Credit risk management is of fundamental importance

Credit risk management is used by banks, credit unions and other financial institutions to mitigate losses primarily associated with loan defaults

by Lorenzo Ciotti
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Credit risk management is of fundamental importance
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Credit risk management is a profession that focuses on reducing and preventing losses by understanding and measuring the likelihood of such losses. Credit risk management is used by banks, credit unions and other financial institutions to mitigate losses primarily associated with loan defaults.

A credit risk occurs when there is a possibility that a borrower may default or default on an obligation as set out in a contract between the financial institution and the borrower.

As a rule, the strategies employed include transferring the risk to third parties, avoiding the risk, reducing the negative effect and finally partially or totally accepting the consequences of a particular risk.

It focuses on risks arising from physical or legal causes such as natural disasters, fires, deaths and criminal trials. Financial risk management, on the other hand, focuses on risks that can be managed using financial trade tools.

It should be noted that recently the concept of risk tends to expand into risk/opportunity, where together with negative impacts, damage, potential positive impacts are also associated with opportunities to be pursued. Establishing the context includes planning the remainder of the process, the identity and purpose are key, the basis on which the risk will be assessed and defining the framework for the process, the agenda for identification and analysis.

Credit risk management is of fundamental importance

In ideal risk management, risks related to a large loss and a high probability of occurrence are treated first, while risks with a low probability of occurrence and low losses are treated with a delay.

In practice the process can be extremely complex, in fact risks with high probability of occurrence, but with low loss, and risks with high loss, but low probability of occurrence, can be poorly governed. Risk management very often faces the difficulty of properly allocating resources; this concept is called opportunity cost.

Time and resources spent on risk management could be spent on more profitable activities.

Furthermore, ideal risk management spends the bare minimum amount of resources in the process of reducing the negative effects of risks.

Opportunity cost differs from monetary cost because it includes not only the money to acquire the good but also the value of the time spent consuming it, expectations and missed opportunities. If a good has no cost, it can always have an opportunity cost.

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