Banks have been under increasing pressure for some time now due to the low interest rate policy. For more than three years now, the European Central Bank has been charging banks penalty interest when they park their money there. The idea is that institutions should not hoard their customers’ deposits, but issue them as loans to get the economy moving. The result is that banks are increasingly granting loans. In order to keep the default risk as low as possible, banks should follow the following six steps of credit risk management.
The Six Elements for A Successful Credit Risk Management Process
1. Know Your Customer
Know your customer (KYC) is an integral part of the credit risk management process and forms the basis for all subsequent steps in the lending process. On the one hand, this involves mandatory verification of new and existing customers’ credentials to prevent money laundering. On the other, it is also important to collect pertinent, accurate, timely information to establish a solid client relationship so that the bank can position itself as a financial advisor and provider of financial products and services.
2. Analyze Non-financial Risks
In addition to a creditworthiness assessment, qualitative criteria play an important role in as-sessing the future of a company. Among the qualitative rating criteria (“soft factors”) are non-quantifiable criteria that can have a lasting adverse effect on company development. Here, the financial institution pays special attention to analyzing success criteria, which are important for the future development of the company.
Factors such as management, competitive situation and market position (local competitors, market share, competitiveness of services, etc.), industry, etc. are assessed qualitatively. These soft factors usually allow the bank to predict future corporate crises with a longer lead time than is possible with quantitative criteria.
3. Understand the Numbers
Establishing a banking relationship and granting loans is associated with various advantages, but also risks. Lenders should therefore know how and for what the requested funds are used, and how they are expected to be repaid. In addition, all risks associated with the customer should be identified, categorized, and prioritized in the credit risk management process. In order to understand the figures, the focus should be on the company’s financial performance – to this end, the company’s economic situation is examined. Documents relating to the company’s net assets and earnings are analyzed. These documents are generally current annual financial statements, business evaluations or, as necessary, net income statements.
4. Give the Deal A Price Tag
Setting an appropriate price is one of the key elements of credit risk management. Qualitative and quantitative evaluations form the basis for assessing the risk associated with granting loans to a company. Rating procedures or other valuation models are used to assess risk, which is used, in turn, to calculate the interest rate. A number of complex factors determine the final interest rate. Among the most important are (1) the company’s economic situation (creditworthiness) and (2) the collateral provided (value retention of collateral). The principle is: the better the financial situation of the company and the more valuable the collateral provided, the lower the interest rate. The interest rate assigned ensures that the financial institution is adequately compensated for the risk associated with the transaction.
5. Present and Close the Deal
The well-founded and professional communication of the rating and scoring results and the costs is an important prerequisite for the deal being accepted and concluded. Credit decisions should not be made solely based on credit ratings. This would not be complete without an equal emphasis on qualitative elements such as the competence of management, the competitive, etc. When analysis, structuring, and pricing are completed, there is nothing else in the way of concluding the transaction.
6. Monitor the Business Relationship
In today’s competitive environment, banks cannot afford to wait for repayment of their loans, expecting customers to actively ask for other products and services. In order to maintain its market position, a bank must continue to monitor the client’s risk profile, looking for opportunities to develop and expand the relationship.
A profitable relationship can quickly become an unprofitable one. Even when loan payments remain timely, deterioration of collateral, untapped potential, or unpaid taxes can pose a serious risk to a bank. Periodic reviews, evaluations, and audits can ensure that the client remains profitable for the bank in the long term.