Explain how banks manage credit risk.

Banks manage credit risk

The credit risk is the possible loss a bank may incur if borrowers fail to pay their obligations. To minimize potential losses and to ensure solvency, banks manage credit risk by using both quantitative as well qualitative measures.

Quantitatively, financial institutions utilize various tools such as credit scoring or value at risk (VaR) models in order to accurately assess borrower’s ability repay loans thus helping determine if additional security may be required. Banks also look at factors including employment, income, collateral or alternative sources of repayment to determine whether they will grant certain requests.

In terms of quality, banks should ensure that they are using adequate procedures and policies for loan approvals as well as monitoring systems capable to detect any anomalies in customer behavior. This includes having a clear understanding of each client’s background including their overall financial circumstances so any issues can be identified early on.

It is important that banks effectively manage their credit risks. Failure to do so can result in substantial losses, which may lead them into trouble later on.