Question

Which method(s) is(are) the best for banks to assess those loan applications and measure credit risk under economic recession

Answer 1

Credit irisk iis ithe ipossibility iof ia iloss iresulting ifrom ia iborrower's ifailure ito irepay ia iloan ior imeet icontractual iobligations. iTraditionally, iit irefers ito ithe irisk ithat ia ilender imay inot ireceive ithe iowed iprincipal iand iinterest, iwhich iresults iin ian iinterruption iof icash iflows iand iincreased icosts ifor icollection. iExcess icash iflows imay ibe iwritten ito iprovide iadditional icover ifor icredit irisk.

Traditionally, iit irefers ito ithe irisk ithat ia ilender imay inot ireceive ithe iowed iprincipal iand iinterest, iwhich iresults iin ian iinterruption iof icash iflows iand iincreased icosts ifor icollection. iWhen ia ilender ifaces iheightened icredit irisk, iit ican ibe imitigated ivia ia ihigher icoupon irate, iwhich iprovides ifor igreater icash iflows.

1. Credit irisk iis ithe ipossibility iof ilosing ia ilender itakes ion idue ito ithe ipossibility iof ia iborrower inot ipaying iback ia iloan. i

2. Consumer icredit irisk ican ibe imeasured iby ithe ifive iCs: icredit ihistory, icapacity ito irepay, icapital, ithe iloan's iconditions, iand iassociated icollateral.

3. Consumers iposing ihigher icredit irisks iusually iend iup ipaying ihigher iinterest irates ion iloans.

When ilenders ioffer imortgages, icredit icards, ior iother itypes iof iloans, ithere iis ia irisk ithat ithe iborrower imay inot irepay ithe iloan. iSimilarly, iif ia icompany ioffers icredit ito ia icustomer, ithere iis ia irisk ithat ithe icustomer imay inot ipay itheir iinvoices. iCredit irisk ialso idescribes ithe irisk ithat ia ibond iissuer imay ifail ito imake ipayment iwhen irequested ior ithat ian iinsurance icompany iwill ibe iunable ito ipay ia iclaim.

Credit irisks iare icalculated ibased ion ithe iborrower's ioverall iability ito irepay ia iloan iaccording ito iits ioriginal iterms. iTo iassess icredit irisk ion ia iconsumer iloan, ilenders ilook iat ithe ifive iCs: icredit ihistory, icapacity ito irepay, icapital, ithe iloan's iconditions, iand iassociated icollateral.

7 iWays ito imanage icredit irisk i

1. iThoroughly icheck ia inew icustomer’s icredit irecord. iFinding iforeign icorporate iinformation ican ibe itricky, iespecially ifor iemerging imarkets. iLocal iconsulting ifirms imay ibe iable ito ihelp, iand iyou ican ialso iget iassistance ifrom ithe iCanadian iTrade iCommissioner iService ioffice. i

2. iUse ithat ifirst isale ito istart ibuilding ithe icustomer irelationship. iYour inumber-one itool ifor imanaging ia icustomer’s icredit irisk iis ibuilding ia ilong-term, itrusted irelationship. iThis ican iobviously itake iyears ito ifully iachieve. iBut istart ilaying ithe igroundwork iby idiscussing iyour icredit iterms iwith ia inew icustomer ibefore iyou iextend icredit. iThis iwill ihelp iyou igauge ithe icustomer’s iattitudes ito icredit, iand iensure ithat ithey iclearly iunderstand iwhat iyou iexpect iof ithem.

3. iEstablish icredit ilimits. iTo iset ia icredit ilimit ifor ia inew icustomer, iyou ican iuse itools isuch ias: iCredit-agency ireports, iwhich ican iprovide icomprehensive iinformation iabout ia icompany’s ifinancial ihistory. iBank ireports, iwhich ishould igive idetails iof ithe ibank’s irelationship iwith ithe icompany, ithe icompany’s iborrowing icapacity iand iits ilevel iof idebt. iAudited ifinancial istatements, iwhich ican iprovide ia igood iview iof ithe ibusiness’s iliquidity, iprofitability iand icash iflow. i

4. iMake isure ithe icredit iterms iof iyour isales iagreements iare iclear. iA isales iagreement ithat iincludes iwell-worded, icomprehensive iterms iof icredit iwill iminimize ithe irisk iof idisputes iand iimprove iyour ichances iof igetting ipaid iin ifull iand ion itime. i

5. iUse icredit iand/or ipolitical irisk iinsurance. iThe iReceivables iInsurance iAssociation iof iCanada iprovides iuseful iinformation iabout iinsuring iyour icompany iagainst inon-payment.

6. iUse ifactoring. iTo ido ithis, iyou isell iyour ireceivable ito ia ifactoring icompany ifor iits icash ivalue, iminus ia idiscount. iThis igives iyou iyour imoney iimmediately ibecause iyou idon’t ihave ito iwait ifor ipayment ithe icustomer iwill ipay ithe ifactoring icompany iinstead iof iyou. iBut imake isure ithe ifactoring iis ion ia i“non-recourse” ibasis, iwhich imeans iyou’re inot iliable iif ithe icustomer idefaults. i

7. iDevelop ia istandard iprocess ifor ihandling ioverdue iaccounts. iYour ichances iof icollecting ion ia idelinquent iaccount iare ihighest iin ithe ifirst i90 idays iafter ithe idue idate

i i i i i i i i i i i i i i i i i i i i i i i i i iA ilot iof ibusiness iis itransacted ibetween icompanies i(read isupplier-customer) ion icredit, iand iin imany iways iit’s ifinanced iby ibanks. iBut imore iimportantly ithe iborrowers ineed ito ipay iback ias iwell iand ithat itoo iin itime. iCredit iRisk iManagement, iessentially iensures ithat ithe iborrower iis iof isound icredit istanding, ihas icapability ito irepay idebt, iis irun iand imanaged iby igood ipersonnel, iforms ia ipart iof iperforming iindustry, iis icomplaint iwith iregulatory iand ilegal irequirements iand iimportantly ihas inot idefaulted ior iis idelinquent iin iother iobligations. iIf ia iborrower iaccount ibecomes idelinquent, iit ihas ian ioverarching iimpact ion ibanks, ias iapart ifrom iincreasing ithe icost iof imanaging ia iparticular iaccount iit ihampers iprofitability iof ibanks. iThe ihidden icosts iof ian iaccount igone ibadly iare imany, iand iapart ifrom icausing iadministrative ihassles iand ipains, iattempts ito irecover idues icauses ia ilot iof iefforts iand iexpenses. iWhen ia ilarge inumber iof iborrower iaccounts ibecome inon-performing iit iends iup istressing ithe ibank.

The ibenefits iof iCredit iRisk iManagement itranscends imuch ibeyond ibanking, ias iany icompany iis itied iacross ithe isupply ivalue ichain iand ieven ia isingle irotten ione ican idisrupt ithe iproductive ichain i(by inot ipaying isuppliers, ithat iare imainly iSMEs, iin itime) icausing ilosses i(think iof iwhole ilot iof ibad icompanies inot ipaying) ithat iare ibeyond ioverall icomprehension, iand ihence iCredit iRisk iManagement iis iof iutmost iimportance.

i i i i i i i i i i i i i i i i i i i i i iBanks iface iseveral itypes iof irisks iin idoing ibusiness. iThe itop itwo ikinds iof irisks ithat ievery ibank ifaces iare icredit irisk iand iliquidity irisk. iLet’s idiscuss iwhat ithese irisks iare, ihow ithey iaffect ibanks, iand iwhat ibanks ican ido ito imitigate ithese.

The iBasel iCommittee ion iBanking iSupervision i(or iBCBS) idefines icredit irisk ias i“the ipotential ithat ia ibank iborrower ior icounterparty iwill ifail ito imeet iits iobligations iin iaccordance iwith iagreed iterms.” iIt iincludes iboth ithe iuncertainty iinvolved iin irepayment iof ithe ibank’s idues iand irepayment iof idues ion itime.

Credit irisk isignifies ia idecline iin ithe icredit iassets’ ivalues ibefore idefault ithat iarises ifrom ithe ideterioration iin ia iportfolio ior ian iindividual’s icredit iquality. iCredit irisk ialso idenotes ithe ivolatility iof ilosses ion icredit iexposures iin itwo iforms ithe iloss iin ithe icredit iasset’s ivalue iand ithe iloss iin ithe icurrent iand ifuture iearnings ifrom ithe icredit.

Banks icreate iprovisions iat ithe itime iof idisbursing iloans i(see iWells iFargo’s iprovision ichart iabove). iA inet icharge-off iis ia idifference ibetween ithe iamounts iof iloan igone ibad iminus iany irecovery ion ithe iloan. iAn iunpaid iloan iis ia irisk iof idoing ibusiness. iThe ibank ishould iposition iitself ito iaccommodate ithe iexpected ioutcome iwithin iprofits iand iprovisions, ileaving iequity icapital ias ithe ifinal icushion ifor ithe iunforeseen icatastrophe.

Banks imanage icredit irisks iby imonitoring ia inumber iof ifactors iincluding iloan iconcentrations, icredit irisk iby icounterparties, icountry iexposures, iand ieconomic iand imarket iconditions. iProvisions iand inet icharge-offs iare iindicators iof ibanks’ iasset iquality. iImproved iasset iquality iresults iin ilower icharge-offs iand ihigher iprofits ifor ibanks.