Measuring and Managing Credit Risk: Tools, Techniques & Best Practices
When it comes to ways to manage credit risk, do you want to do the bare minimum to please the regulators, or do you want to provide a superior service to your clients, and wonder how to improve credit risk management across your enterprise? Hopefully, you chose the latter.
So then, what are the best ways to manage credit risk? Join us as we take a rundown of the key elements of effective credit risk management and the best credit risk management tools you need to make your organization’s processes a roaring success.
What Is Credit Risk Management?
Credit risk management is about managing the risk that a borrower will not repay a loan or follow up on their contractual obligations to the lender. For any lending provider, ensuring sound management of credit risk is crucial to business viability. But not only that, proper credit default risk management is essential in fulfilling regulatory obligations.
So, first things first, let’s go back to basics and see how credit risk is calculated? Typically, credit risk is calculated based on the five C’s criteria:
- Character – the credit history of the applicant
- Capacity – how much debt-to-income the applicant would have if the loan were issued
- Capital – the overall amount of money the applicant has or has access to
- Collateral – any asset the client has that acts as a ‘security item for the loan
- Conditions – the nitty-gritty, contract details, and why the loan is being issued
Methods of measuring credit risk vary depending on the company doing the assessment. However, generally speaking, the majority of procedures use historical data to predict future behavior and the likelihood that the borrower will repay the loan.
What’re the Best Ways of Measuring and Managing Credit Risk?
Detecting a red-flag credit risk can be tricky. That’s why credit providers often employ a variety of credit risk management tools and procedures to ensure minimal risk to a business and maintain maximum profitability. Below we’ve lain out some of the credit risk management techniques used and how they work.
KYC and AML
Know your customer (KYC) and anti-money laundering (AML) are fairly standard financial regulatory procedures. They are designed to make sure your client is who they say they are and avoid fraudulent monetary practices. Depending on local requirements, you may undertake one or both of these procedures. Usually, this is done by running a client’s ID and proof of address data through a database to verify their identity.
Traditional credit scoring systems often involve running a potential client through a database to see their credit score. In the US, this may be an agency such as FICO or Vantage Score, which returns a digital value to the lending provider that they can use to decide whether to issue a loan or not. Although credit scores do give some indication of a person’s creditworthiness, they have also received criticism for not being inclusive. For example, almost 45 million Americans can be defined as credit visible, meaning they don’t have a credit score.
Micro and macro loans
Credit risk doesn’t always come from one singular client. Instead, it might be a portfolio risk. By assessing the number of the micro (single loans) and macro (groups of loans), a company can detect risk or risky lending patterns that it may engage in. This helps the corporation to maintain a healthy debt-to-capital ratio and ensure competitively priced lending products.
Credit default risk management platforms
Credit risk management platforms are where technology meets credit risk head-on. More and more lending providers are choosing to create such systems for assessing credit risk within their business. Often, they will work with a software provider or purchase a ready-made system to integrate into their overall business and use it to analyze risk. These systems may involve a variety of features designed specifically to the lender’s precise needs or more general software as well.
AI and ML tools
It’s vital to remember—the risk isn’t static. A client’s past payment behavior does not always predict future behavior accurately. That’s why, to assess current risk, companies are increasingly turning to AI and ML-based tools such as GiniMachine to extrapolate big data and transform it into usable intel that empowers a company to make smarter loan decisions.
Each of the above ways to manage credit risk has its own unique advantages and disadvantages. Lending providers often engage a combination of these tools and utilize them for managing credit and lending risk. This combined approach offers the best chance to catch bad loans early and protect profitability.
Credit Risk Management Best Practices
In today’s competitive business environment, it’s not enough to know about tools and methods of measuring credit risk. You have to use them right. To provide the best service possible, satisfy the regulators, and gain client confidence, all while protecting your business’s bottom line, it’s essential you follow the credit risk management best practices for the modern market.
1. Be transparent
No one likes fine print or hidden details. Be clear with your client from the beginning, and they are more likely to trust you as a provider. In addition, transparency also helps clients understand exactly how much they need to repay and what they’re paying for. This makes them more likely to repay the loan and less likely to rack up bad debt.
2. Onboard the best technology
Relying on older tools leaves your business more vulnerable to credit risk. One of the key elements of effective credit risk management is constantly looking forward to the latest technologies. It means that you will be on the cutting-edge of credit trends and more easily able to adapt to a rapidly changing market. In our lifetimes, we’ve observed at least two major credit risk events. That’s why it’s vital you prepare for the worst in advance. Getting the right credit risk management tools is the first step.
3. Create a structure
That said, all the modern technology in the world won’t be of much use unless it is used properly. When choosing to onboard new tech, it’s vital to analyze how it will fit neatly into your business and be employed to its utmost capacity. Sometimes this might be as simple as training your staff to enter data into a new program. For others, it may mean a more major overhaul. But either way, it’s essential you develop a structure for assessing credit risk and allow yourself to manage it more efficiently.
To Sum Up: Future of Credit Risk Management
Way back in 2009, in the wake of the financial crisis, the lending industry heralded in more stringent regulations for lending, and rightly so. Subprime mortgages crippled the market, and the market vowed never again.
Now as we prepare for a world after another global crisis, the need for responsible lending couldn’t be clearer. Lending providers need to protect themselves and their clients from unnecessary risk. Not only is this the ethical thing to do to prevent another financial collapse, but it’s also good for business. Smart lending decisions can empower people and businesses to boost the economy, and that’s good news for all of us. So the answer to the question of how to manage credit risk effectively lies in getting the right technology. It is a crucial step to delivering that much-needed push out of crisis and into the future.
How to improve credit risk management? Get in touch with GiniMachine to get the answer.