For this assignment, you will write a minimum three-page paper (not including APA title or references pages). In this paper, please address the following: Discuss why credit risk management within the financial sector is so significant. What are the consequences of failures of credit risk management and who do they affect? What measures can banks employ to mitigate credit risks? Be sure to include an introductory paragraph at the beginning and a concluding paragraph at the end of your paper.
The Consequences of Failures of Credit Risk Management
About 80% of businesses and consumers pay their obligations as they come due. It is the remaining 20% that cause problems. The problems can be slowly paying off invoices or outright default. While the typical business buys goods on 30-day terms, they typically take about 53 days to pay those bills (Belás et al., 2018). About a quarter of the credit problems will become lousy debt write-offs without aggressive collection efforts. Write-offs impact profits, and to cover these losses, the business owner must allow for the losses in their pricing if they wish to make a profit. Thus everyone ends up paying more for just about everything. Businesses exist to monitor and score the risk of every business and every consumer in North America. They are not free, and credit cards are one example of these monitoring costs. Retailers pay as much as 3% of a sale to a credit card company to avoid bad debt losses. All consumers pay higher prices to cover the retailer’s cost of avoiding terrible debt losses (Qin et al., 2020). Hundreds of thousands of people are employed in credit-related industries, e.g., credit managers, collectors, sales, systems, lawyers, statisticians, etc. The consumers end up paying more for everything so these people can be employed to minimize bad debt losses.
The Measures Banks Employ to Mitigate Credit Risks
Some strategies to mitigate credit risk include risk-based pricing, inserting covenants, post-disbursement monitoring, and sectoral exposure. For risk-based pricing, banks charge different interest rates to borrowers with different risk profiles (Mukatuni, 2021). The Lending institutions also attempt to gauge the risk appetite of various borrowers and their respective ability to completely service the loan and accordingly charge them a higher or a lower rate of interest. Secondly, the banks often insert loan covenants into the loan agreements. The covenants inserted are agreements that specify the terms and conditions of loan policies between the debtor and the lending institution before funds are disbursed to the bellower. Thirdly, the bank must ensure that the borrowers use the disbursed loan properly and have adequate cash flow to provide their loan on time (Gornall & Strebulaev, 2018). This enables them to access the cash flow of the debiting company and whether it will be able to service the debt quickly or not. Another essential component of credit risk management is establishing exposure limits across sectors to reduce the chances of default and keep non-performing assets at a prudent level. Credit risk mitigation helps lending institutions in managing their cash flows more efficiently, lowering non-performing assets, enhancing customer management and improving their bottom line
Conclusion
Credit risk management is managing the probability of a company’s losses if its borrower default in repayment. The main purpose is to reduce the rising quantum of non-performing assets from the customers and recover the same in time with appropriate decisions. Credit risk management helps minimize revenue losses as it helps in monitoring credit risk, allowing one to understand the potential clients who may come at high risk and above one’s pre-identified risk tolerance. Credit management is crucial because it reinforces a company’s liquidity. Due to failures of management, borrowers will default on any debt by failing to make required payments. The risk is primarily to the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. Strategies to mitigate credit risk may include risk-based pricing, inserting covenants, post-disbursement monitoring, and limiting sectoral exposure. Understanding the benefits and consequences of failures is essential.