Key Risk Indicators (KRIs) : Credit Risk Management

Key Risk Indicators (KRIs) : Credit Risk Management?

Introduction

Effective credit risk management is critical for the long-term success of financial institutions. One of the primary responsibilities of credit risk managers is identifying and monitoring key risk indicators (KRIs) that can impact the credit portfolio.

In this article, we will explore some of the most significant KRIs that institutions must consider while managing credit risk. We will delve into the increase in Non-Performing Loans (NPLs), high loan concentration, poor risk rating assessment, increase in the provision for credit losses, and other critical risk indicators and how they impact credit risk management.

1.?????Increase in Non-Performing Loans (NPLs):?NPLs are loans that are either in default or are about to default. An increase in NPLs may indicate ineffective credit risk management.

Risk Management Strategy: Institutions may adopt a proactive approach toward credit risk management by implementing proper credit policies that establish lending criteria, assess a borrower's creditworthiness and track their creditworthiness constantly.

2.?????High Loan Concentration:?High loan concentration within a specific group or individual borrower may increase the level of credit risk exposure for the financial institution.

Risk Management Strategy:?Institutions may diversify their loan portfolio to minimise risk and adjust loan covenants and credit limits for high-risk borrowers.

3.?????Poor Risk Rating Assessment:?Ineffective credit risk management may lead to low credit ratings that could cause financial institutions potential losses resulting in lower earning assets.

Risk Management Strategy:?Institutions may periodically assess credit risks with the most recent diagnostic tools and allocate additional loan loss reserves where required.

4.?????Increase in Provision for Credit Losses:?Provision for credit losses is a count of net income allocated to cover faulty loans in the financial institutions' books.

Risk Management Strategy:?Institutions may consider periodically reviewing and stress-testing loan portfolios to minimise the potential for credit loss.

5.?????High Credit Exposure to Single Counterparty:?High exposure to a single borrower, industry, or financial instrument may increase credit risk exposure.

Risk Management Strategy:?Institutions may proactively monitor concentration risk by setting appropriate limits on credit exposure to individual counter-parties and keeping their portfolios diversified.

6.?????High Debt-to-Income Ratios:?High debt-to-income ratios may indicate that borrowers are overextended and unable to manage their debt, increasing the risk of default.

Risk Management Strategy:?Institutions may establish lending policies that limit total debt-to-income ratios for borrowers and conduct regular stress tests.

7.?????Acceptance of Poor Collateral:?Inadequate collateral could lead to a significant loss.

Risk Management Strategy:?Institutions may implement procedures that ensure appropriate collateral valuation, management, and verification as well as establish risk-based loan-to-value ratios.

8.?????Change in Interest Rates:?Changes in interest rates can significantly affect loan repayments, especially if borrowers are highly leveraged.

Risk Management Strategy:?Institutions may use proper interest rate risk exposure management tools and establish benchmark interest rates for the valuation of assets and liabilities.

9.?????Increase in Loan Delays:?Delays in loan processing or approval may indicate poor credit risk management.

Risk Management Strategy:?Institutions may review their lending policies and streamline their loan processing procedures, as well as establish policies to continuously monitor loans that have been approved.

10.??High Loan-To-Deposit Ratio:?High loan-to-deposit ratios can indicate that the institution is overly dependent on loans for its revenues.

Risk Management Strategy:?Institutions may monitor and manage liquidity risks, establish appropriate loan-to-deposit ratios, and develop a funding strategy that diversifies the sources of funding.

11.??Incomplete Information on Borrowers or Industries:?Lack of information on borrowers or collateral could increase the risk of default.

Risk Management Strategy:?Institutions may establish procedures to verify borrower information, such as background checks, credit histories, and financial statements.

12.??Inadequate Credit Monitoring:?Inadequate credit monitoring can lead to missed warning signs and incomplete or incorrect credit grades.

Risk Management Strategy:?Institutions may develop credit risk monitoring procedures that include analysing factors such as credit scores, transaction history, and financial statements

13.??High Concentration in a Specific Industry or Sector: High concentration in a specific industry or sector can increase the risk of default if that industry or sector experiences economic downturns.

Risk Management Strategy:?Institutions may diversify their loan portfolio across different industries and sectors, and establish limits on the percentage of total loans in a specific industry or sector.

14.??High Concentration in a Specific Geography:?High concentration in a specific geography can increase the risk of default if that region experiences economic downturns or natural disasters.

Risk Management Strategy:?Institutions may diversify their loan portfolio across different regions, establish limits on the percentage of total loans in a specific geography, and monitor economic and environmental conditions in those regions.

15.??Low Credit Ratings for Borrowers:?Low credit ratings indicate a higher probability of default.

Risk Management Strategy:?Institutions may establish lending policies that specify minimum credit ratings, and may require collateral or other forms of security from borrowers with lower credit ratings.

16.??Unsecured Borrowing:?Unsecured borrowing can increase the risk of default if the borrower is unable to repay the loan.

Risk Management Strategy:?Institutions may establish policies that require collateral or other forms of security for unsecured loans, and may limit the amount of unsecured lending.

17.??High Loan-to-Value (LTV) Ratios:?High LTV ratios indicate a higher risk of default if the value of the collateral declines.

Risk Management Strategy:?Institutions may establish policies that limit the LTV ratio for loans, and may require additional collateral or security for loans with high LTV ratios.

Conclusion:

Institutions face enormous pressure to manage credit risk, and this requires a disciplined approach to identifying and monitoring key risk indicators. The KRIs covered in this article are just a starting point, and it is important for institutions to evaluate and track other relevant KRIs specific to their portfolios. By consistently assessing and monitoring KRIs, financial institutions can make informed decisions about their credit portfolio, reduce credit risk, and enhance their overall financial stability.

Ultimately, successful credit risk management will enable institutions to maintain the confidence of their customers, investors, and regulators while contributing to the stability of the wider financial system.