Financial Institutions must constantly monitor various risks involved in business activities. The ability to handle specific investment or loan failures is a requirement rather than an option. To complicate the issue, financial institutions must also be able to weather systemic failures.
Research Optimus (ROP) provides credit risk analysis services that help financial institutions handle such critical risks and prepare them from the early stage of the credit cycle. As credit risk analysis is one of the important areas for a financial organization, ROP offers to assist them with detailed analysis reports and suggestions around how they can utilize it to create the right credit risk policies.
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Credit Risk Faced by Financial Institutions
Financial Institutions face several credit risks spread across different areas of business. These include lending, trading and investing. The following describes risks associated with each area.
Lending Risk
Banks can do much to qualify loan customers, but there are always risks. Implementing a stringent verification process will not only reduce the risk of loan failures but time and cost as well. By disqualifying an applicant early on, banks will save time and money in processing a potentially higher risk applicant.
Trading Risk
Not all financial Institutions have trading departments and thus will not face any trading risk. For those financial Institutions with trading departments, which focus on short-term, highly-liquid trading profits, trading activities may involve foreign currencies, equities, futures, bonds, mortgages and more.
As banks take on positions in any asset class, they must manage their equity to margin ratio to avoid generating margin calls. This is not only a matter of managing position sizing but also factoring in the asset class and market risk. The bank will need enough capital to handle any market decline, which may also cause its positions to decline.
Investing Risk
Investing activities are often related to long-term profit generation in illiquid assets. This can involve taking stakes in businesses, purchasing real estate, or purchasing alternative investments. Without a mark-to-market price available in such illiquid assets, banks take on valuation risk. While their balance sheet may show a value for an illiquid asset, which may be based largely on a model, the asset’s actual value may be much lower. If a buy/sell transaction occurs on a similar asset by another bank and its price is much lower, the bank will need to decrease the price of its illiquid asset to more accurately reflect the asset’s current value.
Decreasing the value of an illiquid asset will overall decrease total asset value on the balance sheet. Because banks must maintain certain capital percentages, the decreased asset value can be problematic for the ratios it must maintain.
Designing Credit Policy Through Credit Risk Analysis
While doing corporate credit analysis and developing a credit risk policy for a financial institution, Research Optimus analyzes the types of activities the business is engaged in along with customer risk levels for more precise planning.
Some financial institutions may engage in riskier investments and customers to generate higher income. By profiting more from risky investments and charging much higher interest rates to riskier customers, the financial Institution generates enough cash flow to offset bad investments and loan failures.
Risky investments and customers are still highly scrutinized by the financial institution. For each, the financial institution still has a defined level of risk it is willing to accept based on its financial model. The financial model will require higher capital on hand to handle larger investment drawdowns. Besides its own investment and loan risks, the financial institution must have enough capital on hand to handle overall market downturns. In such downturns, many of the financial institution’s investments may drawdown and more loans may fail.
Market Events vs. Cashflow Management
There is a balancing act in maintaining capital requirements for market events vs. having too much idle cash during good times. Handling market downturns and specific investment and loan failures are risk mitigations against negative events. Idle cash doesn’t present such a negative event. The risk from idle cash is the loss of profits due to cash not being put to work. That type of risk is an opportunity cost and not a credit risk. Such explicit identification of risks allows financial Institutions to better categorize risks and create more actionable risk policies.
Partner with ROP’s Experienced Credit Risk Analysis Team
With the team of financial analysts having profound years of corporate credit analysis and cash flow modeling experience, ROP has been assisting businesses with extensive credit rating advisory reports. ROP by the side, financial institutions will immensely benefit from its credit research and credit risk analysis services for the present as well as anticipated scenarios. Our team can also help you create a credit risk mitigation policy. Contact us to learn how we can help.
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