Briefly explain how banks manage credit risk and interest rate risk.
Answers
Consumers posing higher credit risks usually end up paying higher interest rates on loans. Understanding Credit Risk.
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1) Setting up an Ideal Credit Risk Environment
The bank’s board of directors, in an ideal credit risk environment, should involve and take the responsibility of periodically reviewing the credit risk policies of their bank. The policy, as and when undertaken by the board, should clearly state the bank’s tolerance level for risks, and also the interest rate spread it requires for taking such risks.
2) Formulating a Full Proof Credit Granting Process
It is essential for banks to operate within well-defined credit criteria. These criteria should clearly lay down the bank’s target market, the borrower’s credential requirements, purpose and structure of credit, and the source of repayment.
3) Securing Control Over Credit Risks
Banks must establish a process for continuous review of credit risk management strategies. Results of such assessments should be forwarded directly to the board of directors.
The reviews are intended to provide valuable insights on whether the bank’s credit granting functions are being accurately managed within the defined standards and limits.
Banks must enforce an internal control mechanism to make sure that exceptions of policies, limits, and procedures are communicated to the appropriate authority in time.
There should be a streamlined system in place for early detection of fraudulent activities, and for corrective action on deteriorating credits.
4) Intelligent Recruitment of Human Resource
It is also a responsibility of the management to ensure that sufficient and competent resources are allocated to control and manage the credit risks. Credit managers should –
Have a comprehensive perception of the risks associated with the bank’s credit activities.Be capable of understanding relevant factors and conditions which can directly or indirectly affect the credit quality and risk profile of the institution.Immediately report a change in the risk profile or credit portfolio to the concerned authority for consideration.
The bank management should consistently organize credit training programs to equip its personnel with adequate knowledge about the institution’s credit standards and culture.
5) Incorporation of Effective Information System
Banking institutions must have an information system in place to effectively manage the inherent credit risks in its activities.