The Importance of Credit Risk Management in Banking
Banking operations come with the factor of risk; it’s inevitable. In the simplest way possible, risk is an uncertainty of a situation or event that may happen in the future and for banks, it’s the uncertainty of an outcome of business investments. The various types of banking risks may be classified as Strategic risk, Compliance risk, Credit risk, Cyber Security risk, Liquidity risk, Market risk, Operational risk, etc. Out of these Credit Risk represents the most important type of risk for commercial banks.
Credit risk is understood simply as the risk a bank takes while lending out money to borrowers. They might default and fail to repay the dues in time and these results in losses to the bank. Loan portfolio management is very important but most times a bank can’t fully assess if it will retrieve the money back because even if the borrowers have been paying their dues on time, the economy might show shift and change the way things have always been. So, what do banks do then? They need to manage their credit risks.
The goal of credit risk management in banks is to maintain credit risk exposure within proper and acceptable parameters. It is the practice of mitigating losses by understanding the adequacy of a bank’s capital and loan loss reserves at any given time. For this, banks not only need to manage the entire portfolio but also individual credits.
How do banks set up a Credit Risk Management system?
Even though every bank may have their own approach to establishing credit risk management models, there are a few basic steps that every Credit Risk Management includes-
- A complete understanding of a bank’s own capital reserve.
Understanding a bank’s overall credit risk based on individual, customer and portfolio levels.
- Implementing an integrated and quantitative credit risk solution to make an appropriate credit risk environment.
- The business model in place should be such that is ever-evolving, able to achieve real-time scoring to limit monitoring, have data visualization capabilities and business intelligence tools to make it available any time.
- Establishing a sound credit-granting process or criteria that will clearly indicate the bank’s target market. This should include appropriate credit administration, measurement and monitoring process.
These are some principle ways to set up a Credit Risk Management system that will help in minimizing risk and maximizing reputation and productivity. Often, banks do prefer having a consulting agency to look after their Credit Risk Management since managing credit risk is a tricky task due to a lot of recommendations and predictions, thus there shouldn’t be any possibility of loopholes in the process.
What are the advantages and disadvantages of Credit Risk Management?
- It helps in predicting and/ or measuring the risk factor of any transaction.
- It helps in planning ahead with strategies to tackle a negative outcome.
- It helps in setting up credit models which can act as a valuable tool to determine the level of risk while lending.
- Prediction is not entirely scientific, so judgement made can go either way.
- Cost and control of operating a credit scoring system are questionable.
- While different models may work, there are no guarantees. For this reason, some banks prefer one model
Finally, whether you’re trying to manage risk at your own company or you’re just trying to manage your credit, the study of credit risk management provides a framework for understanding the true nature of credit risk present in your organization. While profitability is a consideration, credit risk management is about seeing beyond profitability, and more precisely to help the CEO and CFO to develop a quantifiable sixth sense about operational cash flow.