Credit Risk is Inherent to Lender or Banker. It’s one of the prominent types of Risks and is a current and futuristic risk to earnings arising from a borrower’s failure to repay (pay back) the loan undertaken as per the agreed terms of the contract with the Financial Institution (or Bank). It can arise any time the funds are extended or invested through agreements and can be reduced by several methods as follows:
- Lenders should diversify their risk by making a pool of different borrowers. If they lend to only specific type of borrowers (example: Large corporates) then they face higher amount of risk.
- Lenders should reduce the amount of credit approved in total to certain borrowers who they think may turn out to be defaulters in future.
- Lenders should mention strict covenants (Do’s and Dont’s) in their legal agreements with the Borrowers so as to safe guard themselves against any future losses.
- Lenders could hedge their Credit risk by getting insured against credit insurance so that they could transfer their risk to insurer in exchange for an amount paid.
- Lenders could charge higher interest rate from Borrowers who they think could default.
- Lenders should do time to time monitoring of the Loan accounts and the payment patterns of their borrowers and keep an eye on the sources of their income as well.
- Due Diligence should be adopted by banks as an ongoing process till the time the loan is not repaid completely.
However, due to strict norms by regulatory bodies it is now become a practice of bigger banks to distinguish the functions or duties of Credit risk management from other business of lending and customer relationship management.
In addition to the above mentioned strategies adopted, credit risk mitigation can be possible by taking Borrowers credit standing or guarantees or collateral in order to increase the quality of the credit exposure. Collateral could include marketable securities, commercial bills, real estate, Government bonds or stocks of listed companies.