Banking operations inevitable comes with with a factor of risk. Risk can stem from failed or inadequate internal systems, policies due to employee errors, procedures, fraud, breaches, or external events that can disrupt the operations of a financial institution. One of the more prominent types of risk is credit risk.
But what exactly is credit risk in banking?
Understanding What is Credit Risk in Banking
Credit risk is simply understood as the possibility of a bank’s loss resulting from a borrower’s inability to meet the obligations in a contract. Traditionally, it refers to the risk that a bank may not receive the money it is owed, leading to increased costs for collection and an interruption of cash flows.
Credit risks are calculated based on the borrower’s overall capacity or ability to repay a loan following its original terms.
So what do banks need to do to mitigate credit risk? They need a solid credit risk management solution. This brings us to our next question: What is risk management in banking?
What is Credit Risk Management in Banks?
The goal of credit risk management in banking is to maintain exposure to credit risk within proper, acceptable parameters. A strong credit risk management system does more than just mitigate economic risks — it also confers a competitive advantage to private lenders and commercial banks by improving their decision-making process.
With a credit risk management strategy, lenders can experience increased financial security and borrowers can be approved for loans they can handle to build their credit. In crafting a risk management solution, it’s imperative to understand what the credit risk management process is as well as its best practices and techniques.
What is the Credit Risk Management Process?
When a borrower applies for a loan, the bank must assess their ability to make monthly payments. Beyond requesting for information on the borrower’s income and current financial situation, banks can also see their payment and borrowing history.
Aside from these traditional methods, there’s a new, innovative way to evaluate the creditworthiness of a borrower – through credit risk analysis using alternative data. For instance, FinScore’s advanced credit risk analysis and management solutions let you effectively predict the creditworthiness of a customer using telco data variables such as data and voice usage, location, top-up patterns, and many more. It can be used as a standalone model or in combination with existing Credit Bureau and/or Social-Demographic models.
Banks can leverage alternative data together with the borrower’s information (past behaviors and current debts) to assess if they can maintain the loan. Combined, these factors paint a clear picture of the borrower, helping banks understand the credit risk level of a specific loan.
What is the Importance of Credit Risk Management in Banking?
While credit risk is an inevitable part of banking operations, that doesn’t mean it shouldn’t be mitigated. Private lenders and commercial banks are constantly putting in the effort to reduce the risk of cybersecurity threats and fraud to protect their customers’ financial information. It’s only necessary for them to protect their own treasury from unreliable borrowers.
When a customer misses a monthly payment, or worse, defaults altogether on a loan, the bank will be at a loss. Even if the collateral is taken, the money and time spent to turn it into funds still leave the bank with negative returns. That’s why precise credit scoring in the Philippines is important for financial institutions to evaluate each borrower’s credit risk thoroughly.
Credit Risk Management Best Practices
Yes, the first step to mitigating the probability of a default is through understanding the borrower. With techniques such as digital credit scoring, you can easily assess a borrower’s future actions and probability in paying off loans.
However, evaluating a borrower’s background is only one part of credit risk management. It’s also good to conduct a thorough inspection of nonfinancial risks. As a bank, you should also review your own financial capabilities, such as your existing capital, to help you understand the risk of a loan. You should also have tracking controls in place to monitor the loan and ensure you are adequately compensated for the risk.
Manage Your Credit Risk with FinScore
In banking, it’s always crucial to have a strong understanding of your customers and their ability to repay loans. Assessing a customer’s credit profile and managing credit risk is only possible if your data is accurate and up-to-date.
Aside from valuable information from a credit bureau, revolutionary credit risk analysis tools such as telco data give banks better insight to improve credit approval rates while reducing bad debt. FinScore’s credit risk analysis and management solutions simplify the risk-profiling process, generating information on credit-invisible individuals in mere seconds. The insights gathered from our innovative credit analysis tools are accurate in predicting customer behavior beyond transactions.
For more information and inquiries about our advanced credit risk analysis and management, contact us today.