Credit risk is inherent to all lending operations; an investor that lends money takes some chance that the borrower will not repay the debt. Managing credit risk is a major issue for banks, businesses, and other lending institutions that allow borrowers to repay debts over time. While credit risk can never be eliminated, there are some useful strategies for managing credit risk that can help mitigate any losses. Some of the more common ways to manage credit risk include diversification, sliding-scale interest rates, and insurance.
Diversification is a typical strategy for managing credit risk in lending institutions that offer many types of credit. The theory suggests that, in general, lending a large amount of credit to a few borrowers is more dangerous than issuing smaller loans to many borrowers. Diversification is the practice of limiting loans to a certain amount, and spreading out credit between different markets, such as personal credit cards, home loans, and margin investing. This means of managing credit risk can also come in handy in the case of a market crash, since not all loans will be in one segment of the market.
Interest rates and fees are an important means of managing credit risk for any type of lending institution. Charging interest on a loan is the way in which most lenders make a profit; without an interest rate, a lender would simply receive back the money it lent out. Charging higher interest rates for riskier loans helps balance out the possibility that the borrower will default in several ways. First, a higher interest rate may help scare off investors who can see at the outset that payments will be unmanageable. Second, ensuring a profit through interest and other fees helps create a buffer of profit that guards against losses on other loans.
Many lending institutions use insurance as a means of managing credit risk. Credit insurance works similarly to car or health insurance: the lender pays the insurance company a monthly premium, and in return the insurance company restores some or all of the money lost in the case of a loan default. In order for credit insurance to be effective, however, the lending institution needs to make sure that insurance premiums do not outweigh the likely amount of loss from defaulted loans.
Managing credit risk can also be done through efficient lending practices. Financial and lending institutions must be vigilant about measuring the risk of each individual borrower by looking at his or her credit history, speaking to references, and examining his or her plans for the credit line. By carefully examining the borrower, lenders have a good chance of eliminating some of the highest risk loans before the money is even transferred.