Every time a bank or any other financial institution gives a loan, there is always the risk that the borrower may default on repayment.
This is Credit Risk (CR), which may be defined as the risk of the non-fulfilment of a financial obligation, such as a borrower not being able to repay the financial institution from which it has taken the loan. While some banks make loan applications sound as simple as tying shoelaces, the truth is that it is a long, risky process for the institution that has decided to lend you the funds. The growing number of financial scandals in recent years past hasn’t helped either. If anything, financial misbehaviour worldwide has resulted in tougher, more stringent regulatory reform.
Of course, not all borrowers default, but credit risk exists even with the best repayment intentions. Hence, precautions are a practical approach; risk needs to be managed systematically. After all, not all risk is bad, and if you don’t take chances, you’ll never know your own strength. There are some schools of thought which posit that if a business doesn’t experience some extent of failure over the course of its existence, it may be playing too safe – which may adversely affect its competitiveness in the long run. Rather than just being averse to failure, businesses should cultivate resilience to it, and part of developing this kind of strength is learning what risks to take, managing and mitigating them.
There are generally three situations where credit risk mitigation strategies should be applied: when lending to individuals; to businesses; and when extending credit to customers in the course of doing business. Banks are well aware that their customers may become unable to make repayments on their credit cards, housing or hire purchase loans. To mitigate this, the bank/financial institution may allocate a score to the customer to determine the risk, and apply a credit limit based on the customer’s income. Where large amounts like housing loans are concerned, the institution may decide to underwrite it based on the value of the loan.
Credit risk exists when banks give out loans to individuals; the risk grows when the customer is a business. When lending to businesses, banks may choose to mitigate by varying the loan interest rate according to the risk which they determine. Perhaps even monthly reports and financial statements will need to be filed by the business receiving the loan, as it will probably be for a very large amount, over a long period. Additionally, the bank may include a clause that allows it to recall the loan if they feel the business may be unable to repay within the specified timeframe.
It’s not just banks that have to deal with credit risk; ordinary businesses grapple with it too, if they provide products to their customers on consignment, for instance, or are contracted to supply first and receive payment later. In cases like these, the business should assess the creditworthiness of the customer beforehand, and set terms and conditions for payment, such as a credit period of 15 or 30 days. It doesn’t hurt to check on customers’ ability to pay either. Discreet enquiries about how good a paymaster a client is, may save a great deal of stress later. Firms should first ascertain how much bad debt they can tolerate when extending credit to customers.
A pragmatic approach to credit risk is the formulation of an organisational policy, determining who is responsible for managing it, and why it should be integrated into the firm’s day-to-day activities and overall strategy. An effective credit policy will incorporate several disciplines and include risk identification, risk evaluation or re-evaluation, policy setting and control & monitoring. It is also capable of establishing clear boundaries in an organisation, and can also be used in training and development and ascertaining methods of risk distribution as well as portfolio management.
