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A credit risk management system analyzes the amount of risk present in a potential loan and in a portfolio, then decides the terms and interest rate of the loan. This system generally consists of two main components: a credit risk analyst and risk management software. Together, the person and the computer analyze the potential risk in a loan, the current portfolio of loans that the bank is managing and the amount of capital the bank has available. Then they give a recommendation to the bank concerning the term and interest rate of a loan.
First, the information about a potential loan is put into the computer program. Then, the program analyzes the data and creates a report. The credit risk analyst uses the report to determine the length and interest rate of the proposed loan. Some financial institutions use individualized credit risk management systems, and others use external systems. Either way, the system ensures that the greater the credit risk, the more compensation required, usually in the form of interest.
Individual credit risk is the measurement of the likelihood that the loan will be paid in full and on time. It is the job of a credit risk management system to identify and assess risk, deciding the probability of an unfortunate event that might cause the loan to default. Most banks use a cutoff to determine whether a loan is given and how much interest will be charged on that loan.
Another aspect a credit risk management system must cover is portfolio management. Credit risks need to be diversified to provide stability for the lender. Many companies use risk management software to keep track of the percentages of each type of loan. Banks want to make sure that they don't have too much money loaned to companies in one particular segment of the economy or one particular type of borrower, because the bank risks losing money if that segment of the economy or that type of borrower is affected by certain events or economic changes.
In addition, a credit risk management system should assess whether the lender has adequate capital to make the loan. If the lender does not have enough capital, a loan will not be provided. Generally, the system will warn the bank if it is in any danger of overreaching itself.
Some companies create their own credit risk management system to address their particular needs. Others pay a fee to use a system created by another company or group of companies. Although these third-party companies don’t manage portfolios, they do analyze the credit risks of individuals and businesses.