What is Credit Risk Management?
Credit Risk Management refers to the management of the probability of the Loss that a company may suffer if any of its Borrower defaults in their repayment and is done by implementing various Risk ControlRisk ControlRisk control is the activity of analyzing, interpreting, and assessing the business environment and decisions in order to minimize losses by detecting pitfalls and preventing businesses from falling victim to calamities, hazards, and avoidable losses. strategies in the Company to mitigate the same. In a Bank or an NBFC, the Loan Loss Reserve and the Capital Adequacy RatioCapital Adequacy RatioThe capital adequacy ratio measures the bank's financial ability to pay off its obligations. The capital-to-risk weighted assets ratio (CRAR) is evaluated as the percentage of the bank's capital to its risk-weighted assets. Bank's capital is the aggregate of tier 1 and tier 2 capital. plays a Vital Role in the Credit Risk Management policy of the same.
- The main purpose of the Credit Risk Management is to reduce the rising quantum of the Non-performing assetsNon-performing AssetsNon-Performing Assets (NPA) refers to the classification of loans and advances on a lender's records (usually banks) that have not received interest or principal payments and are considered "past due." In the majority of cases, debt has been classified as non-performing assets (NPAs) when loan payments have been outstanding for more than 90 days. from the customers and to recover the same in due time with appropriate decisions.
- Credit Default has a significant impact on the Financial Performance of the Company since if one Borrower does not pay his dues on time; It leads to higher provisioning, Legal Cost, Collection / Recovery Cost Rises in order to get the Money-back and the Company’s Cash Flow also has been impacted.
- Generally, seeing the past trend, it has been observed that when there is a Credit risk Management Policy in place, the chances of NPA’s are very less and there are good quality Borrowers in the Loan Book of the Company.
- Default Risk and Credit SpreadCredit SpreadCredit Spread is the yield gap between similar bonds but with different credit quality. If a 5-year Treasury bond yields 5% and a 5-year Corporate Bond yields 6.5 percent, the gap over Treasury is 150 basis points (1.5 percent ). Risk are the two types of Credit Risk, which the Company needs to manage on a daily basis to run the Company in the long term.
- It is also useful to find ways to increase the Credit Rating of the Company with regards to the Credit Rating Agencies like S&P, Fitch, Moody’s, etc.
Credit Risk Management Strategies
Below mentioned are some of the Examples of Credit Risk Management.
#1 – Risk-Based Pricing
In this, the Lender generally charges a higher rate of Interest to the Borrowers, where they sense a Risk of Default seeing the Financial Condition or the past history of the Borrower. Hence in this type of Credit Risk Management Strategy, different Rates will be applicable for different Borrowers depending upon the Risk Appetite and the Ability to pay back the loan.
The Company may charge a Higher Rate of Interest for the Loans disbursed to Start-up Companies and relatively decrease the Interest Rate as and when the Company starts performing. In this, Any Default to a Good Customer with a Lower Rate of Interest gets compensated with the other Customer to whom the Loan has been given at a Higher Rate.
#2 – Inserting Covenants
The Lender may insert certain provisions or debt covenantsDebt CovenantsDebt covenants are formal agreements between different parties like creditors, suppliers, vendors, shareholders, investors, and a company, establishing limits for financial ratios such as leverage ratios, working capital ratios, and dividend payout ratios, which a debtor must refrain from breaching. in the Loan agreements before disbursing the funds to the Borrower. They can be divided into Financial Covenants, Operational Covenants, Technical Covenants & Business Level Covenants. Any breach in the Covenant as per the Agreement will trigger a warning signal for the Lender that there is a default that is going to happen in the near future, and appropriate actions need to be taken to secure the Loan Amount.
For example, Capital Adequacy Ratio is one of the most important Covenant for an NBFC to maintain up to 15% as per the recent changes in the RBI Guidelines. Anytime if this Ratio goes below 155, it would be a regulatory breach for the NBFC, which in turn can have serious repercussions on the Company and its Lenders for not monitoring the same efficiently.
#3 – Periodic MIS Reporting
In this, the Lender asks the Borrower to submit the Financial StatementFinancial StatementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. in a predefined format for analysis. It can be Monthly, Quarterly, Bi-Monthly, or Annually depending upon the Type and Amount of Exposure. A Monthly MIS gives the Full picture of the Cash Flows of the Borrower and whether he is financially sound enough to repay the Debt Obligations on time.
It is a very useful tool to monitor the Business Decision of the Borrower since Further Borrowing from any other Lender or Buyback of sharesBuyback Of SharesShare buyback refers to the repurchase of the company’s own outstanding shares from the open market using the accumulated funds of the company to decrease the outstanding shares in the company’s balance sheet. This is done either to increase the value of the existing shares or to prevent various shareholders from controlling the company., etc., may create pressure on the Working Capital and the Liquidity of the Company to meet its Short Term Obligations. There is a dedicated Professional appointed to take care of the MIS Part since it requires a high level of Understanding to prepare the Information as required in the Template and share the Same to the Lender on a periodic basis.
#4 – Limiting Sector Exposure
In this, the Lender may decide the Sectors in which he will be Active in Lending the funds to the Borrower as it will have a massive impact on the NPA Ratios of the Company. Since many defaults are happening in the Jewellery Sector in India due to the Nirav Modi Scam, the Lender may decide not to take any exposure in this Segment to any kind of Borrower as the Chances of the Borrower becoming insolvent are more.
Alternatively, the Lender may decide to lend only in one particular Industry or Geography in order to further Control the Damage. For example, he may decide to take maximum Exposure in Service Sector and Minimum Exposure to Petrol Pumps or Hotels. The Lender may also decide to Lend only to a particular city or state in order to maximize his Returns and keep a Control on the Target Customers rather than disbursing the Funds on Pan India Level.
Hence Sector Exposure is one of the Most important Credits Risk Management Techniques to minimize the Loan Loss Reserves.
Hence Credit Risk Management is one of the Important Tool in any Lending Company to survive in the Long Term since, without proper Mitigation strategies, it will be very difficult to stay in the Lending Business due to the rising NPA’s and Defaults happening.
In every Bank/NBFC, there is a separate Credit Risk Management Department to take care of the Quality of the Portfolios and the Customers by framing appropriate Risk mitigating Techniques.
This has been a guide to what is Management of Credit Risk and its definition. Here we discuss Top 4 strategies of credit risk management along with examples & explanation. You can learn more about Risk Management from the following articles –