Credit Risk Management

Credit risk is the threat of defaulting a debt that may arise when a borrower fails to meet the payment requirements. The loss incurred is usually full or partial. Full loss arises when the defaulter fails to pay any amount associated with the loan while a partial loss is when the defaulter fails to complete payment of the loan. Defaulting result in losses to the render in form of principal and interest, cash flow disruption and the extra cost of collecting the defaulted amounts. Credit risk management can be termed as the assessment done to identify the risks that may arise in an investment or capital allocation. The document will discuss the significance of credit risk management in the financial sector, the collapse of the financial institution as a result of poor credit risk management and measures which can be employed to mitigate credit risk.

In 2007, a global financial crisis started and its aftermath has been referred as The Great Recession which saw billion being lost in both household and firm industries in the United States (Grech, 2015). The recession saw the collapse of the financial institutions in the country. The failure has been related credit risk management failure in this institutions.

Significance of credit risk management

             Many financial institutions experience heavy losses due to the failure of risk management. The financial systems have been employing different measure which most of them are revolutionary from the ancient measures. In determining the risk that comes with lending and investment, the bank must assess all possible risks that can arise.

            Credit risk management has much significance in the financial industry. By having a fully functional system, a financial institution is able to predict and forecast the potential risk factor in any transaction involving the investment or rendering. The bank can analyze the probability of default through the principles in lending and the financial history of the risk involved.

             Credit risk management increases the confidence of the financial institution involved in the marketplace. This originates from its ability to tackle default when it arises and recovery assurance. Having in place credit models which can help in determining the lending level and the market risk, will improve the way one tackles the market and potential investment of borrowers. It will also create alternative ways of transferring credit or making investments.

Failure in Managing Risks.

During the recession, many financial institutions failed to manage the risks due to former strategies used to manage risks. Most of the institution which collapsed used the Value at Risk model to manage their credit risks. It is not a single model but collection of mathematical and scientific models which measures the probability of occurrence of risk using the normal market values.

When a financial institution offers loan to its client under the normal statues of the market, the institution can refer itself to be on the safe side because the risk involved is evaluated from an individual perspective. When the market crisis occurred, the individual risk spread to everyone making the institution at high-end risk from all individual borrower from the company. The approach saw the collapsing of many financial institutions because of concentrating on narrow measures. The approach translated to an assumption of a normal market in the near future.

Consequences of Failure

            The first step in risk management is identifying and measuring risk. Failure occurs when either the risk is measured incorrectly or important risks are ignored or wrongly addressed.  The people who suffer most when the failure occurs is the company owner, management and employees. In regard to this, when risk is identified, formal communication should be done to management to decide on which type of risk to take. Communicating with them will also ensure they monitor and manage the risk they have decided to take. A risk management failure can also be using the wrong risk metric to answer the correct identified risk. The credit risk management department should work together with other departments, it being the core risk identifier so that any failure reverberates throughout the company as fast as it is identified.

Measures to mitigate credit risks

One of the platforms that give a bank a competitive successful market share is a strong credit culture (Kay, 2015). Granting credit risk is unavoidable, and banks can come up with better strategies to handle the risks involved in lending and improve their lending capabilities. Mary Ellen suggests four steps which can be used to mitigate risks in banking (Mary, 2015). The first is having a document the address loan upgrades. The document should be developed to eliminate guesswork in analyzing risks. The second step is the capability of the financial institution to uncover vulnerabilities and reduce the possible harm they can cause. The third step is to develop a system that will test the impact of stress on the charging environment in the market. The system will ensure the institution is prepared and can manage stress test that impacts on the banks capital and liquidity. The last step is setting a hard deadline in changing risk-rating, charge-offs and reviewing loans and determining those which require impairment.

            In conclusion, credit risk management is important for the financial institution to survive in the market. The different evaluation must be made to an individual or an organization to determine if they qualify for a loan. Since the Great Recession, companies have undertaken different step to safeguard their business from collapsing in case the financial crisis arises again.

References

Grech, V. (2015). The Great Recession of 2007 in the United States and the male: female ratio at birth. Journal of the Turkish German Gynecological Association, 16(2), 70–73. http://doi.org/10.5152/jtgga.2015.15009

Kay, M.S. (2015). Steps to Mitigate your Bank’s Credit Risks. Retrieved from http://fosaudit.com/steps-to-mitigate-your-banks-credit-risk/

Mary, E.B. (2013). Bank Systems and Technology: 4 Ways to Mitigate Risk in Banking. Retrieved from http://www.banktech.com/4-ways-to-mitigate-risk-in-banking/a/d-id/1296699?