why is credit risk management important

7/30/2019 Why Is Credit Risk Management Important

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Definition of 'Credit'

1. A contractual agreement in which a borrower receives something of value now and agrees to repay

the lender at some date in the future, generally with interest. The term also refers to the borrowing

capacity of an individual or company.

Definition of 'Risk'

The chance that an investment's actual return will be different than expected. Risk includes the

possibility of losing some or all of the original investment. Different versions of risk are usually

measured by calculating the standard deviation of the historical returns or average returns of a

specific investment.

Why Is Credit Risk Management Important?

Entering into a contract with a new partner may turn to be very beneficial for your company. However,

not all business relationships are successful; some partnerships may lead to big losses which can affect

your credibility and reputation on the market. Today many companies decide oncredit risk

managementbefore signing an agreement with an unknown business. This helps avoid dealing with

financially unstable partners and reduce the risk of losing your assets or badly impacting your business

reputation.

Some companies often attempt to hide their credit history, particularly when it is unfavourable.

Bankruptcies, failures of credit payments or licence issues can affect a companys credit history. If a

company has a record of poor business practices, you can find out about these things throughcredit riskmanagementreports. Before you begin any financial dealings with a new business, requesting a

company credit report is crucial to ensure that this business is creditworthy. Credit reporting bureaus

can provide you with updated information about any company that interest you within a few hours, so

that you can make a smart credit decision quickly. In a business credit report you will find an objective

and complete view of who your potential partners are, whether they are reliable and do not carry any

risk to you or your business.

If you need to make a basic assessment of your partners credibility and minimise the risk of losses, a

general overview of their business credit status can be optimal. A snapshot report provides you with

companys statutory information and accounts data, information about profits and losses, ownershipand company offices, balance sheets and changes of directors.

If yourcredit risk managementis related to a high-risk decision, then a comprehensive credit check

providing a detailed analysis of the business financial standing can be more beneficial. It can give you

accurate up-to-date information about the companys payment history, bank loans, leasing,

bankruptcies, information about shareholders, cash flow, growth rates, summaries of any County Court

Judgements (CCJs) etc. It may help you determine the probability of the company going out of business.
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You can also compare the partner you are interested in with others within the industry and learn about

their relationship with suppliers and customers. This information can tell you whether joining this

business is a good financial move.

Credit risk managementis a necessary tool that you should use before going into business with other

companies. It can help protect your business from any financial danger and an unnecessary risk of losingyour assets. Since it takes a few hours to get a business credit report on another company, you can take

a confident credit decision within the same day.

Running credit checks on other companies or trusting your instincts when going into business with an

unknown company is the difference between having a long lasting relationship beneficial for both

companies or a short term partnership that may end up badly affecting your company because of the

insolvency of your business partner. This risk can be easily avoided ifcredit risk managementis

performed each time you are about to make a business decision.

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Types of Risk Systematic and Unsystematic Risk in Finance

Types of Risk

First let's revise the simple meaning of two words, viz., Types and Risk.

In general and in context of this finance-related article,

Types mean different classes or various forms / kinds of something or someone.

Risk implies the extend to which any chosen action or an inaction that may lead to a loss or some

unwanted outcome. The notion implies that a choice may have an influence on the outcome that exists

or has existed.

However, in financial management, risk relates to any material loss attached to the project that may

affect the productivity, tenure, legal issues, etc. of the project.

In finance, different types of risk can be classified under two main groups, viz.,

Systematic risk.

Unsystematic risk.
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Two main groups under which types of risk are classified is depicted below.

Now let's discuss the simple meaning of systematic and unsystematic risk.

Systematic risk is uncontrollable by an organization and macro in nature.

Unsystematic risk is controllable by an organization and micro in nature.

Systematic Risk

Systematic risk is due to the influence of external factors on an organization. Such factors are normally

uncontrollable from an organization's point of view.

Systematic risk is a macro in nature as it affects a large number of organizations operating under a

similar stream or same domain. It cannot be planned by the organization.

Types of risk under the group of systematic risk are listed as follows:

Interest rate risk.

Market risk.

Purchasing power or Inflationary risk.

The types of risk grouped under systematic risk are depicted below.
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Now let's discuss each risk classified under the group of systematic risk.

1. Interest rate risk

Interest-rate risk arises due to variability in the interest rates from time to time. It particularly affectsdebt securities as they carry the fixed rate of interest.

The interest-rate risk is further classified into following types.

Price risk.

Reinvestment rate risk.

The types of interest-rate risk are depicted below.
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Image Credits Moon Rodriguez.

The meaning of various types of interest-rate risk is discussed below.

Price risk arises due to the possibility that the price of the shares, commodity, investment, etc. may

decline or fall in the future.

Reinvestment rate risk results from fact that the interest or dividend earned from an investment can't

be reinvested with the same rate of return as it was acquiring earlier.

2. Market risk

Market risk is associated with consistent fluctuations seen in the trading price of any particular shares or

securities. That is, it is a risk that arises due to rise or fall in the trading price of listed shares or securities

in the stock market.

The market risk is further classified into following types.

Absolute risk.

Relative risk.

Directional risk.

Non-directional risk.

Basis risk.

Volatility risk.
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The types of market risk are depicted in the following diagram.

The meaning of different types of market risk is briefly discussed below.

Absolute Risk is the risk without any content. For e.g., if a coin is tossed, there is fifty percentage chance

of getting a head and vice-versa.

Relative risk is the assessment or evaluation of risk at different levels of business functions. For e.g. arelative risk from a foreign exchange fluctuation may be higher if the maximum sales accounted by an

organization are of export sales.

Directional risks are those risks where the loss arises from an exposure to the particular assets of a

market. For e.g. an investor holding some shares experience a loss when the market price of those

shares falls down.

Non-Directional risk arises where the method of trading is not consistently followed by the trader. For

e.g. the dealer will buy and sell the share simultaneously to mitigate the risk.

Basis risk is due to the possibility of loss arising from imperfectly matched risks. For e.g. the risks whichare in offsetting positions in two related but non-identical markets.

Volatility risk is the risk of a change in the price of securities as a result of changes in the volatility of a

risk factor. For e.g. volatility risk applies to the portfolios of derivative instruments, where the volatility

of its underlying is a major influence of prices.

3. Purchasing power or inflationary risk

Purchasing power risk is also known as inflation risk. It is so, since it emanates (originates) from the fact

that it affects a purchasing power adversely. It is not desirable to invest in securities during an

inflationary period.

The purchasing power or inflationary risk is classified into following types.
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Demand inflation risk.

Cost inflation risk.

The types of purchasing power or inflationary risk are depicted below.


Demand inflation risk arises due to increase in price, which result from an excess of demand over

supply. It occurs when supply fails to cope with the demand and hence cannot expand anymore. In

other words, demand inflation occurs when production factors are under maximum utilization.

Cost inflation risk arises due to sustained increase in the prices of goods and services. It is actually

caused by higher production cost. A high cost of production inflates the final price of finished goods

consumed by people.

Unsystematic Risk

Unsystematic risk is due to the influence of internal factors prevailing within an organization. Such

factors are normally controllable from an organization's point of view.

Unsystematic risk is a micro in nature as it affects only a particular organization. It can be planned, so

that necessary actions can be taken by the organization to mitigate (reduce the effect of) the risk.

The types of risk grouped under unsystematic risk are depicted below.

Business or liquidity risk.

Financial or credit risk.
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Operational risk.

The types of risk grouped under unsystematic risk are depicted below.


Now let's discuss each risk classified under the group of unsystematic risk.

1. Business or liquidity risk

Business risk is also known as liquidity risk. It is so, since it emanates (originates) from the sale and

purchase of securities affected by business cycles, technological changes, etc.

The business or liquidity risk is further classified into following types.

Asset liquidity risk.

Funding liquidity risk.

The types of business or liquidity risk are depicted and explained below.
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Asset liquidity risk is the risk of losses arising from an inability to sell or pledge assets at, or near, their

carrying value when needed. For e.g. assets sold at a lesser value than their book value.

Funding liquidity risk is the risk of not having an access to sufficient funds to make a payment on time.

For e.g. when commitments made to customers are not fulfilled as discussed in the SLA (service levelagreements).

2. Financial or credit risk

Financial risk is also known as credit risk. This risk arises due to change in the capital structure of the

organization. The capital structure mainly comprises of three ways by which funds are sourced for the

projects.

These are as follows:

Owned funds. For e.g. share capital.

Borrowed funds. For e.g. loan funds.

Retained earnings. For e.g. reserve and surplus.

The financial or credit risk is further classified into following types.

Exchange rate risk.

Recovery rate risk.

Credit event risk.

Non-Directional risk.
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Sovereign risk.

Settlement risk.

The types of financial or credit risk are depicted and explained below.


Exchange rate risk is also called as exposure rate risk. It is a form of financial risk that arises from a

potential change seen in the exchange rate of one country's currency in relation to another country's

currency and vice-versa. For e.g. investors or businesses face an exchange rate risk either when they

have assets or operations across national borders, or if they have loans or borrowings in a foreign

currency.

Recovery rate risk is an often neglected aspect of a credit risk analysis. The recovery rate is normally

needed to be evaluated. For e.g. the expected recovery rate of the funds tendered (given) as a loan to

the customers by banks, non-banking financial companies (NBFC), etc.

Sovereign risk is the risk associated with the government. In such a risk, government is unable to meet

its loan obligations, reneging (to break a promise) on loans it guarantees, etc.

Settlement risk is the risk when counterparty does not deliver a security or its value in cash as per the

agreement of trade or business.

3. Operational risk

Operational risks are the business process risks failing due to human errors. This risk will change from

industry to industry. It occurs due to breakdowns in the internal procedures, people, policies and

systems.

The operational risk is further classified into following types.
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Model risk.

People risk.

Legal risk.

Political risk.

The types of operational risk are depicted and explained below.


Model risk is the risk involved in using various models to value financial securities. It is due to probability

of loss resulting from the weaknesses in the financial model used in assessing and managing a risk.

People risk arises when people do not follow the organizations procedures, practices and/or rules. That

is, they deviate from their expected behavior.

Legal risk arises when parties are not lawfully competent to enter an agreement among themselves.Furthermore, this relates to regulatory risk, where a transaction could conflict with a government policy

or particular legislation (law) might be amended in the future with retrospective effect.

Political risk is the risk that occurs due to changes in government policies. Such changes may have an

unfavorable impact on an investor. This risk is especially prevalent in the third-world countries.

Conclusion on Types of Risk

So these are some basic types of risk seen in the world of finance. Click on the following diagram or

image to get an enlarged, overall or a complete view on the types of risk in finance which we have

discussed in this article.
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Every organization must properly group the types of risk under two main broad categories, viz.,

systematic risk and unsystematic risk.

Systematic risk is uncontrollable, and the organization has to suffer from the same. However, an

organization can reduce the impact of systematic risk, to a certain extent, by properly planning the risk

attached to the project.

Unsystematic risk is controllable, and the organization shall try to mitigate the adverse consequences of

the same by proper and prompt planning.

The Benefits of Risk Management
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Risk management is a process which provides assurance that:

objectives are more likely to be achieved;

damaging things will not happen or are less likely to happen;

beneficially things will be or are more likely to be achieved.

It is not a process for avoiding risk. The aim of risk management is not to eliminate risk, rather to

manage the risks involved in all University activities to maximise opportunities and minimise adverse

effects.

Note: risk management is not the management of insurable risks. Insurance is an important way of

transferring risk but most risks will be managed by other means.

Good risk management provides upward assurance from business activities and administrative

functions, from department to faculties, to the senior management team and ultimately to the

governing body.

The potential benefits from risk management are :

supporting strategic and business planning;

supporting effective use of resources;

promoting continuous improvement;

fewer shocks and unwelcome surprises;

quick grasp of new opportunities;

enhancing communication between Schools and Departments;

reassuring stakeholders;

helping focus internal audit programme;


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etc.

Principles of effective credit risk management

The following are what are considered to be the nine principle components necessary to conduct safe

and sound lending activities and to ensure for an effective credit risk management program.

Credit Risk Appetite - Establishing a well-defined credit risk appetite for your institution is the critical

first step toward an effective lending and credit risk management program.

Underwriting Criteria - Establishing equally well-defined underwriting criteria, which includes both

quantitative (objective) and qualitative (subjective) factors, and provides the foundation upon which the

institution can build a quality loan portfolio consistent with its risk appetite.

Credit Analysis - Conducting a thorough and appropriate (i.e., CRE vs. C&I) analysis of credit risk at the

approval phase and throughout the life of a loan is critical to ensuring that lending decisions are made

according to the institutions risk appetite and underwriting criteria. The analysis should include both

quantitative (objective) and qualitative (subjective) factors.

Credit Risk Rating Methodology - Adopting a clear and concise credit risk rating methodology which

similarly includes both quantitative (objective) and qualitative (subjective) factors provides for the

effective grading of credit risk across the loan portfolio. It is also the basis upon which proactive and

effective measurement, monitoring, and control of credit risk exposure can be built.

Loan Review - In order to ensure that loans have been appropriately risk rated, a periodic assessment of

the credit risk of each loan should be performed. This review should be independent from the lending

area and be conducted with an appropriate scope of coverage (in terms of both number of loans and

outstanding balances) and frequency.

Loan Monitoring/Management - Once a loan has been originated it becomes a living, breathing

organism of credit risk which must be proactively and appropriately monitored throughout its

life. Receipt and analysis of updated financial information on the borrower and guarantors (if any), as

well as the periodic assessment of collateral coverage, is key for ensuring that the level of credit risk is


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effectively measured, monitored, and controlled from origination through maturity.

Portfolio Monitoring and Reporting - Similarly to the measurement, monitoring, and management of

credit risk at the individual loan level, doing so at the portfolio level provides for an aggregate

perspective on overall credit risk across the portfolio, particularly in terms of concentrations by loan,borrower, industry type, product/commodity type, and/or geographical location, as well as the

aggregate level of exposure to related borrowers.

Stress Testing - As the loan portfolio grows in terms of both number and variety, stress testing on both a

loan-by-loan basis and at the portfolio level becomes increasingly important to measure the overall

credit risk exposure inherent in the loan portfolio and the potential increase or decrease due to changes

in key factors (i.e., interest rates, cap rates, net operating income, etc.).

Allowance for Loan and Lease Losses (ALLL) - A clearly defined loan loss reserve methodology that is

consistent with applicable regulatory guidelines and Generally Accepted Accounting Principles (GAAP)

is critical towards protecting the institution from credit losses

why is credit risk management important

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