Any organization lending money or extending credit needs a credit risk management framework to protect itself from unnecessary risk. Without a framework, it’s easy to become overextended on financial obligations and put your organization at greater risk.
No two credit risk management frameworks are the same, and they shouldn’t be. Every lending institution is in a different place and looks at different qualifying factors and elements, which necessitates a unique framework depending on risk tolerance, governance, and competitive factors.
Institutions are also willing to make certain considerations and sacrifices when it comes to their credit risk management model and framework for a variety of other reasons, so the credit risk management framework is highly personalized and fluid.
What is a Credit Risk Management Framework?
A credit risk management framework helps identify, monitor, measure, and control risk when extending credit to minimize risk. By understanding the full financial picture of borrowers and associated risk, banks, credit unions, leasing companies, and others can better protect themselves against defaults and improve their financial health.
The credit risk management framework is significantly different than it was 20 years ago. Then, lenders may have only looked at a borrower’s credit score or a small handful of other factors in making risk assessments. Today, risk management frameworks are dynamic. The best frameworks will analyze hundreds of data sources to make better credit decisions to mitigate risk.
Credit risk is no longer a subjective judgment made by lenders based solely on character, capacity, capital, and collateral. It is an objective measure based on real-time credit assessment in relation to a company’s entire portfolio.
The 5 Components of a Credit Risk Management Framework
There are five traditional components to a credit risk management framework. This includes;
- Risk identification
- Risk analysis
- Risk mitigation
- Risk reporting and measurement
- Risk governance
Risk Identification
While risk management can cover a broad range of areas, including operational, regulatory and legal, strategic risk, and IT, credit risk management focuses on identifying potential risks in financial transactions such as loans and leases.
Financial institutions and FinTech companies need to identify key risk factors that can inhibit performance and growth for measurement and mitigation. Risk identification applies to individual lenders and organizations.
Enterprises should regularly do risk modeling to look at different scenarios that may change their risk posture. For example, how would an economic downturn impact default rates, and how increased defaults in specific areas impact overall financial health?
Risk Measurement and Analysis
Once risk is identified, it must be analyzed to determine the scope and impact. It’s also important to understand the contributing factors and links between risk factors and performance. In every industry, there are key risk indicators (KRIs) that improve the likelihood of performance or non-performance. Credit risk management is no different.
Your credit risk analysis should look at the leading indicators that are common to risk exposure and analyze applications in relation to these risks. This technique should be applied anytime you consider new loans or leases. Assessments should also be carried out on your entire portfolio to ensure compliance with regulatory, industry, and company performance measures.
You need to understand where you are as an organization and the potential impact any new credit can have on your business.
Risk Mitigation
Credit risk management also requires a deep dive into how you extend credit. For example, the credit terms you offer and the rates you provide. Risk mitigation balances risk and reward to make sure you stay in line with organizational frameworks.
For example, managing credit concentrations so that your financial institution has enough diversification to limit exposure in particular areas.
Risk mitigation also requires discipline to avoid taking on unnecessary risks. This requires adherence to:
- Credit risk policies
- Underwriting and purchase criteria
- Loan administration
- Investment portfolio management
Risk Reporting and Measurement
Measurement should occur each time a new borrower comes forward. It is also important to maintain robust reporting on aggregate risk to ensure risk levels are within organizational tolerances.
Risk Governance
Governance is a broad term that covers a lot of areas. Credit risk governance includes the set of policies and mechanisms to ensure company employees are working within the parameters set by the credit risk management framework.
Risk governance provides a regimented set of rules that must be followed, including how loans are assessed, what scores or metrics must be achieved for lending, authority and approvals, risk limits, and general oversight.
Building The Right Credit Risk Framework for Your Financial Institution
A good place to start is by looking at risks in three specific categories:
- Preventable risks
- Strategic risks
- External risks
Preventable Risks
Preventable risks are things that happen internally, such as decisions are made that fall outside the credit risk management framework. Organizations need controls and defined business processes to avoid preventable risks.
Strategic Risks
Not all risk is bad. Organizations assume strategic risks to maximize returns and grow markets. What’s important is that you understand the impact of strategic risk and build it into your credit risk management procedures to reduce exposure and meet your goals.
For example, a company that focuses on high returns will need to take on more significant risks. The more tightly define the credit risk management framework is, the more easily companies will be able to make decisions about their strategic risks that fall outside those guidelines.
External Risks
You can’t control everything. Natural disasters, economic disruptors, policy and political changes, and unplanned disruptions can all impact your risk profile. We’ve all seen that first-hand over the past few years during the pandemic and resulting supply chain disruption.
It’s important to assess external risks and impacts to keep risk guidelines in compliance. Scenario planning is important to understand what types of scenarios are acceptable, possible, and which are not okay
A Custom Credit Risk Framework That Fits You
Developing a custom credit risk framework that works for your business is essential to compete effectively and stay in compliance what your acceptable risk profile.
To learn more about GDS Link and our portfolio of Credit Risk Solutions and Services, request a demo today.