Credit risk management is about understanding, measuring and mitigating the risk that a company will not be paid back by the counterparties that owe it money. Solutions that manage credit risk involve skilled risk professionals and information technology and systems.
- Credit risk management has always been important, but the events of 2008 in the global banking system have highlighted how dangerous it can be to fail to manage credit risk. This is not only the domain of banks, as corporations have credit exposures throughout their businesses as well. Vendors, suppliers, customers and services firms can all be sources of commercial relationships that create credit risk.
- Solutions for credit risk management, whether using technology or personnel, all have the initial goal of real-time measurement of credit exposures. Exposures mean the amount of actual money that can be lost if a counterparty to a transaction or business contract fails to pay. Risk professionals in this function must be able to know at all times the total value of a corporation's exposure as well as where it is concentrated in terms of counterparties. The likelihood of a default, and the potential timing of a default, will depend on factors unique to the counterparty as well as market considerations. As soon as there is a clear understanding of credit exposures, the risks can then be managed using a variety of tools.
- There are market, technology and negotiated solutions for the management of credit risk. Market solutions include the use of credit default swaps, whereby derivatives are purchased that pay if a specific counterparty fails to. Information technology products can be used to track and monitor credit pricing and ratings in the marketplace and to alert risk professionals of changes in their status. Standard & Poor's and Moody's are good examples of firms that provide information technology solutions in the credit risk arena. Negotiated solutions, such as netting, involves specific contractual arrangements that are put in place to lower credit risk. Netting does this by causing the net amount of cash to be settled between two parties rather than the aggregate amount to be paid.
- Regardless of the type of credit risk management utilized, the most important component is the human one. Experienced credit professionals need to be involved in using the tools so that the information they provide is priced correctly and interpreted properly. The vast amount of information available is best screened by personnel who understand credit risk.
- The most obvious benefit to good credit risk management is the prevention of a major, or even disastrous loss or series of losses. A more subtle benefit is that the kind of data produced by a well-functioning credit risk team can be used to make better pricing decisions and better investment decisions at the corporate level.
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