Attention: No. 2005-14. 

Instructions: All submissions received must include the agency name and 

document number or Regulatory Information Number (RIN) for this notice. All 

comments received will be posted without change to 

http://www.ots.treas.gov/pagehtml.cfm?catNumber=67&an=1, including any personal 

information provided. 

Docket: For access to the docket to read background documents or comments received, 

go to http://www.ots.treas.gov/pagehtml.cfm?catNumber=67&an=1. In addition, you 

may inspect comments at the Public Reading Room, 1700 G Street, NW, by appointment. 

To make an appointment for access, call (202) 906-5922, send an e-mail to 

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public.info@ots.treas.gov, or send a facsimile transmission to (202) 906-7755. (Prior 

notice identifying the materials you will be requesting will assist us in serving you.) We 

schedule appointments on business days between 10:00 a.m. and 4:00 p.m. In most 

cases, appointments will be available the next business day following the date we receive 

a request. 

FOR FURTHER INFORMATION CONTACT: 

OCC: Daniel Bailey, National Bank Examiner, Credit Risk Division, (202) 874-

5170, Office of the Comptroller of the Currency, 250 E Street SW, Washington, DC 

20219. 

Board: Robert Walker, Senior Supervisory Financial Analyst, Credit Risk, (202) 

452-3429, Division of Banking Supervision and Regulation, Board of Governors of the 

Federal Reserve System. For the hearing impaired only, Telecommunication Device for 

the Deaf (TDD), (202) 263-4869, Board of Governors of the Federal Reserve System, 

20th and C Streets NW, Washington, DC 20551. 

FDIC: Kenyon Kilber, Senior Examination Specialist, (202) 898-8935, Division 

of Supervision and Consumer Protection, Federal Deposit Insurance Corporation, 550 

17th Street NW, Washington, DC 20429. 

OTS: William J. Magrini, Senior Project Manager, (202) 906-5744, Supervision 

Policy, Office of Thrift Supervision, 1700 G Street, NW, Washington, DC 20552. 

SUPPLEMENTARY INFORMATION: 

Background Information 

The Uniform Agreement on the Classification of Assets and Appraisal of 

Securities Held by Banks (current classification system1

) was originally issued in 1938. 

The current classification system was revised in 1949, again in 1979,2 and most recently 

in 2004. Separately in 1993, the agencies adopted a common definition of the special 

mention rating. The current classification system is used by both regulators and 

institutions to measure the level of credit risk in commercial loan portfolios, benchmark 

The supervisory categories currently used by the agencies are: 

Special Mention: A “special mention” asset has potential weaknesses that deserve management’s close 

attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment 

prospects for the asset or in the institution’s credit position at some future date. Special mention assets are 

not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. 

Substandard: A “substandard” asset is inadequately protected by the current sound worth and paying 

capacity of the obligor or by the collateral pledged, if any. Assets so classified must have a well-defined 

weakness, or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct 

possibility that the institution will sustain some loss if the deficiencies are not corrected. 

Doubtful: An asset classified “doubtful” has all the weaknesses inherent in one classified substandard with 

the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently 

known facts, conditions, and values, highly questionable and improbable. 

Loss: An asset classified “loss” is considered uncollectible, and of such little value that its continuance on 

the books is not warranted. This classification does not mean that the asset has absolutely no recovery or 

salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset 

even though partial recovery may be affected in the future. 2

 The Federal Home Loan Bank Board, the predecessor of the OTS, adopted the Uniform Agreement in 

1987. 

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credit risk across institutions, assess the adequacy of an institution’s capital and 

allowance for loan and lease losses (ALLL), and evaluate an institution’s ability to 

accurately identify and evaluate the level of credit risk posed by commercial exposures. 

The current classification system focuses primarily on borrower weaknesses and 

the possibility of loss without specifying how factors that mitigate the loss, such as 

collateral and guarantees, should be considered in the rating assignment. This has led to 

differing applications of the current classification system by institutions and the agencies. 

Under the current classification system, rating differences between an institution 

and its supervisor commonly arise when, despite a borrower’s well-defined credit 

weaknesses, risk mitigants such as collateral and the facility’s structure reduce the 

institution’s risk of incurring a loss. The current classification system does not 

adequately address how, when rating an asset, to reconcile the risk of the borrower’s 

default with the estimated loss severity of the particular facility. As a result, the system 

dictates that transactions with significantly different levels of expected loss receive the 

same rating. This limits the effectiveness of the current classification system in 

measuring an institution’s credit risk exposure. 

To address these limitations, the agencies are proposing a two-dimensional rating 

framework (proposed framework) that considers a borrower’s capacity to meet its debt 

obligations separately from the facility characteristics that influence loss severity. By 

differentiating between these two factors, a more precise measure of an institution’s level 

of credit risk is achieved. 

The proposal includes three borrower rating categories, “marginal,” “weak” and 

“default.” Facility ratings would be required only for those borrowers rated default (i.e. 

borrowers with a facility placed on nonaccrual or fully or partially charged off). 

Typically, this is a very small proportion of all commercial exposures. For borrowers not 

rated default, institutions would have the option of assigning the facility ratings as 

discussed in the proposed framework. 

The agencies believe that this flexibility will allow institutions with both onedimensional and two-dimensional internal risk rating systems to adopt the proposed 

framework. Under the current classification system, institutions with two-dimensional 

internal credit rating systems have encountered problems translating their internal ratings 

into the supervisory categories. 

The agencies also propose to adopt common definitions for the “criticized” and 

“classified” asset quality benchmarks. 

In this proposed framework, the agencies have sought to minimize complexity 

and supervisory burden. The agencies believe that the proposed framework attains these 

goals and that institutions of all sizes will be able to apply the approach. 

The proposed framework aligns the determination of a facility’s accrual status, 

partial charge-off and ALLL treatment with the rating assignment process. The current 

framework does not provide a link between these important determinations and a 

facility’s assignment to a supervisory category. The proposed framework leverages off 

many determinations and estimates management must already make to comply with 

generally accepted accounting principles (GAAP). As a result, financial institutions 

should benefit from a more efficient assessment process and improved clarity. 

This proposed framework, if adopted, would apply to all regulated financial 

institutions and their operating subsidiaries supervised by the agencies. Institutions will 

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be provided transition time to become familiar with the proposal and to implement the 

framework for their commercial loan portfolios. In addition, the agencies will need to 

review the existing classification guidance for specialized lending activities, such as 

commercial real estate lending, to reflect the proposed rating framework. The text of the 

proposed framework statement follows below. 

UNIFORM AGREEMENT ON THE CLASSIFICATION OF 

COMMERCIAL CREDIT EXPOSURES 

This agreement applies to the assessment of all commercial credit exposures both 

on and off an institution’s balance sheet. An institution’s management is encouraged to 

differentiate borrowers and facilities beyond the requirements of this framework by 

developing its own risk rating system. Institutions may incorporate this framework into 

their internal risk rating systems or, alternatively, they may map their internal rating 

system into the supervisory framework. Note that this framework does not apply to 

commercial credit exposures in the form of securities. 

The framework is built upon two distinct ratings: 

• Borrower3

 rating – rates the borrower’s capacity to meet financial 

obligations. 

• Facility rating – rates a facility’s estimated loss severity. 

When combined, these two ratings determine whether the exposure will be a 

“criticized” or “classified” asset, as those asset quality benchmarks are defined. 

BORROWER RATINGS: 

MARGINAL 

A “marginal” borrower exhibits material negative financial trends due to 

company-specific or systemic conditions. If these potential weaknesses are not mitigated, 

they threaten the borrower’s capacity to meet its debt obligations. Marginal borrowers 

still demonstrate sufficient financial flexibility to react to and positively address the root 

cause of the adverse financial trends without significant deviations from their current 

business strategy. Their potential weaknesses deserve institution management's close 

attention and warrant enhanced monitoring. 

A marginal borrower exhibits potential weaknesses, which may, if not checked or 

corrected, negatively affect the borrower’s financial capacity and threaten its ability to 

fulfill its debt obligations. 

The existence of adverse economic or market conditions that are likely to affect 

the borrower’s future financial capacity may support a “marginal” borrower rating. An 

adverse trend in the borrower's operations or balance sheet, which has not reached a point 

where default is likely, may warrant a “marginal” borrower rating. The rating should also 

be used for borrowers that have made significant progress in resolving their financial 

weaknesses but still exhibit characteristics inconsistent with a “pass” rating. 

WEAK 

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 Borrower means any obligor or counterparty in a credit exposure, both on and off the balance sheet. 

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A “weak” borrower does not possess the current sound worth and payment 

capacity of a creditworthy borrower. Borrowers rated weak exhibit well-defined credit 

weaknesses that jeopardize their continued performance. The weaknesses are of a 

severity that the distinct possibility of the borrower defaulting exists. 

Borrowers included in this category are those with weaknesses that are beyond the 

requirements of routine lender oversight. These weaknesses affect the ability of the 

borrower to fulfill its obligations. Weak borrowers exhibit adverse trends in their 

operations or balance sheets of a severity that makes it questionable that they will be able 

to fulfill their obligations, thus making default likely. Illustrative adverse conditions that 

may warrant a borrower rating of “weak” include an insufficient level of cash flow 

compared to debt service needs; a highly leveraged balance sheet; a loss of access to the 

capital markets; adverse industry and/or economic conditions that the borrower is poorly 

positioned to withstand; or a substantial deterioration in the borrower’s operating 

margins. A “weak” rating is inappropriate for any borrower that meets the conditions 

described in the definition of a “default” rating. 

DEFAULT 

A borrower is rated “default” when one or more of the institution’s material4 

credit exposures to the borrower satisfies one of the following conditions: 

(1) the supervisory reporting definition of non-accrual,5

 or 

(2) the institution 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. 

Borrowers rated “default” may be upgraded if they have met their contractual debt 

service requirements for six consecutive months and their financial condition supports 

management’s assessment that they will recover their recorded book value(s) in full. 

FACILITY RATINGS: 

Facilities to borrowers with a rating of default must be further differentiated based 

upon their estimated loss severity. The framework contains additional applications of 

facility ratings; however, institutions may choose not to utilize them. An institution can 

estimate how severe losses may be for either individual loans or pooled loans (provided 

the pooled transactions have similar risk characteristics), mirroring the institution’s 

allowance for loan and lease losses (ALLL) methodologies. Institutions may use their 

ALLL impairment analysis as a basis for their loss severity estimates. 

The four facility ratings are: 

4

 The materiality of credit exposures is measured relative to the institution’s overall exposure to the 

borrower. Charge-offs and write-downs on material credit exposures include credit-related write-downs on 

securities of distressed borrowers for other than temporary impairment, as well as material write-downs on 

exposures to distressed borrowers that are sold or transferred to held-for-sale, the trading account, or other 

reporting categories. 

 An asset should be reported as being in nonaccrual status if (1) it is being maintained on a cash basis 

because of deterioration in the financial condition of the borrower, (2) payment in full of principal and 

interest is not expected, or (3) principal or interest has been in default for a period of 90 days or more 

unless the asset is both well secured and in the process of collection. 

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Loss Severity Category Loss Severity Estimate 

Remote Risk of Loss 0% 

Low <=5% of recorded investment6 

Moderate >5% and <=30% of recorded investment 

High > 30% of recorded investment 

REMOTE RISK OF LOSS 

Management has the option to expand the use of the “remote risk of loss” facility 

rating to borrowers rated “marginal” and “weak.” Facilities or portions of facilities that 

represent a remote risk of loss include those secured by cash, marketable securities, 

commodities, or livestock. In the event of the borrower’s contractual default, 

management must be capable of liquidating the collateral and applying the funds against 

the facility’s balance. The balance reflected in this category should be adequately 

margined to reflect fluctuations in the collateral’s market price. 

Loans for the purpose of financing production expenses associated with 

agricultural crops may be rated “remote risk of loss” if management can demonstrate that 

the loan will be self-liquidating at the end of the production cycle. That is, based upon 

current estimates of yields and market prices for the crops securing the loan, the borrower 

should be expected to yield sufficient cash from the sale to repay the loan in full. 

Facilities guaranteed by the U.S. government or a government-sponsored entity 

(GSE) that have a high investment grade external rating might be included in this 

category. If the guaranty is conditional, the “remote risk of loss” rating should be used 

only when the institution can satisfy the conditions and qualify for payment under the 

terms of the guaranty. 

Asset-based lending facilities may be rated “remote risk of loss” only if certain 

criteria are met, as described below (see “Treatment of Asset-Based Lending Activities.”) 

LOW LOSS SEVERITY 

The “low loss severity” rating applies to exposures to borrowers rated default. 

Loss severity is estimated to be 5 percent or less of the institution’s recorded investment. 

Asset-based lending facilities to Weak borrowers may be rated “low loss severity” only if 

certain criteria are met, as described below (see “Treatment of Asset-Based Lending 

Activities.”) 

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 Recorded investment means the exposure amount reported on the financial institution’s balance sheet per 

the Call Report or Thrift Financial Report instructions. 

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MODERATE LOSS SEVERITY 

The “moderate loss severity” rating only applies to exposures to borrowers rated 

default. Loss severity is estimated to be greater than 5 percent and at most 30 percent of 

the institution’s recorded investment. Recovery in full is not likely. 

HIGH LOSS SEVERITY 

The “high loss severity” rating only applies to exposures to borrowers rated 

default. Loss severity is estimated to be greater than 30 percent of the institution’s 

recorded investment. Recovery in full is not likely. 

LOSS 

Assets rated “loss” are considered uncollectible and of such little value that their 

continuance on the institution’s balance sheet is not warranted. This rating does not 

mean that the asset has absolutely no recovery or salvage value (it may indeed have some 

fractional future value), but rather that it is not practical or desirable to defer writing off 

this basically worthless asset. 

Portions of facilities rated “low loss severity” and “moderate loss severity” must 

be rated loss when they satisfy this definition. Entire facilities or portions thereof rated 

“high loss severity” must be rated loss if they satisfy the definition. Balances rated loss 

are charged off and netted from the facility’s balance and the institution’s loss severity 

estimate must be updated to reflect the uncertainty in collecting the remaining recorded 

investment. 

A loss rating for an exposure does not imply that the institution has no prospects 

to recover the amount charged off. However, institutions should not maintain an asset or 

a portion thereof on their balance sheet if realizing its value would require long-term 

litigation or other lengthy recovery efforts. A facility should be partially rated “loss” if 

there is a remote prospect of collecting a portion of the facility’s balance. When the 

collectibility of the loan becomes highly questionable, it should be charged off or written 

down to a balance equal to a conservative estimate of its net realizable value under a 

realistic workout strategy. When access to the collateral is impeded, regardless of the 

collateral’s value, the institution’s management should carefully consider whether the 

facility should remain a bankable asset. Furthermore, institutions need to recognize 

losses in the period in which the asset is identified as uncollectible. 

TREATMENT OF ASSET-BASED LENDING FACILITIES 

Institutions with asset-based lending (ABL) activities can utilize the following 

facility ratings for qualifying exposures; however, this treatment is not required. Some 

ABL facilities, including some debtor-in-possession (DIP) loans, may be included in the 

“remote risk of loss” category if they are well-secured by highly liquid collateral and the 

institution exercises strong controls over the collateral and the facility. ABL facilities 

secured by accounts receivable or other collateral that readily generates sufficient cash to 

repay the loan may be included in this category. In addition, the institution must have 

dominion over the cash generated from the conversion of collateral, prudent advance 

rates, strong monitoring controls, such as frequent borrowing base audits, and the 

expertise to liquidate sufficient collateral to repay the loan. Facilities that do not possess 

these characteristics are excluded from the category. 

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ABL facilities and the lending institution must meet certain characteristics for the 

exposure to be rated “remote risk of loss.” 

z Convertibility 

– Institution is able to liquidate the collateral within 90 days of 

the borrower’s contractual default. 

– Collateral is readily convertible to cash. 

z Coverage 

– Loan is substantially over-collateralized such that full recovery 

of the exposure is expected. 

– Collateral has been valued within 60 days. 

z Control 

– Collateral is under the institution’s control. 

– Active lender management and credit administration can 

mitigate all loss through disbursement practices and collateral 

controls. 

For ABL facilities whose borrower is rated weak, management may assign the 

“low loss severity” rating if the conditions set forth below are satisfied: 

z Convertibility 

– Institution is able to liquidate collateral within 180 days of the 

borrower’s contractual default. 

– Substantial amount of the collateral is self-liquidating or 

marketable.

z Coverage 

– Loss severity is estimated to be 5 percent or less. 

– Collateral has been valued within 60 days. 

z Control 

– Collateral is under the institution’s control. 

– Active lender management and credit administration can 

minimize loss through disbursement practices and collateral 

controls. 

The institution’s ABL controls and capabilities are the same as those described in 

the “remote risk of loss” description above. This category simply lengthens the period it 

would likely take the institution to liquidate the collateral from 90 days to 180 days and 

increases the loss severity estimate from full recovery of the exposure to 5 percent or less. 

COMMERCIAL CREDIT RISK BENCHMARKS: 

Criticized Assets = All loans to borrowers rated marginal, excluding those facilities, or 

portions thereof, rated “remote risk of loss” 

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plus 

ABL transactions to borrowers rated weak, if they satisfy the “low 

loss severity” definition. 

Classified Assets = All loans to borrowers rated default, excluding those facilities, or 

portions thereof, rated “remote risk of loss” 

plus 

All loans to borrowers rated weak, excluding those facilities, or 

portions thereof, rated “remote risk of loss” and ABL transactions 

rated “low loss severity.” 

When calculating a financial institution’s criticized and classified assets, the 

institution’s recorded investment plus any undrawn commitment that is reported on the 

institution’s Call Report or Thrift Financial Report is included in the total, excluding any 

balances rated “remote risk of loss.” In the cases of lines of credit with borrowing bases 

or any other contractual restrictions that prevent the borrower from drawing on the entire 

committed amount, only the amount outstanding and available under the facility is 

included — not the full amount of the commitment. However, the lower amount should 

be used only if it is management’s intent and practice to exert the institution’s contractual 

rights to limit its exposure. 

FRAMEWORK PRINCIPLES 

The borrower ratings should be utilized for both improving and deteriorating 

borrowers. Management should refresh ratings with adequate frequency to avoid 

significant jumps across their internal rating scale. 

When a facility is unconditionally guaranteed, the guarantor’s rating can be 

substituted for that of the borrower to determine whether a facility should be criticized or 

classified. If the guarantor does not perform its obligations under the guarantee, the 

guarantor is rated default and the facility is included in the institution’s classified assets. 

Loss severity estimates must relate to the institution’s recorded investment, net of 

prior charge-offs, borrower payments, application of collateral proceeds, or any other 

funds attributable to the facility. 

Each loss severity estimate for borrowers rated default must reflect the 

institution’s estimate of the asset’s net realizable value or its estimate of projected future 

cash flows and the uncertainty of their timing and amount. For this purpose, financial 

institutions may use their impairment analysis for determining the adequacy of their 

ALLL. Facilities may be analyzed individually or in a pool with similar facilities. 

The “default” borrower rating in no way implies that the borrower has triggered 

an event of default as specified in the loan agreement(s). The rating indicates only that 

management has placed one or more of the borrower’s facilities on non-accrual or 

recognized a full or partial charge-off. Legal determinations and collection strategies are 

the responsibility of management. If a borrower is rated default, it does not imply that 

the lender must take any particular action to collect from the borrower. 

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When management recognizes a partial charge-off, the loss severity estimate and 

facility rating should be updated. For example, after a facility is partly charged off, its 

loss severity may improve and warrant a better rating. 

Estimating loss severity for many exposures to defaulted borrowers is difficult. If 

borrowers have filed for bankruptcy protection, there is normally significant uncertainty 

regarding their intent and ability to reorganize, to sell assets, to sell divisions, or, if it 

comes to that, to liquidate the firm. In addition, there is considerable uncertainty 

regarding the timing and amount of cash flows that these various strategies will produce 

for creditors. As a result, the loss severity estimates for facilities to borrowers rated 

default should be conservative and based upon the most probable outcome given current 

circumstances and the institution’s loss experience on similar assets. The financial 

institution should be able to credibly support recovery rates on facilities in excess of the 

underlying collateral’s net realizable value. Supervisors will focus on estimates where 

institution management has estimated recovery rates in excess of a loan’s collateral value. 

Market prices for a borrower’s similar exposures are one indication of a claim’s intrinsic 

value. However, distressed debt prices may not be a realistic indication of value if 

trading volume is low compared to the magnitude of the institution’s exposure. 

Split facility ratings should be used only when part of the facility meets the 

criteria for the “remote risk of loss” category. When a portion of a facility is rated 

“remote risk of loss,” management’s loss severity estimate should only reflect the risk 

associated with the remaining portion of the facility. 

To eliminate the need for split facility ratings and further simplify the framework, 

institutions have the option to disregard the “remote risk of loss” category for loans 

partially secured by collateral that qualify for the treatment. In that case, the institution 

would reflect the loss characteristics of the loan in its entirety when estimating the loan’s 

loss severity and slot the loan in one of the three remaining facility ratings. 

Because individually rating every borrower would be labor-intensive and costly, 

institutions may use an alternative rating approach for borrowers with an aggregate 

exposure below a specified threshold. Examiners will evaluate the appropriateness of the 

alternative rating approach and aggregate exposure threshold by considering factors such 

as the size of the institution, the risk profile of the subject exposures, and management’s 

portfolio management capabilities. 

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The following chart summarizes the structure of the proposed framework: 

APPENDIX A. APPLICATION OF FRAMEWORK 

The following examples highlight how certain loan facilities should be rated 

under the “Uniform Agreement on the Assessment of Commercial Credit Risk.” 

Example 1. Marginal Borrower Rating 

Credit Facility: $100 line of credit for working capital, $50 outstanding 

Source of Repayment: 

 Primary: Cash flow from conversion of assets 

 Secondary: Security interest in all corporate assets 

Collateral: Accounts receivable with a net book value of $70 from 

large hospitals, nursing care facilities, and other health care 

providers. Receivables turn slowly, 120-150 days, but with a low 

level of uncollectible accounts. No customer concentrations 

exceed 5 percent of sales. Modest inventory levels consist of 

products to fill specific orders. 

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Situation: The borrower is a distributor of health care products. 

Consolidation of health care providers in the firm’s market area 

has had a negative effect on its revenues, profitability, and cash 

flow. The borrower’s balance sheet exhibits moderate leverage 

and liquidity. The firm is currently operating at break-even. The 

firm has developed a new relationship with a hospital chain that 

operates in adjacent markets to the firm’s traditional trade area. 

The new client is expected to increase sales by 10 percent in the 

coming fiscal year. If this expectation materializes, the borrower 

should return to profitability. Line utilization has increased over 

the last fiscal year; however, the remaining availability should 

provide sufficient liquidity during this slow period. 

Borrower Rating: The borrower has shown material negative financial trends; 

however, it appears that there is sufficient financial flexibility to 

positively address the cause of the concerns without significant 

deviation from its original business plan. Accordingly, the 

borrower is rated marginal. 

The loan is included in criticized assets. 

Example 2. Weak Borrower Rating 

Credit Facility: $100 line of credit for working capital purposes, $100 outstanding. 

Borrowing base equal to 70 percent of eligible accounts receivable. 

Sources of Repayment: 

 Primary: Cash flow from conversion of assets 

 Secondary: Security interest in all unencumbered corporate assets 

Situation: The borrower is a regional truck transportation firm. A 

sustained increase in fuel prices over the last six months led to 

operating losses. The borrower has been unable to increase prices 

to offset the higher fuel prices. 

The borrower’s interest payments have been running 15 to 

30 days late over the last several months. Net cash flow from 

operations is breakeven, but sufficient to meet lease payments on 

its truck fleet. The borrower leases all of its trucks from the 

manufacturer’s leasing company. The line was recently fully 

drawn to pay registration fees and insurance premiums for the 

fleet. The borrower is moderately leveraged and has minimal 

levels of liquid assets. Borrower continues to maintain its 

customer base and generate new business, but pricing pressures are 

forcing it to run unprofitably. 

The most recent borrowing base certificate indicates the 

borrower is in compliance with the advance rate. 

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Borrower and 

Facility rating: The borrower’s unprofitable operations and lack of 

liquidity constitute well-defined credit weaknesses. As a result, 

the borrower is rated weak. 

The loan is included in classified assets. 

Example 3. Remote Risk of Loss Facility Rating 

Credit Facilities: $100 line of credit to fund seasonal fluctuations in cash flow 

$100 mortgage for the acquisition of farmland 

Sources of Repayment: 

 Primary: Cash flow from operations 

 Secondary: Security interest in collateral 

Collateral: The line of credit is secured by livestock and crops with a 

market value of $110. The mortgage is secured by a lien on 

acreage valued at $75. A U.S. government agency guarantee was 

obtained on the mortgage loan. The guarantee covers 75% of any 

principal deficiency the institution suffers on the mortgage. 

Situation: Borrower’s financial information reflects the negative 

effect of low commodity prices and a reduction in the value of the 

livestock. The borrower does not have adequate sources of 

liquidity to remain operating. Both loans have been placed on 

nonaccrual since they are delinquent in excess of 90 days. 

Institution management has completed a recent inspection of the 

livestock and crops securing their loan. The borrower has placed 

its operations up for sale, including all of the collateral securing 

both loans. The farmland is under contract with a purchase price 

of $75. Management expects to realize after selling expenses $100 

from the sale of livestock and crops and $70 from the sale of the 

farmland. As a result, management expects to collect 

approximately $20 (75% of $30) under the government guarantee. 

Management estimates that the mortgage has impairment of $10 

based on the fair value of the collateral and the guarantee. 

Borrower and 

Facility rating: The borrower is rated default because the loans are on 

nonaccrual. 

Because the line of credit is adequately collateralized by 

marketable collateral, the facility is rated “remote risk of loss.” 

The portion of the mortgage supported by the sale of the property 

and proceeds from the government guarantee, $90, is also 

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considered “remote risk of loss.” The remaining $10 balance is 

rated loss due to the collateral shortfall and the unlikely prospects 

of collecting additional amounts. 

The line of credit and the portion of the mortgage supported 

by the government guarantee are included in pass assets. 

Example 4. Rating Assignments for Multiple Loans to a Single Borrower 

Credit Facilities: $100 mortgage for permanent financing of an office building 

located at One Main Street. 

$100 mortgage for permanent financing of an office building 

located at One Central Avenue. 

Sources of Repayment: 

 Primary: Rental income

Secondary: Sale of real estate 

Collateral: Each loan is secured by a perfected first mortgage on the 

financed property. The values of the Main Street and Central 

Avenue properties are $85 and $110, respectively. 

Situation: The borrower is a real estate holding company for the two 

commercial office buildings. The Main Street building is not 

performing well and is generating insufficient cash flow to 

maintain the building, renovate vacant space for new tenants, and 

service the debt. The borrower is more than 90 days delinquent on 

the building’s mortgage. Because the building’s rents have 

declined and its vacancy rate has increased, the fair market value 

of the troubled property has declined to $85 from $120 at the time 

of loan origination. Market conditions do not favor better 

performance of the Main Street property in the short run. As a 

result, management has placed the loan on nonaccrual. 

The Central Avenue property is performing adequately, but 

is not generating sufficient excess cash flow to meet the debt 

service requirements of the first loan. The property is currently 

estimated to be worth $110. Since the loan’s primary source of 

repayment remains adequate to service the debt, the credit remains 

on accrual basis. 

According to institution management’s estimates, 

foreclosing on the troubled Main Street building and selling it 

would realize $75, net of brokerage fees and other selling 

expenses. However, the institution is exploring other workout 

strategies exclusive of foreclosure. These strategies may mitigate 

the amount of loss to the institution. To be conservative, the 

institution bases its loss severity estimate on the foreclosure 

16 
scenario. If the Central Avenue building continues to generate 

sufficient cash flow to service the loan and maintains its fair 

market value, the institution does not expect to incur any loss on 

the second loan. Therefore, management assigns a 5 percent loss 

severity estimate to the facility, which is equal to its impairment 

estimate for a pool of similar facilities and borrowers. 

Borrower and 

Facility Ratings: The borrower is rated default because the one mortgage is 

on non-accrual. 

The mortgage on the Main Street property is rated 

“moderate loss severity” (>5% and <=30%) because 

management’s estimate is a 25 percent loss severity. The 

mortgage on the Central Avenue property is rated “low loss 

severity” (<=5%) because management’s estimate is a 5 percent 

loss severity. 

Both facilities are included in classified assets. 

Example 5. Loss Recognition 

Credit Facility: $100 term loan 

Source of Repayment: 

Primary: Cash flow from business 

Secondary: Security interest in collateral 

Collateral: The institution has a blanket lien on all business assets with 

an estimated value of $60. 

Situation: The borrower is seriously delinquent on its loan payments 

and has filed for bankruptcy protection. Because the borrower’s 

business prospects are poor, liquidation of collateral is the only 

means by which the institution will receive repayment. 

Management estimates net realizable value ranges between $50 

and $60. As a result, management charges off $40 and places the 

loan on nonaccrual. Management also assigns a 10 percent loss 

severity estimate to the remaining balance, which is equal to its 

impairment estimate for a pool of similar facilities and borrowers. 

Borrower and 

Facility Rating: Since the borrower’s facility was placed on nonaccrual and 

partially charged off, the borrower is rated default. 

After recognizing a loss in the amount of $40, the facility’s 

remaining balance is rated “moderate loss severity” (>5% and 

17 
<30%) because management’s analysis indicates impairment of 10 

percent of the loan balance. 

The loan is included in classified assets. 

Example 6. Asset-backed Loan 

Credit Facility: $100 revolving credit facility, $50 outstanding with $20 available 

under the borrowing base 

Sources of Repayment: 

 Primary: Conversion of accounts receivable 

 Secondary: Liquidation of collateral 

Collateral: Accounts receivable from companies with investment grade 

external ratings. 

Situation: The borrower manufactures patio furniture. Because the 

prices of aluminum and other raw materials have increased, the 

borrower’s profit margin has compressed significantly. As a 

result, the borrower’s financial condition exhibits well-defined 

credit weaknesses. 

Despite the borrower’s financial weakness, the financial 

institution is well-positioned to recover its loan balance and 

interest. The institution controls all cash receipts of the company 

through a lock-box and applies excess funds daily against the loan 

balance. The institution also controls the borrower’s cash 

disbursements. The facility has a borrowing base that allows the 

borrower to draw 70 percent of eligible receivables. Eligibility is 

based on restrictive requirements designed to exclude low-quality 

or disputed receivables. Management monitors adherence to the 

requirements by conducting periodic on-site audits of the 

borrower’s accounts receivable. Management estimates that the 

facility is not impaired because the collateral is liquid and has 

ample coverage, the account receivables counterparties are highly 

creditworthy, and the institution’s management not only has tight 

controls on the loan but also has a favorable track record of 

managing similar loans. In the event of the borrower’s contractual 

default, the institution’s management believes that it would recover 

sufficient cash to repay the loan within 60 days. 

Borrower and 

Facility Rating: The borrower is rated weak due to its well-defined credit 

weaknesses. 

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The facility is rated “remote risk of loss” because of 

institutional management’s expertise; the facility’s strong controls 

and high quality; and the collateral’s liquidity and ample coverage. 

The facility is included in pass assets. 

Example 7. Debtor-in-Possession 

Credit Facility: $100 debtor-in-possession (DIP) facility, $70 outstanding with $10 

available 

$100 term loan 

Sources of Repayment: 

 Primary: Cash flow from operations 

 Secondary: Liquidation of collateral 

Collateral: The DIP facility is secured by receivables from several 

investment grade companies and underwritten with a conservative 

advance rate to protect against dilution risk. 

The term loan is secured by equipment. 

Situation: The borrower has filed for Chapter 11 bankruptcy 

protection because the recall of one of the company’s products has 

precipitated a substantial decline in sales. The product liability 

litigation resulted in substantial legal expenses and settlements. 

Because collecting the term loan in full is very unlikely, the 

financial institution’s management placed the term loan on 

nonaccrual prior to the borrower’s bankruptcy filing. Management 

estimates the institution will collect 70 percent to 80 percent on 

their secured claim under the borrower’s bankruptcy 

reorganization plan. Based on this estimate, management charges 

off $20 and estimates impairment of $10 for the remaining 

balance. The DIP facility repaid the pre-petition asset-based line 

of credit. Management has expertise in asset-based lending and 

strong controls over the activity. 

Borrower and 

Facility Rating: The borrower is rated default since one of its facilities was 

placed on nonaccrual. 

The DIP facility is rated “remote risk of loss” not only 

because it is secured by high-quality receivables with ample 

coverage, but also because the financial institution’s management 

has performed frequent borrowing-base audits and has strong 

controls over cash disbursements and collections. The term loan is 

rated “moderate loss severity” (>5% and <=30%) because 

19 
___________________________________________________________________ 

management’s impairment estimate for the remaining loan balance 

falls within this range. 

The DIP facility is included in pass assets. 

The term loan is included in classified assets. 

Request for Comment 

The agencies request comments on all aspects of the proposed policy statement. 

In addition, the agencies also are asking for comment on a number of issues affecting the 

policy and will consider the answers before developing the final policy statement. In 

particular, your comments are needed on the following issues: 

1. The agencies intend to implement this framework for all sizes of institutions. 

Could your institution implement the approach? 

2. If not, please provide the reasons. 

3. What types of implementation expenses would financial institutions likely incur? 

The agencies welcome financial data supporting the estimated cost of 

implementing the framework. 

4. Which provisions of this proposal, if any, are likely to generate significant 

training and systems programming costs?

5. Are the examples clear and the resultant ratings reasonable? 

6. Would additional parts of the framework benefit from illustrative examples? 

7. Is the proposed treatment of guarantors reasonable? 

Please provide any other information that the agencies should consider in determining the 

final policy statement, including the optimal implementation date for the proposed 

changes. 

20 
[THIS SIGNATURE PAGE PERTAINS TO THE JOINT NOTICE AND REQUEST 

FOR COMMENT, “INTERAGENCY PROPOSAL ON THE CLASSIFICATION OF 

COMMERCIAL CREDIT EXPOSURES”] 

Dated: March 17, 2005 

Julie L. Williams (signed)

Julie L. Williams, 

Acting Comptroller of the Currency 

21 
[THIS SIGNATURE PAGE PERTAINS TO THE JOINT NOTICE AND REQUEST 

FOR COMMENT, “INTERAGENCY PROPOSAL ON THE CLASSIFICATION OF 

COMMERCIAL CREDIT EXPOSURES”] 

Board of Governors of the Federal Reserve System, March 21, 2005 

Jennifer J. Johnson (signed)

Jennifer J. Johnson, 

Secretary of the Board. 

22 
[THIS SIGNATURE PAGE PERTAINS TO THE JOINT NOTICE AND REQUEST 

FOR COMMENT, “INTERAGENCY PROPOSAL ON THE CLASSIFICATION OF 

COMMERCIAL CREDIT EXPOSURES”] 

Dated at Washington, D.C., this 18th day of March, 2005. 

FEDERAL DEPOSIT INSURANCE CORPORATION 

Robert E. Feldman (signed)

Robert E. Feldman, 

Executive Secretary. 

23 
[THIS SIGNATURE PAGE PERTAINS TO THE JOINT NOTICE AND REQUEST 

FOR COMMENT, “INTERAGENCY PROPOSAL ON THE CLASSIFICATION OF 

COMMERCIAL CREDIT EXPOSURES”] 

Dated: March 18, 2005 

 By the Office of Thrift Supervision, 

James E. Gilleran (signed)

James E. Gilleran, 

Director. 

24