Credit risk refers to the probability of loss due to a

borrower's failure to make payments on any type of Credit risk management is the process of controlling
debt. Credit risk is the primary financial risk in the the potential consequences of credit risk. The process
banking system and exists in virtually all income follows a standard risk management framework,
producing activities. Identifying and rating credit risk namely identification, evaluation, and manage.
is the essential first step in managing credit risk
effectively. This process will help a business identify the cause of
risk and the extent of the risk must be evaluated and
Credit risk is also variously referred to as default risk, decisions should be made on how to manage the risk.
performance risk, and counterparty risk. Credit risk
constitutes the possibility of losses associated with a Best components of credit risk.
decline in the credit quality of borrowers or
counterparties default due to inability or There are two significant components of credit risk
unwillingness of a customer or counterparty to meet default and portfolio risks.
commitments to lending, trading, settlement, and
other financial transactions.  Default risk has a risk that a borrow or all
counterparty is unable to meet its commitment.
Three characteristics define credit risk.  Portfolio Risk arises from the composition and
1. Exposure to a party that may default or suffer an concentration of a firm.
adverse change in its ability to perform. For example, a bank exposure based on its
2. The likelihood that this party will default on its operations, internal and external factors.
obligations, the default probability, For example, state of the economy, fiscal deficit
3. The recovery rate, that is how much can be size, and national financial inclusion can influence a
retrieved if a default takes place. firm's credit risk exposure.

The more significant, the first two elements, that is Internal factors influencing a firm’s credit risk
credit risk exposure and the likelihood the greater the exposure.
exposure.
A business credit risk exposure can be influenced by
On the other hand, the higher the amount that can be internal factors that is affirms specific features. For
recovered, the lower the risk. Credit risk can be example, a bank can manage its internal factors
expressed as: through adopting a proactive loan policy, good
quality credit analysis, loan monitoring and sound
credit risk = exposure X probability of default(1- credit culture.
recovery rate).
external factors influencing affirms credit risk
Forms of credit risk. exposure.

Credit risk may be in various forms, including: A firm’s credit risk exposure can be influenced by
1. Non repayment of the interest on loan nor loan. external factors, including the state of the economy,
size of fiscal deficit, and the level of national
2. Inability to meet contingent liabilities such as financial inclusion. Businesses can manage external
letters of credit guarantees issued by the bank on factors through:
behalf of the client. 1. Diversification of loan portfolio.
3. Default by the counterpart in meeting the 2. Scientific credit appraisal for assessing the
obligations in terms of treasury operations financial and commercial viability of loan proposals.
4. Not meeting settlement in terms of security trading
when it is. 3. Setting standards and requirements for single and
5. Default from the flow of foreign exchange in terms group borrowers.
of cross-border obligations 4. Established a standard for sector deployment of
6. Default due to restrictions imposed on remittances funds,
out of the country. 5. strong monitoring and internal control systems, and
6. Delegation of duty and effective accountability
Credit risk management. principles of credit risk manage.

Credit risk management is the practice of mitigating The principles of credit risk management for banks
losses by understanding the adequacy of a bank's and higher purchase firms are similar.
capital and loan loss reserves at any given time.
 11. Procedures and systems for monitoring the
Essentially, the principles of credit risk adopted by financial performance of customers.
each business should be sound and well-integrated in 12. controlling outstanding loan performance so
the structure and operation of the firm. that the non-performance is within limits
organizational structure.
Here are good principles for credit risk management.
A sound credit risk management should be well
1. A bank board of directors must take responsibility situated with a firm's organizational structure. For
for approving and periodically reviewing the credit example, bank credit risk management should provide
risk strategy. for:
 One independent group responsible for credit
2. Senior management must take the responsibility to risk management.
implement the credit risk strategy,  Two, formulation of credit policies,
3. Bank must identify and manage the credit risk of formulation of credit policies.
all banking products and activities.  Three procedures and controls of all credit risk
functions, and
Credit risk management  Four credit management team responsible for
overall credit risk board of directors.
Regardless of the credit risk management framework
adopted by a firm. The board of directors should oversee its overall
Sound credit risk management framework should credit risk management policy based on its credit
include the following eight components: risks exposures, including credit, liquidity, interest
1. Policy framework, rate, foreign exchange, and price risk. To ensure a
2. credit risk rating framework. sound and effective credit risk management system
3. credit risk limits, necessary, committees should be set up and well-
4. credit risk modeling, integrated for the overall success of the company's
5. credit risk pricing, credit risk management policy and framework.
6. risk mitigation,
7. loan review mechanism,
8. credit audit.

Now let us examine the eight components of sound

credit Risk Management

Policy framework. The credit risk policy framework

should clearly articulate the firm's credit risk strategy
and policy operations and systems support and
organization's structure.

For clarity, it is good to consider key aspects of the

policy framework of credit risk management,
strategy, and policy.
A sound credit Risk management strategy and policy
should address the following areas.
1. Documented policy specifying target markets.
2. Statement of risk acceptance criteria.
3. Credit approval authority.
4. Credit follow up procedures.
5. Guidelines for portfolio management.
6. Systems of loan restructuring to manage
problem loans.
7. follow up procedures and provisioning of non-
performing loans and advances.
8. A consistent approach to early problem
recognition.
9. Classification of exposures in problem loans.
10. Maintain a diversified portfolio of loans in
line with the desired capital.