A credit risk policy refers to the standards and procedures that a business implements to minimize the possibility of clients defaulting on their payment obligations. To be effective, this type of policy should perform four major functions. It should identify and measure risks and capabilities. Additionally, it should include mechanisms to monitor and control the transactions that it approves.
Credit risk is the potential for borrowers to fail to repay or fully repay their debts. Risks are also posed when clients do not fulfill their obligations in the manner that they agreed. Examples of such behavior are making late or partial payments. Any business that makes loans or extends credit will face these types of risks.
The probability that a business will experience problems receiving payments drastically increases if there are no standards in place. If this problem materializes on a large scale, it can result in major financial problems for a business. A credit risk policy is a collection of tools that helps to avoid such a situation.
The first way that this is done is by identifying threatening elements. A business cannot adequately determine risk without having criteria to gauge a particular situation. Once a business has outlined these elements, it must also have a system to measure the extent that they apply on an individual basis. For example, financial obligations may be considered a threatening factor, but an effective policy should recognize that a client with $500,000 US Dollars (USD) worth of debt is in a different risk category than a client with $5,000 USD worth of debt.
The credit risk policy should also include guidelines to monitor existing relationships. If a business does not have a policy to determine how it will act once it has become a creditor, financial problems may still arise. Risk factors can fluctuate, or clients can act unexpectedly, and a business needs to be aware of these activities. In addition to being aware, a company needs to have control measures. Knowing that a client is defaulting or has increased potential to do so without having a set of procedures to deal with the situation is not very beneficial.
Credit risk policies will vary from one company to another. Despite their differences, each company should aim to formulate a cohesive policy that covers all of the major tasks. It is also important for businesses to realize that their credit risk policy will need to be adjusted periodically. Otherwise, they will become ineffective and outdated, allowing the risk potential to increase again.