Credit Risk Management
Introduction to Credit Risk Management (CRM)
Credit Risk refers to the probability of loss that a lender suffers due to the borrower’s failure to pay his debts. Credit Risk Management refers to a process of anticipating and mitigating the losses taking into consideration, the lender’s capital and reserves at a particular point. Every lending institution (the most important – bank) or individual, lending money or money’s worth has to manage the risk associated with the credit given.
All the lenders (especially banks) function with limited resources. They collect a lump sum from various sources (banks – service charges, deposits in the savings account, etc.; individuals – saved or invested money, etc.). This lump sum is then divided into two parts based on the credit risk analysis wherein one part is given as loans to multiple borrowers (maybe in exchange for the money’s worth) while the other smaller part is kept as reserves for bad debts (unrecovered amount).
However, the above-given paragraph is a simpler version of credit risk management. In reality, it is complicated. A wrong anticipation of credit risk may lead to a major financial crisis which has been observed a number of times, the most recent and popular case being the Nirav Modi fraud.
The relevance of CRM to the Indian Banking Sector
The Indian Banking Sector has developed to a great extent post-independence. After the New Economic Policy of Liberalization, Privatisation, and Globalisation, new methods of business transactions have opened up which involves a high-risk factor. Hence, the CRM policies of the Banks have also transformed.
A risk is an opportunity as well as a threat. The Banking sector is also exposed to a number of risks. To survive in a highly competitive market, the banks have no choice but to anticipate and mitigate the loss than waiting for the loss to occur and then reacting to it. It is crucial to be proactive than to be reactive. Thus, the essence of CRM lies in deciding which risk to exploit and which risk to avoid or to hedge.
The focus of this blog is on the Banking Sector because they play a major role in the entire credit flow in the economy. With so many private and public sector banks in India, it is important to understand the position of our country’s CRM policies and efforts to avoid the situation observed in Nigeria and many other countries. The CRM method followed affects the liquidity of banks and eventually trickles down to affect the entire nation.
The Reserve Bank of India (RBI) has notified certain guidelines to be followed to effectively manage credit risk for banks. They can be summarised as follows:
Every bank should constitute a Credit Policy Committee. This committee should comprise of a Chairman or CEO or ED along with heads of Credit Department, Treasury, Credit Risk Management Department (CRMD) and the Chief Economist.
The committee should frame policies for effective credit risk management.
Every bank should have a CRMD independent of the Credit Administration Department.
The RBI has also given guidelines on various instruments that can be used by the banks to mitigate the effect of credit risk.
Credit risk is a simple concept. An effective management of credit risk can bring huge prosperity. It is essential for banks to maintain a proper flow of credit in the economy and avoid cases of bankruptcy.
Read more on:
(This blog is focused to let the readers understand the meaning of credit risk and credit risk management along with a short summary of the RBI’s recent initiatives taken for the same.)