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Understanding Credit Risk Management

Apr 18, 2008
Companies and other institutions, such as banks, are often faced with certain risks. Risk is always a part in every business. But if the risk involved is financial in nature, companies must come up with a system that can help manage risk. In the financial world, credit risk management plays an important role in managing the risks that come with credit and investment.

For a company to have a good credit risk management system, it needs a framework and must perform certain processes to have better knowledge of their customers. The customer is always a factor to the attainment of the company's goals. But if a company does not recognize the risks in providing products and services to their customers, the company is inclined to experience pitfalls.

Knowing your customers is very important. That is why in marketing plan, a business must recognize their target markets, whether they are of primary, secondary, or tertiary levels. Recognizing the market is very significant. If the company targets the wrong market, it is one step behind to its downfall.

In the financial world, credit risk is a great concern among banks and lending companies. Credit risk is defined as the potential risk of losses resulting from the default of payment of the debtor. This is a kind of risk that potentially leads a financial company to instability and insolvency. That is why it is important to recognize, analyse, measure, and manage the credit risks.

Risks abound in granting loans. A debtor has the potential to default in payment, even if at the first impression he appears to be financially sound. Because of the probability to experience losses from the granting of loans, banks and lending companies must assess the risks that come in borrowing, as well as with the person who obtains a loan. Before a person is to be granted a loan, he is still brought the scrutiny of the department that handles the investigation of the person's credit standing and financial background.

The statistical data of credit history of a person is one of the factors based by lending companies before extending the credit to the loan applicant. The credit history of an individual is among the different bases used. This practice is a norm in financial institutions to assess the credit risks that come with the person.

When it comes to investment, credit risk management is a helpful system to employ to determine the amount of capital that a company must keep in its reserve. As a rule stipulated in Basel II, a company that has greater exposure to credit risks must have greater amount of capital to sustain its financial equilibrium and solvency. The Basel II applies primarily to banking institutions when it comes to the regulation of capital to be stored in its reserve.

Financial companies are not only the entities exposed to credit risks. Any company that extends credit to its customers is also faced with credit risk. For-profit entities that sell goods and services on credit also have credit risks.

To manage credit risks effectively, a company must employ a credit risk management system that is proven to provide satisfactory results.
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