Credit portfolio risk refers to the risk incurred by any entity which builds up a series of investments that depend upon credit relationships. The entity makes money from these investments through the interest payments they receive on loans, but they also run the risk that their debtors will default on their payments. When default occurs on several credit investments in a portfolio, the entity can be in serious financial trouble. Banks are the institutions which are at the biggest credit portfolio risk, since they issue loans to customers on a regular basis.
Much of the business that is conducted throughout the world is done through credit relationships, in which one party receives goods or services from another while making the promise to pay the other at a later date. Loans are also types of credit relationships, with the loaner generally benefiting from interest payments and the eventual return of the principal of the loan. There is always the risk that one party will default on its loan obligations. For that reason, institutions that issue loans on a regular basis always have to be concerned with credit portfolio risk that can damage their investments.
There are many different parties that must consider the possibility of credit portfolio risk. For example, individual investors who deal in the fixed income market and buy bonds from various institutions must be wary of credit default. An investor with a variety of risky corporate bonds should consider balancing that out by choosing some safer, investment-grade bonds from the government or other stable entities.
For the most part though, banks and other institutional lenders are the entities that need to be most concerned with credit portfolio risk. To deal with the risk, banks usually have an individual or a whole department in charge of overseeing loans. The best way to manage risk is to assess a portfolio's risk as a whole by determining whether there are enough safe loans to offset the riskier ones.
To achieve this, banks must analyze each loan on a case-by-case basis, checking the past credit histories of potential customers to see if they have the ability to pay back their loan obligations. For riskier cases, the bank might deny the loan completely. The bank might consider issuing a loan to these individuals or businesses only by attaching higher interest rates to compensate for the risk. Every loan represents an investment to the bank, and credit portfolio risk managers must do all they can to protect those investments.
