A strong risk management system can do more than just mitigate economic risk; it confers a competitive advantage to commercial banks and private lenders by improving their decision-making.
Implementing a credit risk management strategy can result in increased financial security for lenders and provide borrowers with loans they can handle to build their credit. Understanding the credit risk management process, best practices and techniques is the first step in crafting a risk assessment solution.
What is the credit risk management process?
When a borrower applies for a loan, the lender must evaluate their reliability to make future monthly payments. Beyond requests for information on a borrower’s current financial situation and income, many lenders will also want to see their borrowing and payment history.
Inc. Magazine described this as a borrower’s creditworthiness. It’s a deep look at past behaviors and current debts to determine how likely a borrower is to maintain a new loan. In addition to this personal information, lenders will take into consideration the size of the loan being requested and the length of the commitment.
Combined, these factors paint a picture of the borrower that helps lenders understand the risk level of a loan. While this has long been the traditional credit risk management process, it fails to acknowledge additional internal and external factors that could affect the risk of a loan.
Why is credit risk management important?
Risks are an inevitable part of banking operations, but that doesn’t mean they can’t be mitigated. Commercial banks and private lenders are constantly taking efforts to reduce the risk of fraud and cybersecurity threats to protect the financial information of their clients, but also need to protect their own treasury from unreliable borrowers.
When a borrower misses a monthly payment, or worse, defaults on a loan altogether, the lending party at a loss. Even if collateral is taken, the time and money spent to turn it into funds can still leave the lender with a negative return. That’s why it’s incredibly important for financial institutions to thoroughly evaluate each borrower’s credit risk, and as you will see, their own reserves and environmental factors before signing off on a loan.
Credit risk management best practices
According to The Risk Management Association, the first step to mitigate the probability of default begins with understanding the borrower. A common approach is by evaluating them by the “Five Cs of Credit” to obtain a profile on their financial risks. This assessment runs on the belief that past payment performance (as well as current finances) can be an indicator of a borrower’s future actions.
A borrower’s background is only one part of credit risk management. Another best practice described by the RMA is a thorough inspection of nonfinancial risks. Lenders should review their own financial capabilities, such as their existing capital, to help them understand the risk of loan. Thinking in the long-term, lenders should also ensure they are being adequately compensated for the risk and have tracking controls in place to monitor the loan.
This leads to the last credit risk best practice, and possibly the most important: Risk management must be a continuous effort. Determining risk based on one or two factors (such as credit history and income) fails to acknowledge if the lender is financially capable of handling a default or current economic conditions that could affect a borrower’s ability to make payments.
Risks are not static. They are subject to sudden changes that can affect the current status of the loan, so it’s vital for lenders to continuously monitor their own means, borrowers’ portfolios and environmental factors that can affect their actions moving forward.
Credit risk management techniques and methods
After evaluating credit risk, a lender’s decision does not have to be a strict yes or no. While major red flags in a borrower’s portfolio and their own treasury might call for a rejection, there are other techniques to mitigate risk.
One such method is risk-based pricing. As Wall Street Mojo explained, this is when lenders charge a higher interest rate to a borrower deemed of moderate risk. This is ideal for banks or lenders that have a large loan reserve, so in the event of a default they have capital available. By continuously monitoring these relatively risky loans, lenders can be proactive in requesting payment or changing the terms to reduce hazards.
Lenders can also request periodic MIS reporting to manage credit risks. In this scenario, the borrower will be asked to submit pre-determined financial statements to the lender periodically. This allows the bank to monitor the borrowers current financial status and ability to pay their loan.
Advantages & disadvantages of credit risk management
When lenders have access to the most recent, precise data of the borrower and internal resources, they receive a comprehensive analysis of the loan in question.
Continuously monitoring these factors helps commercial banks and private lenders be proactive in how they need to interact with a borrower or manage their reserves. An adaptive risk management system can help lenders prioritize their loan offerings and target products and services to existing borrowers to expand their portfolio without marketing to new customers.
As beneficial a strong credit risk management system can be, it doesn’t come without its challenges. Financial institutions should be aware of the factors that can limit the effectiveness of these programs, including:
- Inefficient data management – your information is only as valuable as it is relevant. Data storage solutions should be secure, organized and updated in real-time.
- Limited infrastructure – robust stress-cycling that spans the entire credit life cycle ensures an accurate risk assessment.
- Poor reporting and visualization – data should be organized in a way that clearly identifies the strengths and weaknesses of a loan without being weighed down by irrelevant information.
GDS Link’s credit risk solutions for lenders have been developed with these best practices and techniques in mind.
Contact us today to find out how we can add value and security to your operations.