Credit Risk Management is used to minimize a bank‘s risk, like adjusting credit facility pricing (rate of return) to maintain credit risk exposure within acceptable parameters. Banks are required to manage the credit risk of the entire portfolio and the risk in individual credits or transactions. Banks have to consider relationships between credit risk and other risks with the effect of credit failure on additional risks. Credit Risk Management is the process of reducing losses by understanding the adequacy of a bank’s capital and loss of loan reserves at any given time. Effective Credit Risk Management is a challenge for financial institutions but essential to get long-term success for any banking organization.
A comprehensive understanding of the overall credit risk of a bank by looking at the risk of individuals, customers, and portfolios is necessary for effective credit risk management. To analyze and manage risk, banks are using significant resources and sophisticated programs; some banks run a Credit Risk Management department whose work is to assess their customers’ financial health from time to time.
Nowadays, most banks have their credit rating (scoring) mode. These models generally have qualitative and quantitative sections for corporate and commercial borrowers, illustrating multiple aspects of the risk, but are not restricted to, operating experience, management expertise, asset quality, leverage and liquidity ratios, etc. After the banks have thoroughly checked this information, the lender provides the funds according to the terms and conditions presented in the contract. Also, they are using the portal Consumer CIBIL to know the customer’s past credit history. Risk is controlled by setting credit limits on products like credit cards, overdrafts, etc. Some products also require collateral security; usually an asset pledged to secure the loan’s repayment.
The lender may perform a pre-lending inspection of the prospective borrower and verify the prospective borrower’s information to reduce credit risk. The borrower is expected to take adequate insurance, such as mortgage insurance, or obtain protection over any of the borrower’s properties or a third-party guarantee. The lender can also carry risk insurance or sell the debt to another business to minimize its risk. Generally, the lender asks the borrower to pay a higher interest rate if the risk is high.
As a result of the global financial crisis and the credit crunch, Credit Risk Management is becoming a regulatory priority, and regulators demand greater transparency regarding bank’s knowledge of customers and their associated credit risk. Also, the new Basel III regulations will create an even more significant regulatory burden for banks. A better credit risk management significantly improves overall performance and secures a competitive advantage.
The Credit Risk Management strategy of any bank is the impression of Credit risk-taking, and one can understand the bank’s direction through bank credit lending or credit risk over time.