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Credit Risk Management: What It Is and Why It's Important

Anna Burgess Yang

Every commercial loan originated involves an assessment of risk. Financial institutions have to evaluate the business, the borrower's ability to repay, and the collateral. The approval of a loan is based on the bank's willingness to take on that risk.

But at the same time, credit risk management is more than individual loans. It is about the portfolio as a whole and the bank's overall risk tolerance. In order to manage credit risk, you need to have an effective loan policy in place, monitor your credit analysis and underwriting, and evaluate the ongoing risk of your portfolio.

Establishing an Effective Loan Policy

Loan portfolios have a significant impact on bank earnings. Lenders will always want to originate more loans, but it is important to mitigate the bank's risk of loss. Your bank's loan policy should reflect your bank's strategic goals and support safe and sound lending practices.

Your loan policy is the framework for all credit decisions. It will outline everything about the loan products offered. It should also include lending authority and loan limits on individual loan types.

Part of your policy should also include how you will assign each borrower a risk rating. Your risk rating, or grade for that borrower, will be the lender's assessment of that borrower's risk.

Your examiners will look for justification of that risk rating. You may use objective measures, subjective measures, or a combination. Each loan file should provide documentation that supports the risk rating.

Consistent Underwriting and Approvals

Your loan policy is only as good as it is followed. Each loan should go through underwriting with a trained credit analyst. The analyst should review the borrower's financial statements, tax returns, and repayment history.

For more complex credits, an analyst may need to review market conditions, conduct stress tests, or prepare projections. Either the analyst or the loan officer may assign the risk rating.

When the officer prepares the loan for approval, the credit risk rating is a huge factor. Borrowers with lower risk ratings can still be approved, but a loan committee should discuss the level of risk. The loan committee should only approve loans if they are in line with the bank's loan policy.

Ongoing Credit Risk Portfolio Management

After approval and closing, loan operations staff should continue to manage the overall risk of the loan. This includes ensuring the loan does not have any documentation or policy exceptions. It also includes collecting updated financial information from the borrower each year.

A credit analyst should conduct annual reviews of commercial loans. If the borrower's situation has deteriorated, the loan risk rating should be downgraded accordingly.

Review Your Credit Risk Practices

It is a good practice to review your loan policy and procedures periodically. Economic conditions, market demand, and other factors may contribute to revising your bank's approach to credit risk. You want to prepare to answer examiners' questions about how you are effectively managing your commercial loan portfolio.

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