Risk is a part and parcel of doing business and no business is immune to risks. However, the degree of risk varies for businesses in different industries. Banks and financial institutions who are in the business of lending funds have a higher degree of risk as they are involved in loaning funds to multiple individuals and businesses. When the borrowers default on their loan repayments it increases the credit risk for banks and other lending parties.
Credit risk cannot be mitigated but they can be controlled and managed to a controllable level that reduces the risk exposure for lenders. Credit risk management is an important aspect for those who are in the business of loaning money. Loaning funds to individual customers can be riskier as compared to loaning money to businesses and corporations. Assessing the risk element based on the profile of the customer is the key to managing risks.
Credit risk can be simply explained as the risk or loss that occurs when a borrower fails to meet its loan obligations and repay the money within a specified time frame as decided in the contract. Credit risk can take multiple shapes and forms. Some of the most commonly known types of credit risks include credit default risk, concentration risk, country or sovereign risk.
The concentration credit risk arises when banks or financial institutions specialise in lending their money to a specific sector or industry. In this case, an economic downtrend in the given sector can lead to huge defaults and losses for the lending party. Concentrating the lending to a limited number of segments should be avoided as it leads to unwanted defaults when that particular industry is not performing well.
The country or sovereign risk is associated with the political and macro-economic factors of a particular country or region. Unfavourable business circumstances can cause huge losses and lead to an overall economic slowdown in a country, this can lead to heavy losses for banks and financial institutions who are lending funds to borrowers in these countries.
Let’s delve deeper into how credit risk management can be facilitated effectively and improved by the lending parties.
- Credit Strategy & Credit Policy: A robust credit strategy helps to keep a check on how the funds are lent out to borrowers. Credit strategy of a bank or financial institution helps to identify the bank’s willingness to take risk and bear loses. Credit policies are built to guide the credit strategy and the lending process of a financial institution. If the borrower falls outside the desired credit risk limits, the loans request should be refused to avoid larger than expected or normal loses.
- Credit Analysis: A strong credit analysis process helps to provide a comprehensive understanding of the borrower’s profile and analyse the feasibility of loaning money to different borrowers. During the credit analysis process, the borrower’s personal financial information is gathered and analysed to see his historical track record and performance.
- Credit Risk Mitigation: There are various ways to mitigate credit risk for banks and other lending institutions. One of the most common ones is by the method of diversification. Diversification leads to a reduced concentration of funds to any one industry or segment. This helps to reduce the risk exposure in the care industry is not performing well. Lending institutions can mitigate their risk by loaning out to players in multiple industries or segment instead of focusing on just one.
- Another way to reduce credit risk is by charging a different rate of interest from different borrowers. Those who have a higher credit risk will have to pay a higher level of interest rate as compared to the ones who are categorised under low credit risk category based on the credit score. Lending parties can also avail credit insurance that aims to hedge the credit risk in case of default by a borrower for a premium amount.