Question

Explain how financial managers in commercial banks can reduce the credit/ default risk?

Answer 1

A credit risk refer to the loss that a lender(here the bank) suffers when the borrower fails to repay the loan or adhere to the loan contract.A financial manager of a commercial bank can reduce the default risk or credit risk by resorting to credit risk management .Credit risk management (CRM) is a continuous process which involves the identification,measurement and implementation of steps aimed to lower or eliminate credit risk.One such(CRM)technique is the Five C's of credit method to perform an assessment of the credit worthiness of the applicant.The Five Cs are Character , Capacity , Collateral,Capital and Conditions.The character refers to the applicants history when it comes to credit or borrowing.the aforementioned information regarding the applicant can be obtained from detailed credit reports that indicate past borrowings and repayments.Capacity indicates the ability of the loan applicant to repay the loan.The bank can assess the capacity of the applicant by using debt to income ratio.The Capital n Five C's refers to the amount paid by the applicant(down payment). Higher the amount of downpayment lower the default risk and therefore the rates applicable to the borrower will also be lower.Collateral refers to the asset that the applicant is willing to pledge against the loan.A collateral helps lower the default risk and thereby lowers the interest rate.Conditions refers to the amount the applicant intends to borrow(principal),the interest rate, the purpose of borrowing etc.