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Given credit and market upheavals that can threaten a bank's survival, a defensive posture involving the rudimentary measurement of risk is understandable. However, taking a proactive approach that goes beyond the usual elements of loss avoidance and risk measurement is also vital to the continued well being and prosperity of a bank. While it may not be possible for a bank to maintain a full portfolio of well performing loans, still they can be expected to lend in a more prudential manner. CRM models help banks project risk, measure profitability and reduce the NPA levels. how does CRM lead to better allocation of capital by banks and financial institutions? Read on.
For centuries, financial intermediaries such as lenders, institutional investors, dealers, and insurers have engaged in risk modeling. In olden times the model was based on judgment and experience. Essentially, it involved categorizing and evaluating the proposed risk and reaching a series of interrelated decisions. For example, in the context of bank lending, for each potential credit those decisions included: (1) whether or not to lend, (2) at what price to lend, (3) what maturity should the loan have, and (4) what collateral to accept and how to structure it.
In recent times, sophisticated models have been developed to manage credit risk. Most Indian banks however continue to follow archaic risk management practices. Many have collapsed due to increasing Non-Performing Assets (NPAs). While it is not practical to expect a bank to have a full portfolio of well performing loans it can be expected of them to lend in a more prudential manner. Banks, above all other institutions, including corporations, insurance companies and asset managers, face the greatest challenge in managing their credit risk. Credit Risk Management (CRM) modeling can be very useful in this regard.
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