How to Build a Credit Risk Management Framework

Any organization that’s lending money or extending credit needs a credit risk management framework to protect itself, as well as assess credit risk. Without a framework, it’s easy to become overextended on financial obligations and put your organization at a greater chance of finding itself in the hole.

No two credit risk management frameworks are the same, and they shouldn’t be. Every lending institution is in a different place and looks at different qualifying factors and elements, which necessitates a unique framework depending on risk tolerance, governance, and competitive variables.

Institutions are also willing to make certain considerations and sacrifices when it comes to their credit risk management model for a variety of other reasons, so a credit risk management framework remains highly personalized and fluid. To properly manage credit risk, a thorough analysis by banks and other financial institutions needs to take place. In this analysis, the right data will showcase how to best formulate a qualifying, processing, and managing framework for an institution’s borrower.

What is a Credit Risk Management Framework?

A credit risk management framework helps identify, monitor, measure, and control risks when you’re extending credit. By understanding the full financial picture of borrowers and the associated risks, banks, credit unions, leasing companies, and others can better protect themselves against defaults and improve their financial health — all while avoiding potential financial crisis.

The average credit risk management framework is significantly different than it was 20 years ago. Then, lenders may have looked only at a borrower’s credit score or a small handful of other factors in making risk assessments. Today, risk management frameworks are dynamic and assess a variety of evaluating components. The best frameworks will analyze hundreds of data sources to help organizations make better credit decisions and mitigate risk.

Credit risk is no longer a subjective judgment made by lenders based solely on  character, capacity, capital, and collateral. It is an objective measure that can be quantified based on a real-time credit assessment in relation to a company’s entire portfolio. This change in the ability to more accurately analyze credit risk has given many banks and other institutions the opportunity to increase cash flows while lowering default probability.

The 5 Components of a Credit Risk Management Framework

There are five traditional components to a credit risk management framework:

  1. Risk identification
  2. Risk measurement and analysis
  3. Risk mitigation
  4. Risk reporting and measurement
  5. Risk governance

Risk Identification

Whereas risk management can cover a broad range of areas, including operational, regulatory, legal, strategic, and IT risks, credit risk management focuses on identifying potential risks in financial transactions such as loans and leases.

Financial institutions and fintech companies need to identify key risk factors that can inhibit performance and growth for measurement and mitigation. Risk identification applies to individual lenders and organizations. 

Enterprises should regularly do risk modeling to look at different scenarios that may change their risk posture. For example, how would an economic downturn impact default rates, and how would increased defaults in specific areas impact your overall financial health? This points to the need for a regular risk assessment to be conducted to best predict potential threats that may be present or on the horizon.

Risk Measurement and Analysis

Once a risk is identified, it must be analyzed to determine the scope and impact. It’s also important to understand the contributing factors and links between risk factors and performance. In every industry, there are key risk indicators (KRIs) that improve the likelihood of performance or nonperformance. Credit risk management is no different. 

Your credit risk analysis should look at the leading indicators that are common to risk exposure and analyze applications in relation to these risks. This technique should be applied anytime you consider new loans, leases, or borrowers. Assessments should also be carried out on your entire portfolio to ensure compliance with regulatory, industry, and company performance measures. Stress testing provides banks and other institutions with a baseline as to where potential breakdowns may occur within practices or unforeseen blind spots can be addressed within a risk framework.

You need to understand where you are as an organization and the potential impact any new credit can have on your business.

Risk Mitigation

Credit risk management also requires a deep dive into how you extend credit, including the credit terms you offer and the rates you provide. Risk mitigation balances risk and reward to make sure you stay in line with organizational frameworks.

For example, you can manage credit concentration so that your financial institution has enough diversification to limit exposure in particular areas. 

Risk mitigation also requires discipline to avoid taking on unnecessary risks. This requires adherence to:

  • Credit risk policies
  • Underwriting and purchase criteria
  • Loan administration
  • Investment portfolio management

Risk Reporting and Measurement

Measurement should occur each time a new borrower comes forward. It is also important to maintain robust reporting on aggregate risk to ensure risk levels are within your organizational tolerance. Individual credit ratings, based on a financial institution’s framework, are a quick way to spot-check a potential borrower and their ability to properly handle a loan.

Risk Governance

Governance is a broad term that covers many areas. Credit risk governance includes the set of policies and mechanisms that ensure employees are working within the parameters set by the credit risk management framework.

Risk governance provides a regimented set of rules that must be followed, including rules on how loans are assessed, what scores or metrics must be achieved for lending, authority and approvals, risk limits, and general oversight.

Building the Right Credit Risk Framework for Your Financial Institution

A good place to start is by looking at risks in three specific categories:

  1. Preventable risks
  2. Strategic risks
  3. External risks

Preventable Risks

Preventable risks are things that happen internally, such as decisions that fall outside the credit risk management framework. Organizations need controls and defined business processes to avoid preventable risks.

Strategic Risks

Not all risks are bad. Organizations assume strategic risks to maximize cash flows and increase potentially higher returns. What’s important is that you understand the impact of strategic risks and build them into your credit risk management procedures to reduce exposure and meet your goals. 

For example, a company that focuses on high returns will need to take on more significant risks. The more tightly defined the credit risk management framework is, the easier it will be for you to make decisions about strategic risks that fall outside those guidelines.

External Risks

You can’t control everything. Natural disasters, economic disruptors, policy, and political changes, and other unplanned disruptions can impact your risk profile. We’ve all seen that firsthand during the Covid-19 pandemic and the resulting supply-chain disruption.

It’s important to assess external risks and their potential impact to keep your risk guidelines in compliance. It’s also important to understand what types of scenarios are acceptable, which are possible, and which are not okay.

A Custom Credit Risk Framework That Fits You

Developing a custom credit risk framework that works for your business is essential if you want to compete effectively and stay in compliance with your acceptable risk profile.

To learn more about GDS Link and the portfolio of credit risk solutions and services, request a demo today.

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