Understanding credit risk in banking

When people think about banks, they often envision large institutions managing significant sums of money, making investments, and safeguarding our savings. However, at the core of their operations, banks primarily focus on one specific type of risk: credit risk.

What is credit risk?

Credit risk refers to the possibility that a borrower will fail to repay a loan or meet their financial obligations as agreed. In simple terms, it is the risk that someone who borrows money from the bank might not pay it back. This risk is paramount for banks because they lend substantial amounts of money to individuals, businesses, and even governments.

While banks are aware of various financial risks, such as market risks from fluctuating stock prices and operational risks from system failures, their main focus remains on credit risk. This emphasis stems from the nature of their business, which revolves around lending money. Although banks can manage other types of financial risks through strategies like diversification and hedging, credit risk is intrinsic to their core operations.

Example: Personal loans

Consider the scenario of taking out a personal loan to buy a new car. The bank will evaluate your credit history, income, and other factors to assess your creditworthiness. If they approve the loan, they expect you to make regular payments until it is fully repaid. However, the credit risk for the bank is that you might encounter financial difficulties, such as job loss, which could hinder your ability to repay. In such cases, the bank risks losing the money it lent you.

Managing credit risk: Insights from FINCA Uganda

To mitigate credit risk, banks employ several key strategies. Speaking to Sophia Kihumuro, Head of Credit of FINCA Uganda, she outlined some of these methods used:

Credit assessments: Before approving a loan, the bank conducts thorough credit assessments to gauge the likelihood of repayment.

Collateral requirements: Borrowers may be required to provide collateral, such as property or other assets, which the bank can claim if the borrower defaults.

Diversification: By lending to a diverse array of borrowers across different industries and regions, banks reduce the impact of any single default on their overall portfolio.

Maintaining reserves: Banks hold reserves, both required and excess, to ensure they have sufficient liquidity for customer withdrawals and to cover potential losses from defaults.

In a nutshell, Credit risk is the primary concern for banks, as lending money constitutes their main business. By understanding and effectively managing this risk through careful credit assessments, collateral requirements, diversification, and maintaining reserves, banks can protect their assets and sustain stability as reliable financial institutions. This proactive approach not only safeguards their operations but also enables them to continue supporting economic growth by providing essential loans to individuals and businesses.

The writer is the head of credit at FINCA Uganda