Question

Explain credit risk as it affects banks and discuss the techniques banks can use to manage the moral hazard created by a credit risk exposure.

Answer 1

Credit risk means all such risk which are related to default on the the principal payments by the borrowers of the bank.

Credit risk are one of the most important risk in the overall business structure of any financial institution because these risks has to be managed properly because this will help in in avoidance of the insolvency of the company as these will be mostly related to default on the payment of the principal amount which is highly injurious to the overall financial health of the banks because this will be leading to a bad asset quality and this will also be leading to default on the payments of the loan to their depositors.

So the bank will be highly sceptical and proactive in management of credit risk in order to avoid any kind of financial distress risk and the risk of going bust.

Moral hazard which are created by the credit risk exposure are needed to be managed properly through better coordination and there should not be gapgap in knowledge to different stakeholders and there should be always an appropriate disclosure by bank in order to keep it self updated and stakeholders updated to avoid information asymmetry.