Credit risk is a key factor in evaluating the performance of a bank and an effective credit risk management process reduces the risk exposure and increase profitability. However, none of it is possible without devising a plan that requires a thorough loan policy, clear guidelines on the underwriting process, the ability to assess risk, and a loan reevaluation process. When you are planning to take a loan from a bank, consult Your Personal Financial Mentor because he will help you decide which bank has strong credit risk management policy in place to evaluate your performance effectively.
Elements of The Loan Policy
The loan policy provides the guidelines of credit risk tolerance and also provide a parameter for managing those risks. It is a foundation for maintaining an asset quality and should address the major elements to manage the credit risk. The policy should clearly mention the type of desirable and undesirable loans, the specifications of transactions requiring credit memorandum, the credit approval process including responsibilities of the board and lending authority, and defined standards of underwriting. These elements should be regularly monitored and controlled to manage the credit risk associated with the loan secured by account receivable.
Also, there should be a proper maintenance of credit and collateral files, details of the documentation required for the loan, risk diversification guidelines, appraisal guidelines to ensure compliance with the regulatory authority and details of the transactions that require environmental audit. The loan policy should be revised at least annually and deviations from the policy should not be excessive.
Underwriting the Credit
Bank management always devises a credit risk management process by keeping in mind the previous experience with the borrowers and proposed collateral values instead of relying on the information in financial statements. They keep in mind the main purpose of the loan because if they are unable to understand the borrower’s needs, it can negatively affect the cash flows and repayment capacity. They should also consider the valuation of any collateral and the source of the valuation. They should also review the summary of the borrower’s current and previous debt with the bank and should assess their performance to repay the debt. The source of repayment, analysis of borrower’s repayment ability, risk assessment, and rationale of deviating from the loan policy guidelines are the critical elements to manage the credit risk.
Loan Review Process
It is important to have a loan review function in order to effectively manage a credit risk. A loan review function ensures accuracy of the credit grades assigned to the borrowers, quality of underwriting, take notice of violations of banking laws, regular review of the loan that is not accompanied by sufficient credit or collateral documentation, and observe deviations from the credit policy guidelines.
Risk rating is developed for different types of credit, keeping in mind the characteristics and features of each credit type. Credit risk rating is a helpful tool to assess the risk. The grading system to rate the credit should be based on the operating cash flows or earnings of the borrower, his leverage ratio and net worth. Moreover, the collateral that is kept as security against the loan should also be considered.