What do banks do to practice credit risk management?

Credit risk management is best described as the practice of mitigating financial loss by understanding and eliminating various risk factors in the credit risk process. Thus, a proper credit risk management strategy is paramount to lenders for a number of reasons. It is not only necessary for the increasingly regulated finance environment, but it can also become a marked business advantage. 

Despite its importance, however, there is still some confusion over the best practices for lenders. 

In the article below, we’ll be going over the best things banks do to mitigate risks and ensure all their loans are sustainable. 

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Traditional ways of credit risk management

Traditionally, credit risk management has hinged on the lender’s understanding of the borrower. Typically, banks would then look at a number of factors that include but are not limited to the borrower’s current financial situation, their past loans, and payment history. 

The information that a bank has on a potential borrower forms the basis of their lending decision, and also the terms and conditions of the loan. Here is where risk-based pricing comes in, where borrowers deemed to have a higher risk of default are subjected to a higher rate of interest. 

Another typical credit risk management practice is to require periodic management information system (MIS) reports. With MIS reports, borrowers will have to submit pre-determined financial statements to their lender every now and then. This makes it easier to monitor one’s financial status and assess whether they’ll be capable of paying back their loan.

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Set up a strict credit granting process

A well-defined lending criteria for banks gives a clear idea of what loans can or cannot be done. These criteria should consider a bank’s target market, the terms and conditions of repayment, the purpose of a loan, and the source of repayment. 

For many banks, there is also a strict cap on the amount that can be lent out―no matter who the borrower is. The purpose of this is to emphasize exactly which risks a bank is willing or not willing to take, and to remind employees to always practice caution when dealing with clients. 

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Credit risk management in the digital world: what’s new?

Though traditional credit scoring has been practiced for numerous decades already, it is not without its downsides. For one, traditional credit scoring has usually relied on past bank statements, loans and credit history as grounds for deciding whether a loan should be approved. This causes it to favor those with longer credit histories, thus rendering it unable to reach the unbanked and underbanked market. The bias towards customers with longer credit history (and therefore more personal data to go off) then dismisses those new to the financial system, simply as “risks”. 

While the traditional data sources look at the past behaviour of the applicant to assess their creditworthiness, more and more banks have realized alternative data sources should be looked at. 

For example, smartphone metadata can look at thousands of behavioural data points (after all, our smartphones leave enormous digital footprints) to predict the likeliness of an applicant defaulting. The abundance of data makes it easier for loan checks to be cleared, a process that would traditionally take weeks,if not months. 

Furthermore, using alternative data makes it easier for banks to reach out to the likes of the unbanked, the fresh graduates and the gig-workers as it solves the problem of them being unable to present a proof of their creditworthiness in the traditional sense. Not only does this let lenders widen their pool of potential clients, but it also promotes financial inclusivity. 

Lenders should also consider the fact that as of 2018, the World Bank has found that as much as 1.7 billion adults remain unbanked—yet two-thirds of these people also own a mobile phone, representing a vastly untapped market. In fact, it’s estimated that extending financial services to the unbanked could add as much as $250 billion (USD) to the global GDP. 

In a field where competition is becoming increasingly fierce and technology is driving new customer behaviour, it’s a no-brainer to invest in proper and up to date credit risk management solutions to tap into new and existing customer segments with greater accuracy and profitability. The digital age, accelerated by the COVID-19 pandemic, will weed out those businesses who lack the vigor to update their legacy practices and offer the customers a smooth, friction-less banking experience that they demand today.