Mitigating Techniques for Commercial Risk/Loans

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Globe for WikiEducator.jpg Unit 3.5- Mitigating Techniques for Commercial Risk 

Introduction | Commercial Banks | Loans | Letter of Credit | Draft Collection | Accounts Receivable | Governments | Factoring | Forfaiting | Banker's Acceptances | Credit Insurance | Summary | Resources | Activities | Assessment


There are many similarities between the ways banks and companies manage credit. Both have similar processes. Credit management at a bank starts with credit analysis. Before a bank creates any exposure, someone needs to prepare a credit analysis describing the prospective borrower's financial condition. Based on the credit analysis and the bank’s risk management policies, a borrower is assigned a risk rating. Banks tend to be more formal about this process because extending credit is a core line of business for banks. Risk ratings usually range from very good to unacceptable. Several levels, 1 through 4, will be considered acceptable, though with different acceptability structures for each level; one or two levels will be considered marginal or "watch list," while remaining levels will be deemed unacceptable.

Risks may not lie entirely in a borrower's financial condition! In trade finance, as in export credit management, risk ratings must also factor in cross-border risks that may cause non-repayment of a loan, such as political events, the economic situation, or even acts of God and nature (earthquakes, monsoons) in the country of the borrower.

When a risk rating is assigned, the next step is to designate a credit limit and indicate permitted structures that may include sub-limits. Some structures may require collateral. The limits and sub-limits will be based on the desire of a borrower or a lender to diversify the risks-- not to lend too much money to any one borrower, or to too many borrowers in any one country or industry. Country limits are particularly important in trade finance. A political or economic event may disrupt payments from all borrowers in a country.

An international credit management system must be able to aggregate all exposures in a country, check that they are within the country limit, and block creation of new exposures that would cause that limit to be exceeded. Limiting factors include different limits for different types of risk: trading risk, risk related to loan, risk related to guarantees and tenor which includes short, medium and long-term trade finance. A lender may also have overall country limits, then limits for each sector (financial, industrial, government), and then limits for each borrower (by tenor and type of risk). With increased regulations and capital adequacy, this whole area of risk management has become very complicated.