What are the main ways to manage credit risk

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Which are the main methods of managing credit risk

Standardization of loan review and decentralization of loan objects

Standardization of loan review and decentralization of loan objects are the traditional methods of managing credit risk. Standardized loan review is the process of examining the creditworthiness of a borrower or bond based on certain procedures and indicators to avoid possible credit risk. For example, if a bank decides whether or not to give a loan to a company, first the bank should have a detailed understanding of the company's financial situation. Then, it should consider various factors of the borrowing company such as profitability, marginal profit, debt position and the number of loans requested.

If these conditions are met, the bank should consider the industry of the company that wants to borrow money and analyze the competitors, the prospects of the industry, the production cycle and other aspects. The bank then negotiates the terms of the loan contract with the company based on the number of loans and the repayment method. Although *** Same as funds and bond investments do not determine the investment horizon, they manage the credit risk of their investments through a similar credit risk analysis.

On the other hand, banks can reduce credit risk through loan diversification. The basic principle of loan diversification is that credit risks cancel each other out. For example, if two kiosks run by a particular parking lot apply for a loan from a bank, and the bank learns that one of them sells ice cream and the other sells rain gear. On sunny days the ice cream seller does well and the rain gear seller does poorly. On rainy days the situation is reversed. Because of the negative correlation between the income of the two kiosks, their total income will be less volatile. Banks can also use such principles to construct their loan portfolios and investment portfolios. Lending across industries can reduce some credit risk.

Loan review standardization and investment diversification are primary and necessary steps in managing credit risk. The ability to use these two steps to control credit risk is often limited by fewer opportunities for diversification. For example, because commercial banks are small, the number of loans granted . . areas and industries tend to be limited. Concentration in loan origination areas makes bank loan returns closely related to local economic conditions. Similarly, the concentration of industries in which loans are originated makes bank loan returns closely related to industry conditions. Moreover, the concentration of loan origination areas and industries tends to have an impact on the criteria relied upon to standardize loan reviews and does not allow for a broader perspective on the prospects for loan returns. As a result, the effectiveness of utilizing the traditional methods of credit risk control described above is limited.

Asset securitization and loan sales

In recent years, new approaches to managing credit risk have been asset securitization and loan sales. Asset securitization is the process of forming a pool of financial assets that are credit risky bonds or loans and selling them to other financial institutions or investors. From an investor's point of view, the securities resulting from this combination of assets are attractive because credit risk can be reduced by investing in a portfolio of multiple loans or bonds. At the same time, purchasing such securities can also help adjust investors' portfolios and reduce risk. Because of the above reasons, asset securitization is growing rapidly. In the U.S. market, the volume of asset securitization transactions was essentially zero in 1984, while by 1994 it reached $75 billion.

Loan sales, on the other hand, involve banks reselling their loans to other banks or investment institutions through the loan sale market. Typically, banks tend to sell their loans to other investors after making short-term loans to companies for mergers and acquisitions. On rare occasions, a bank can make a large number of loans for a single M&A, in which case credit risk analysis becomes important. In the U.S. market, the volume of loan sale transactions increased rapidly from $200 billion in 1991 to $665 billion in 1994.

Asset securitization and loan sales are both effective tools for credit risk management. However, asset securitization is only suitable for loan programs that have stable cash flows or similar characteristics, such as real estate and auto loans. Therefore, the latest credit risk management tools rely on credit derivatives.