What do you mean by the credit risk of a commercial bank? How it can be mitigated? Or what are the credit risk mitigation techniques of a Financial Institution

 Credit risk: Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet contractual obligations. Traditionally, it refers to the risk that a lender may not receive the owed principal and interest, which results in an interruption of cash flows and increased costs for collection. Excess cash flows may be written to provide additional cover for credit risk. When a lender faces heightened credit risk, it can be mitigated via a higher coupon rate, which provides for greater cash flows.

Although it's impossible to know exactly who will default оп obligations, properly assessing and managing credit risk can lessen the severity of a loss. Interest payments from the borrower or issuer of a debt obligation are a lender's or investor's reward for assuming credit risk.

Steps to mitigate the bank's credit risk: Loan portfolios typically have the largest impact on the overall risk profile and earnings of community banks. A strong credit culture provides a platform for the Bank to compete successfully in its market. Although credit risk is inevitable, banks can mitigate the risk by taking steps to strengthen its lending program. The following steps can help assist in providing a framework for a sound lending program:

·  Written Credit Policies-A well-written and descriptive credit policy is the cornerstone of sound lending. Credit policies should address the inherent and residual risks in lending.

·      Standardized Credit Packages-Documented credit request packages should be uniform. Most credit packages will consist of a request, required supporting documentation, and an analysis/financial review.

·        Experienced Underwriting/Decision Making-Underwriters should   effectively apply the Bank's credit policy and risk guidelines to determine the degree of risk involved in the credit request. Too many exceptions to policy may suggest that current underwriting guidelines may not be in line with the Bank's priorities or financial goals.

·        Loan Approval Authority-The Bank should document loan approval authorities which are approved by the Board of Directors. In order to maintain a balance between credit quality and profitable loan portfolio growth, appropriate lending authority controls must exist. Each loan file should contain documentation of proper approval.

·   Well-Managed Credit Risk Rating System-Well- managed credit risk rating systems promote bank safety and soundness by facilitating informed decision making. The Bank's risk rating system should form the foundation for credit risk measurement, monitoring and reporting and should support the board's objectives.

·   Accuracy of Loan Documentation-Properly executed loan documentation is necessary to ensure the bank has an enforceable claim for repayment, including liquidation of collateral or the right to demand payment. Documentation must be properly drafted, completed, executed, filed, and stamped. A secondary review of this documentation should be in place.

·   Monitoring/Reporting Loan Performance is important to identify trends within the loan portfolio and isolate potential problem areas. Reports to senior management should provide sufficient information for an independent evaluation of risk and trends.

·  Problem Asset Management-When collection problems persist and risk ratings deteriorate, many banks find it beneficial to transfer problem loans to an independent work-out team.

Loan portfolio and risk management is not just about avoiding risk. It is also about balancing risk while seizing opportunities in your marketplace and serving your community well. So, go for the opportunities while balancing your risk management strategy. It can help make your organization even more successful.