Define Credit Risk Management

Credit risk refers to the likelihood a potential borrower will default on his or her financial obligations with a lending institution. Credit risk management is the lending institution's primary line of defense to protect itself against customers who fail to meet the terms of the loans or other credit that was extended to them. Credit risk management is an important aspect of a bank's success and ensures a lending institution will not take on more risk than it can handle.

Explanation

Credit risk management exists to protect a bank's rate of return. Risk management ensures that the amount and type of credit exposure remains within appropriate limits for the size and goals of the lending institution. Credit risk is controlled based on individual transactions as well as the bank's lending portfolio as a whole.

Types of Credit

For most banks and lending institutions, the primary type of credit risks are loans. Consumers contact lending institutions to borrow money for homes, automobiles, and educational expenses. Borrowers complete applications that disclose their income and other items describing their ability to repay the debt. Other types of credit risk include credit cards, lines of credit, and loan refinancing.

Underwriting

Underwriting is an important part of credit risk management. Underwriters assess the potential risk of a borrower and compare that risk to the credit-granting criteria of the bank. Underwriters must determine why a borrower is in need of the loan or credit, the borrower's ability to repay, the borrower's credit history and future changes in the borrower's risk profile. Credit applications must first pass through an underwriting department before a credit decision can be made.

Credit Monitoring

Credit monitoring is a form of ongoing credit risk management. Once a bank extends credit, there is no guarantee that the borrower's personal information will remain the same throughout the length of the loan term. As a result, banks have credit monitoring systems in place to periodically determine the borrower's current credit worthiness. If the consumer's credit potential has decreased, this can limit the bank's ability to extend additional credit and might result in reducing existing credit lines.

Credit Due Diligence

Credit due diligence involves a thorough assessment of the lending criteria of the bank. Internal assessments include the type of credit risks an institution is willing to accept as well as the types of losses an institution has suffered in the past. Due diligence also applies to the bank's willingness to review all aspects of a potential borrower's credit worthiness.