When financial institutions, investors, or other lending facilities allow individuals and businesses to borrow money, they risk the chance that the borrower will default on the loan or credit line. Credit risk management is a means of reducing credit risk by employing a variety of strategies meant to prevent or at least offset losses due to default. There are many different strategies employed in credit risk management, including purchasing credit insurance, diversifying lending, reducing available credit, and charging fees to partially offset costs. Nearly every major financial organization in operation relies on a combination of credit risk management tactics to prevent loss from borrower default.
With lines of credit, one of the most commonly employed strategies for credit risk management is to reduce spending limits to help prevent financial over-extension. For instance, if a person has a credit card with a $2000 US Dollar (USD) limit, the bank may initially impose a transaction limit of $200 USD. This prevents the borrower from maxing out the card in one go and then defaulting. Once a borrower has developed a proven track record of regular repayment, the bank may believe that the credit risk is reduce and remove transaction limits or increase the total amount of the credit line.
Credit insurance is purchased by banks and large lending institutions to cover losses by default. The bank generally pays insurance premiums just as a person would for health or car insurance, but may often pass these premiums on to customers through fees and charges. In case of default, the insurance will be able to step in and cover the bank's losses. Credit insurance exists to help the bank out of trouble, though not, it should be noted, the borrower.
One credit risk management strategy relies on the diversification of available credit. Risking a smaller amount of money in many different areas, such as for house loans, auto loans, and credit cars, may be safer than putting all available resources into a single area. If a market crashes, institutions that have invested solely in that market may be crushed in the wake. Institutions that have a diversified portfolio may be more likely to survive a crashing market.
Credit risk management is a complicated subject that often requires excellent professional advice. Many financial institutions, both large and small, employ risk management specialists to assess risk and design and monitor a comprehensive plan for protection against credit risk. Economists, market analysts, and even accountants may be able to find gainful employment in the risk management field.
