Risk management practices within a financial sector Risk management practices within the financial sector are of particular interest to regulators. This is because failures within this sector disrupt the functionality of the financial system that derails economic growth and efficiency. We have referenced the subprime meltdown of 2007 several times within this course because it is the most prominent example of a massive credit risk management failure. In this assignment, you will evaluate the consequences of this failure.
Credit Risk Management
Risk Management Practices within a Financial Sector
“Your investment in a bank account is as secure as your bank is. If your bank goes bankrupt, so does your investment.” (Naved Abdali). Credit risk management is defined as identifying, measuring, monitoring and controlling risk arising from the possibility of default in loan payments (Yanenkova et al., 2021). Credit extended to borrowers may be at the risk of default such that whereas banks extend credit on the understanding that borrowers will repay their loans, some borrowers usually default, and as a result, the bank’s income decreases due to the need to provision for the loans. The fundamental principles of credit risk management are establishing a clear structure, allocating responsibility and accountability, prioritizing and disciplining processes, clearly communicating responsibility, and assigning responsibility. Credit risk management is an essential function within any business because it enables the business to maximize sales while carefully managing its risk exposure (Settembre-Blundo et al., 2021). There are several considerations centered around deciding which customers to do business with and under what credit terms. This essay will explore the significance of credit risk management within the financial sector, the consequences of failures of credit risk management, and finally explore the measures banks employ to mitigate credit risks.
Significance of Credit Risk Management within the Financial Sector
The significance of credit risk management within the financial sector is tremendous. Banks’ credit risk management goal is maintaining credit risk exposure within proper and acceptable parameters. It mitigates losses by understanding the suitability of a bank’s capital and loan loss caches at any time. Credit management is vital because it reinforces a company’s liquidity (do Prado et al., 2019). If done correctly, it will improve cash flow and lower the rate of late payments. It is the difference between a high or low DSO, the amount of bad debt a financial portfolio presents and even negative or positive customer relations. Credit risk management is about managing the risk that a debtor 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. Credit risk management is essential as it aims to maximize the cost-adjusted rate return of a particular bank by maintaining exposure to credit risk acceptable to its shareholders (Ekinci & Poyraz, 2019). Credit risk management helps reduce revenue losses as it helps monitor credit risk, allowing one to understand the potential clients who may come at high risk and above one’s pre-identified risk tolerance. Having the significance of credit risk management in mind is essential as it helps reduce losing revenue.
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