Because of the low interest rate policy, banks have been under increasing pressure for some time. The central bank has been charging banks interest rates for more than three years when they park money with them. After all, the idea is that the institutes should not hoard their customers’ deposits, but rather issue them as loans so that the economy gets going. The consequence of this is that banks are increasingly granting loans. In order to keep the default risk as low as possible, banks should follow these six steps in credit risk management.
1. Know Your Customer
Know Your Customer (KYC) is an integral part of the credit risk management process and forms the basis for all subsequent steps in lending. On the one hand, this is about the mandatory authentication of new and existing customers to prevent money laundering. On the other hand, it is also important to collect relevant, accurate and timely information that helps to build a solid customer relationship so that the bank can position itself as a financial advisor and provider of financial products and services.
2. Analysis of non-financial risks
In order to assess the future of a company, qualitative criteria also play an important role in credit risk management in addition to the credit assessment. The qualitative rating criteria (“soft factors”) are non-quantifiable criteria that can have a lasting impact on the development of the company. Here, the financial institution particularly analyzes the success criteria that are important for future corporate development.
Qualitative factors such as management, the competitive situation, or market position (local competitors, market share, competitiveness of services, etc.), industry assessment, etc. are assessed. Thanks to the soft factors, the bank can usually predict future corporate crises with a longer lead time than using the quantitative criteria.
3. Interpretation of the numbers
There are various advantages, but also risks, that are associated with the establishment of a banking relationship and the granting of loans. Lenders should therefore know how and what the funds are used for and how they are expected to be repaid. In addition, all risks associated with the customer should be identified, categorized and prioritized.
In order to understand the numbers, the focus should be on the financial performance of the company – this examines the company’s economic situation. To this end, documents on the company’s assets and earnings are analyzed. These are usually current annual financial statements, business evaluations or, if applicable, income-surplus calculations.
4. Give the deal a price tag
Setting an appropriate price is one of the key elements in credit risk management. Based on the qualitative and quantitative evaluations, an assessment is made of the risk associated with lending to a company. Rating procedures or other valuation models are used for risk assessment, on the basis of which the corresponding interest rate is calculated.
A variety of complex factors determine the final interest rate. The most important factors include (1) the economic situation of the company (credit rating) and (2) the collateral provided (the collateral is recoverable). The following principle applies: the better the company’s economic situation and the most valuable the collateral provided, the lower the interest rate. The respective interest rate ensures that the financial institution is adequately compensated for the risk of the business.
5. Presentation and conclusion of the deal
The sound and professional communication of the rating and scoring results and the costs are an important prerequisite for accepting and concluding the deal. Credit decisions should not be based solely on the credit assessment. This would not be complete without an equal emphasis on the qualitative aspects such as the ability of management, the competitive environment, etc. After the analysis, structuring and pricing, there is nothing standing in the way of closing the deal.
6. Monitoring the business relationship
In today’s competitive environment, banks cannot afford to wait for their loans to be repaid and expect customers to actively ask about other products and services. In order to maintain the market position, the customer’s risk profile must continue to be monitored and, at the same time, opportunities for developing and expanding the relationship must be sought.
A profitable relationship can quickly become an unprofitable one. Loan payments can be timely, but deterioration in collateral, untapped potential, or unpaid taxes can pose a serious risk to a bank. Periodic reviews, evaluations and audits can ensure that the customer creates long-term profitability for the bank.