6 Key Elements of Credit Risk Management You Cannot Miss

Lenders implement various credit risk management strategies to minimise the chances of a loan default. Though it may seem that risk management only ensures eliminating high-risk involving borrowers, it is also used to find new and better opportunities for lending. In this blog, you will learn what credit risk means, components of credit risk management and understand how lenders make credit decisions to reduce the costs involved. Read on!

What is Credit Risk?

Credit risk is a term mostly used in banks and financial institutions. It defines the probability of any loss that a lender might face if the borrower defaults on a loan. It is a chance all lending institutions have to take with any loan or debt provided to borrowers.

Credit risk is calculated based on a borrower’s ability to repay a loan based on the original repayment terms. The factors that form the basis of credit risk include the 5 Cs of credit.

Benefits of Credit Risk Management

The primary benefit of integrated credit risk management is that it helps reduce losses for lenders. While conducting risk management, the designated officials closely monitor the credit profiles of potential customers. After the process is over, if the credit risk components fall within the company’s pre-identified risk tolerance, the borrower gets the desired principal.

Through pinpoint credit risk management, a bank or NBFC can ensure:

• Competitive advantage.
• Avoid industry-specific crisis.
• Elevate overall performance.

However, the evaluation process is continuous, and the lender must constantly check their customer’s spending behaviours to adopt timely preventive measures.

Also Read: How Credit Inquiries Impact Your Financial Health?

Challenges of Credit Risk Management

These are some common challenges a lending business faces while analysing the elements of credit risk management:

• Complex compliance policies.
• Customer data inaccuracy and unavailability.
• Shortage of skilled professionals.
• Counterparty risk.
• Rapidly evolving market conditions.

Any one or more of these conditions can lead to the wrong evaluation of an individual or business’ creditworthiness. Thus, banks and NBFCs are gradually shifting to technological advancements to eliminate these mistakes and execute recurring tasks more precisely.

Credit Risk Management Principles

To make the credit risk management framework effective, the following principles have been incorporated:

1. Identifying proper credit risk environment.
2. Drawing an effective credit-granting process.
3. Planning an efficient administrative system.
4. Deploying appropriate controls in place.
5. Accurate and constant supervision.

Examples of Credit Risk Management

Here are a couple of situations to help you understand how the risk management concept works in real time:

Example 1

A certain bank has set very negligible eligibility criteria for loan applicants. They have set such credentials to ensure no one faces trouble while availing emergency funds. However, at the same time, they have restricted candidates from applying if they earn below the mentioned minimum income. This is how the bank manages its credit risk.

Example 2

Some lenders add unique provisions termed debt covenants in their loan agreements. For instance, NBFCs need to maintain a capital adequacy ratio of more than 155 to stay compliant with the RBI guidelines. Failing to do so leads to serious penalties for the lending business.

6 Elements of Credit Risk Management

Lenders typically gauge the following parameters while trying to keep their lending risks at a minimum:

1. KYC

KYC or Know Your Customer is a streamlined process across all banking and Non-Banking Financial Companies (NBFCs) that allows them to filter out wrongful funding and money laundering cases. It involves a set of important documents that provide all the required information of a borrower or customer to the financing company to verify their background and identity.

2. Creditworthiness Assessment

Once the KYC is done, the lenders assess the creditworthiness of a potential customer or borrower to determine if they are capable of paying back their debts or dues on time. This step is crucial as it allows lending institutions to ensure that the credit background of those they are lending to checks out.

3. Quantification of Risk

Quantification of risk means figuring out the risk probability or the chances of a borrower defaulting on their loan. This element is crucial as it further establishes the overall pricing and credit terms of the loan. The process involves determining the probability of default, the loss given default, and the risk-adjusted return on capital.

4. Decision-making

The final decision on credit lies with the bank, lender, or lending institution. This is important as borrowers applying for funds via loan may require them quickly, leaving a very small window for financing establishments to approve and disburse funds within a short period. However, several banking and non-banking financial companies (NBFCs) nowadays have an automated process that makes the entire experience quick and hassle-free.

5. Calculation

The total loan amount and interest rate are calculated based on the creditworthiness of the borrower and their ability to fulfil the terms of credit as laid out by the lender or lending institution.

6. Monitoring and Reviewing

After the loan pay-out is done, it is still essential for banks and financing companies to monitor and review the financial growth and repayment activities of the borrower. Also, they ensure that borrowers repay the loan within the stipulated time. Doing so also allows lenders to identify any chances of default and alert the borrower before it happens.

All of these six elements of credit risk management ensure an efficient credit collection process that benefits both the lender and borrower in the long run.

Also Read: Credit Review - Meaning, Purpose, and How Does It Work?

5 Cs of Credit – Framework to Understand Credit Risk

The 5Cs of credit represent:

• Character

Character refers to the profile of the borrower. If you are applying for a Personal Loan, lenders would like to know your personal and financial background and your credit history. In the case of businesses or firms, lenders will look for the credibility or reputation of the company.

• Capacity

Capacity refers to the ability of the borrower to take and repay the debt or loan received from the lender or lending institution within the stipulated terms. In the case of a commercial borrower or a business entity, it refers to its capacity to repay the debt that will depend on its ability to generate steady cash flow and profits.

• Capital

Capital determines a borrower's overall financial strength or ‘wealth’, which further establishes their ability to repay a loan. Lenders also check if the borrower has alternate sources of funds to pay back their debt.

• Conditions

Conditions refer to the purpose as well as the circumstances or external forces that may pose some risk, threat, or opportunity for the borrower. Conditions for business entities could be industry-related challenges or technological developments.

• Collateral

Collateral is any asset a borrower holds that can be used or used as security against a secured loan.

To Conclude

Credit risk management is a primary task for all lenders. It plays a vital role in eliminating bad debts and the customers with greater creditworthiness get more customised deals. Follow the best practices, understand the five Cs of credit risk, and implement the six elements of credit risk management to reduce credit risk successfully.

Frequently Asked Questions

• What are the elements of credit risk analysis?

Estimated losses, risk-adjusted return and several vital components are covered in a credit risk analysis report. These three factors mainly help in evaluating the probability of default or exposure to default for a particular customer.

• What are the main types of credit risk?

The different credit risk possibilities include:

1. Credit spread risk
2. Concentration risk
3. Default risk
4. Fraud risk
5. All the probabilities are evaluated by the lender before extending a loan.

• Why does the creditworthiness of borrowers matter while providing a Personal Loan?

Creditworthiness is a crucial indicator of a person’s financial behaviour. Since a Personal Loan is an unsecured credit, this information is crucial as the lender forecasts a candidate’s repaying capacity.

Disclaimer

We take utmost care to provide information based on internal data and reliable sources. However, this article and associated web pages provide generic information for reference purposes only. Readers must make an informed decision by reviewing the products offered and the terms and conditions. Loan disbursal is at the sole discretion of Poonawalla Fincorp.
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