Credit risk management is a process of looking at the loan loss reserves and adequacy of a bank’s capital for mitigating losses. This is a challenging process for financial institutions that involves risk modeling, expected credit loss, regulatory risk management, and a model implementation platform. But, before we get into the best practices and techniques of credit risk management, first, let’s get an understanding of what the credit risk management process is.
Credit Risk Management Process
When a borrower submits a loan application, the lender evaluates their reliability to ensure that they can make monthly b2b payments in the future. Apart from getting information on the current income and financial situation of the borrower, lenders also need to check their payment and borrowing history. By getting this information, the lender gets an understanding of the risk level associated with loaning to the borrower. This whole process is known as the credit risk management process.
Best practices for Credit Risk Management Process
Depending on the business, the best practices for credit risk management might differ. However, there are some standard practices that can guide your business in managing credit risk. These include identifying the risk of payment default, analyzing these risks, and creating a plan that helps mitigate these risks. Here are the best practices of the credit risk management process that you should know about:
- Identification of the credit risk
There are a lot of ways through which you can get the data required for identifying the credit risk potential for a new client. This includes the company 10k, the local Chamber of Commerce, trade and bank data, and credit bureaus. Through this data, you will be able to understand the creditworthiness of the potential client and decide whether or not you should extend the credit. It will also help you set the terms of the credit.
- Analysis of the credit risk
Before you extend credit to a new client, there are two things that you have to analyze. The first one is their creditworthiness and the second one is the potential impact your cash flow will have in case the client defaults. This will help develop a structure that impacts your decision-making in regards to creditworthiness.
- Creation of a plan
To ensure good credit risk management, you will need a plan that will help in evaluating and extending credit for all your clients. Every credit management system has certain key elements. The first one is determining the credit terms, like the amount of credit that you will be extending and the duration. Next, you have to discuss these terms with the client before extending the credit. Lastly, you need to conduct quarterly or monthly reviews of the SME Accounts Receivables in order to get a clear picture of the risk. With AR automation, this process will become a whole lot easier.
Best techniques for Credit Risk Management
Risk-based pricing is one of the best techniques that you can use for creditor risk management. Through this, in the case of a client with moderate risk, you will be charging a higher interest rate. This works best for lenders or banks with a big loan reserve. So, even if the client defaults, they still have capital available. As a lender, you need to monitor relatively risky loans continuously and be proactive in changing the terms and requesting payments to reduce hazards. You can also manage credit risks by requesting MIS reporting periodically. In this, the client will have to give you predetermined financial statements periodically. This way, you will be able to monitor the current financial status of the client as well as their ability to pay the loan back.
When it comes to banking operations, risks are an expected part. However, this doesn’t mean that you cannot mitigate these risks. Private lenders and commercial banks invest a lot in reducing the risk of cybersecurity threats and frauds against the financial information of the clients. However, they also have to protect their capital from unreliable borrowers. If a borrower misses a payment or defaults on the loan, you will suffer a loss. Even with the collateral, you will have a negative return for the time and money that you spent. This is why you have to evaluate the credit risk of all the clients thoroughly. Before you sign off on loans, you must check your reserves as well as the environmental factors.
When you have access to the updated, precise data of your internal resources and borrower’s financial history, you can do a comprehensive analysis of credit risk and decide whether you should sign off on the loan.