Principles for Credit Risk Management

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Credit card rates are based on the principle of a standard credit rating system.
Credit card rates are based on the principle of a standard credit rating system. (Image: Image by Flickr.com, courtesy of Jason Rogers)

The authors of "Credit Risk Management" attribute a part of the growth of consumer credit during the second half of the 20th century to the principles of credit risk management. Ironically, modern credit risk management may need to return to the basic principles to solve much of the current credit woes.

Function

Credit risk management principles attempt to reduce the chances of lending to parties that will not be able to pay back their loan, according to "Credit Risk Management." A risk principle is not very specific and makes general statements, such as "include risk management into all lending decisions." However, a principle may call for something more detailed, like putting risk into mathematical terms. Businesses are free to implement their own risk management principles, but most follow industry standards.

History

The development of credit risk management principles appears to go back before written history, according to Aaron Brown in the October 2004 issue of Global Association of Risk Professionals. Hammurabi's Code used by Mesopotamian society over 4,000 years ago implied the existence of basic credit principles— such as do not borrow what you cannot pay back—by only listing the penalties for default. Modern credit risk management began during the 1840s when the Mercantile Agency started a periodical that compiled financial information about U.S. businesses. However, credit risk management was more about feelings and personal judgment until the the late 1950s when W. Braddock Hickman used quantitative risk to calculate default rates and return on investment of corporate bonds.

Misconceptions

Credit risk management principles apply not only to loans, but also to other sources of risk inside of a financial institution, such as long-term securities investments, and outside factors such as currency exchanges and interbank transactions, according to Bank for International Settlements.

Basic Principles

The Bank for International Settlements suggests that upper level management and an advisory board frequently review credit risk models and assess whether new lending ventures meet a bank's risk-taking standards. Credit risk management advises that at the credit approval stage, creditors have a comprehensive picture of the borrower, including such things as the borrower's reason for needing a loan and his financial resources.

Future

Much of today's credit risk management relies on extremely complex equations and obscure information, according to Mohamed A. Ramady, visiting associate professor of finance and economics at King Fahd University of Petroleum and Minerals. Ramaday says that lenders should reassess their use of the basic principles of credit risk management and reduce the confusion of elaborate risk models. Banks should also look for solid, profitable deals, not the ones with the greatest potential, which often carry the greatest risk.

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