Lending money—to a friend, a business partner, or to a loan applicant—comes with the possibility that it may not be returned. This could be because the borrower simply doesn’t have the funds to return, or they don’t want to return the amount.

In its most simple form, this is what’s termed as credit risk. And while banks cannot completely eliminate credit risk, they mitigate it through effective credit risk management.

Credit risk management helps keep a lender’s risk exposure within reasonable bounds, and aims to maximise the lender’s risk adjusted rate of return.

This is why financial institutions engage in multiple rounds of checks before sanctioning a loan.

Importance of Credit Risk Management in Financial Institutions

Financial institutions incur losses when borrowers default on their loans or fail to repay on time. Proper credit risk management enables financial institutions to assess, monitor and manage credit risk while ensuring that lending activities are consistent with their risk appetite and risk tolerance.

Plus, effective credit risk management helps financial institutions maintain credit risk exposure within reasonable parameters. 

The crucial elements and principles of credit risk management are as follows:

(i) Creating a suitable setting for credit risk management;

(ii) Following a reliable credit-granting process;

(iii) Keeping a suitable credit administration, measurement and monitoring process; and

(iv) Making sure that credit risk is adequately controlled.

A comprehensive credit risk management programme that covers these principles can help financial institutions manage credit risk effectively. While specific credit risk management procedures may vary among banks based on the nature and complexity of their credit activities, they all require a reliable risk management strategy to safeguard their assets and ensure their long-term success. 

How do Banks Manage Credit Risk?

There are several steps that banks take to manage credit risk effectively:

• Credit Assessment : They conduct a thorough credit assessment of potential borrowers to evaluate their creditworthiness and determine the appropriate terms and conditions for the loan. This may include reviewing the borrower's credit history, financial statements and other relevant information.

• Credit Scoring : Banks use credit scoring models to assess each loan's default or delinquency risk. Credit scoring models use statistical methods to analyse data and assign a credit score that reflects the borrower's risk level.

• Loan Structuring : They structure loans to minimise the risk of default and maximise the likelihood of repayment. This may include setting appropriate loan terms and conditions, such as interest rates, collateral requirements and repayment schedules.

• Credit Monitoring: Banks monitor their loan portfolios to identify potential credit risks and take appropriate action to mitigate them. This may include reviewing borrower financial statements, credit reports and other relevant information.

• Risk Mitigation : They use various risk mitigation techniques to manage credit risk effectively. This may include diversifying their loan portfolios, hedging their credit risk through credit derivatives or insurance and setting aside reserves for loan losses.

• Regulatory Compliance: Banks need to comply with regulatory requirements related to credit risk management, such as maintaining adequate reserves for loan losses, following appropriate lending practices and reporting credit risk exposures to regulatory authorities.

Assessment of Credit Risks

A sound credit risk assessment procedure helps weed out defaulters and ensures that only borrowers who fall within the lending party's intended credit risk limit receive loans. Knowing whether borrowers can repay their debts within a given time helps organisations avoid losses.

A borrower's credit risk profile is partly determined by many factors. These variables include

• Security or collateral,

• Financial capability,

• Credit background,

• Capital needs,

• Loan standards.

Based on these crucial considerations, the suitability of loans and the related credit risk are examined.

When evaluating a borrower's credit risk, the 3C method is quite popular. Let's take a look at these crucial components of the credit risk evaluation procedure.

Credit experience : Based on the borrower's prior borrowing experience, this component evaluates the borrower by assessing the borrower's capacity and intent to repay the loan. However, this does not imply that those with no credit history are risky borrowers.

Collateral : If a borrower offers to put up collateral as security for the loan, this can expedite the loan process and serve as a safety net for the lender. The pledged collateral may be sold to recoup the lender's losses if the borrower defaults on the debt.

Cash flow: Cash flow is a metric for the borrower's ability to repay the debt balance. If the borrower has consistent and ample cash flow, they can easily repay the debt sum.

Aspects of Credit Risk Management

As the world becomes increasingly interconnected, credit risk management has become critical to any successful lending portfolio or financial institution. With so much at stake, from financial losses to reputational damage, it's more important than ever for lenders to manage their risk exposure effectively. This requires a combination of tools and strategies, such as:

1. Credit scoring models : This is the most popular tool lenders use to assess the creditworthiness of potential borrowers. These models use a variety of factors, such as credit history, income and debt-to-income ratio to assign a credit score to the borrower. These help lenders decide whether to approve a loan application and at what interest rate.

2. Loan covenants : Loan covenants are conditions included in a loan agreement that the borrower must adhere to maintain the loan. These conditions may include limits on the borrower's debt-to-income ratio, requirements for maintaining a certain level of collateral or restrictions on the borrower's ability to take on additional debt. These help reduce the risk of default and ensure the borrower can repay the loan.

3. Collateral requirements : Collateral refers to assets a borrower pledges as security for a loan. Collateral requirements mitigate the risk of default by ensuring that the lender has a means of recovering some or all of their losses in the event of a default. Common types of collateral include real estate, vehicles and other high-value assets.

4. Risk-based pricing is a pricing strategy in which lenders adjust the interest rate or fees charged for a loan based on the level of risk associated with the borrower. Borrowers with a higher credit score and lower risk of default may be offered lower interest rates, while those with a lower credit score and higher risk of default may be offered higher rates.

5. Stress testing : Stress testing evaluates how a lending portfolio would perform under various hypothetical scenarios, such as a recession or a sudden increase in interest rates. By stress testing their lending portfolios, lenders can identify potential weaknesses and take steps to mitigate their risk exposure.

By leveraging these tools, lenders can make more informed lending decisions and ensure their operations' long-term stability and profitability.

Why is Credit Risk Management Crucial?

For lenders, 

• Better decision-making: Credit risk management facilitates better credit decision-making because it is meticulously analysed and tracked.

• Increased profitability : As risk is minimised, lending becomes more cost-efficient and profitable. 

• A greater understanding of customer’s creditworthiness: Credit risk management lowers fraud as fraud detection and a customer's creditworthiness can be quickly established by looking at their portfolios.

And while these might look internal, they have a major impact on the organisation as a whole. Here’s how:

1. Defending financial organisations against credit losses: Financial organisations are shielded from credit losses by managing credit risk. It facilitates improved decision-making for financiers. Credit losses can result in significant financial losses for monetary organisations, which could impact their operations and overall reputation.

2. Enhancing the standard of lending portfolios: Credit risk management improves the calibre of lending portfolios by minimising the possibility of frauds and defaults.  A high-quality lending portfolio can improve the organisation's reputation and attract new customers. Borrowers are more likely to trust a lender that has a track record of making sound lending decisions and managing credit risk effectively.

3. Lowering the chance of default on loans: Lack of credit risk management increases the possibility of debt defaults. Credit risk management lowers the chance of default, thus ensuring financial stability.  

Conclusion 

While profit and risk go together, in the end, it comes down to how much risk any given entity is prepared to take. But is credit risk management enough? How can an entity safeguard itself optimally?

FinBox’s DeviceConnect utilises advanced analytics and machine learning algorithms to provide insights into the borrower's behaviour and risk level. DeviceConnect assembles a thorough image of the debtor's resources and behavioural indicators. It works by collecting and analysing device data to generate a risk score that indicates the likelihood of default.

Book a demo to take your credit risk management practices to the next level.