Credit risk is implicit in all commercial banking activities, from traditional loans to complex lending arrangements. A financial institution assesses and monitors risks inherent in transactions to ensure that a borrower has sufficient funds to satisfy loan agreements. Additionally, senior management establishes a risk control program to prevent significant losses.
Credit Risk Defined
Credit risk is the risk of loss that may result from a business partner's (also called counterparty) inability to reimburse a loan or fulfill other monetary promises when they become due. A counterparty may default because of bankruptcy or temporary financial problems. For example, a commercial bank lends $1 million to a car dealer. The loan maturity is five years. If the dealer is out of business after six months, the bank may incur credit losses if it is unable to recover any amount in court.
Types of credit transactions may vary, depending on the firm's size, industry and legal status of counterparties. A commercial bank may engage in a standard loan transaction. For instance, the $1 million loan to the car dealer is a standard, unsecured loan (that is, the borrower does not provide any collateral to the bank). A financial institution can also lend to a counterparty via a line of credit or overdraft agreement. A line of credit allows a customer to use funds, when needed, without applying for new loans. In an overdraft agreement, a bank honors a customer's payments even if funds are insufficient in his account.
A commercial bank can hedge (protect against) credit risk by establishing adequate credit verification procedures, such as credit score checks and financial information assessments, in the loan department. It also can ensure that loan processing employees comply with established protocols when performing their duties. Alternatively, a bank can purchase insurance coverage to hedge credit losses in case of counterparty default, or ask internal auditors to review operating procedures and controls.
Credit risk insurance is a business practice that helps a commercial bank prevent significant losses in financial transactions. As an illustration, a private banking institution wants to lend $10 million to a customer but believes the customer's financial standing is not robust. It can buy risk coverage at 95 percent from an insurance company so that in the event the counterparty defaults, the bank will recover $9.5 million from the insurer.
A bank's top leadership and department heads occasionally review the institution's operations and ask segment employees to prepare risk and control self-assessment (RCSA) reports. An RCSA lists all risks implicit in a segment's or business unit's processes and ranks them as "high," "medium" or "low," based on loss expectations. Senior management typically focus on "high" and "medium" risks, whereas segment employees provide corrective measures for "low" risks.