Credit Risk Management: Meaning, Process, Tools and Benefits

Key takeaways: 

• Credit risk means the chances of loss due to the failure of the borrower to repay on any type of debts. 
   
• Credit risk management is a method to mitigate the loss by assessing the borrower’s payment behaviour. 
   
• With an increase of digital lending and strict rules, an improved credit risk management helps banks and NBFCs to reduce non performing assets (NPAs). 

Bonus tip: 

Do you know? The “Credit Risk Management Services Market Global Report 2026” acts as an important resource to understand the changes in the market. It is used by strategists, marketers and the senior management. 

Imagine you let someone borrow some money and they never pay it back? Credit risk management is a method which is used in similar situations but by institutions like banks and NBFCs. The practice is used to identify, measure and reduce the credit risk that a borrower failed to repay any debt. 

Think of a situation where you lend your bike to your friends. Some friends return it on time, in good condition and some of them damage your bike and also never return it. In such cases, you will do an assessment of your friends: 

• Is this friend responsible? 
• Should I keep something as security? 
• What is the past history of borrowing? 

This assessment will help you to make a clear decision before lending your bike to your friends. Similarly, credit risk management is used by the banks and NBFCs to manage the credit risk caused by the borrowers when they fail to repay the loans and other obligations. 

For example, Neha applied for a business loan of  ₹20,00,000 from a bank. Before approving the loan, the bank will use the credit risk management framework to assess her payment behaviour. The bank will examine:

• Her salary and other statements.
• Her loan repayment history. 
• Her credit score 

If after the proper assessment, the bank is satisfied that Neha has a good salary and repayment history, the bank will provide her the loan. 

What is Credit Risk Management? 

Credit risk means the chances of loss due to the failure of the borrower to repay on any type of debts. In such cases, credit risk management method is used by the banks and NBFCs to identify, measure and reduce the credit risk. With an increase of digital lending and strict rules, an improved credit risk management helps banks and NBFCs to reduce non performing assets (NPAs). 

APS 220 credit risk management requires an ADI to implement a credit risk management framework. The framework should be in accordance with the size, business mix and complex nature. 

Different types of credit risks: 

These are 4 different types of credit risks reduced by the credit risk management framework. 

Settlement risk is also called as counterparty risk as one party in the financial transaction failed to meet their legal obligations. In this situation counterparty credit risk management practice is used. 

Credit Portfolio Management (CPM) 

Credit Portfolio Management (CPM) is an important function for institutions like banks to manage risk exposure in loans, bonds and financial instruments. Today, banks are using new data and methods for credit portfolio management. 

The accurate measurement of credit portfolio risks includes loss distribution, stress testing, reverse testing and capital planning. 

What are the 8 steps of credit risk management 

Below are the 8 steps to manage your credit risk: 

1. Know your customer: the first step to credit management is to know your customer. You have to work on timely and accurate information of your customer. For example, ask questions regarding the product of the company, services, customer, suppliers etc.

2. Analysis of non financial risks: try to understand your customer's business  by doing analysis of non financial risks. 

3. Understand the numbers: As a lender, you should know where the money will be used by the customer and how will the customer repay the amount. 

4. Structure the deal: understand the nature of business, impact of economic conditions, nature of the industry and the business strategy. 

5. Deal price: it is important to know the appropriate price of the deal so that you will be adequately compensated for the risk of the deal. 

6. Present the deal: presenting your findings in a professional manner is better for the proposal to be accepted. 

7. Closing of the deal: closing of the deal happens after a proper analysis, structuring and pricing is completed.

8. Monitor the relationship: you will be able to monitor individual transactions with the relationship. 

These are the 8 steps of credit risk management. 

Conclusion: 

Overall, Credit risk management is an important method to mitigate the loss by assessing the borrower’s payment behaviour. There are four different types of credit risks like default risk, counterparty credit risk, concentration risk and country risk. Credit Portfolio Management (CPM) is an important function for institutions like banks to manage risk exposure in loans, bonds and financial instruments. 

FAQs: 

What is the first step in 8 other steps to manage the credit risk? 

The first step is to know your customer.You have to work on timely and accurate information of your customer.

How to pivot from credit risk? 

You can move to risk management, investment banking or equity research. 

How is credit risk model development perceived in the world of finance? 

Credit risk model development is perceived as essential in the world of finance because it works on mitigating the credit risks. 

What is credit risk management? 

Credit risk management is a method to mitigate the loss by assessing the borrower’s payment behaviour. 

Why is credit risk management important to banks? 

Credit risk management is important to banks. There is an increasing need to manage the risk exposure, market as well as credit risks.