Bank credit risk refers to the totality of risk incurred by a bank from all of the loans that it issues to various customers. The risk for banks in issuing loans is that the borrowers will not repay the amount that is owed in the time that is specified by the loan agreement. If enough customers default on their loans, a bank can find itself in a serious financial predicament. As such, individual banks manage bank credit risk by doing thorough credit checks of their prospective borrowers and by insuring themselves against loans of significant capital.
Many people view banks as reliable institutions that have the stability to issue loans in a prompt manner. There is no guarantee for banks, however, that these loans will be repaid. Since many of the loans offered by banks are unsecured, which means that there is no collateral offered by the borrower, banks receive little recompense when a borrower defaults on a loan. For that reason, a bank must manage bank credit risk to protect against the severe complications that can arise from multiple defaults.
Most banks have a specific department that specializes in the management of bank credit risk. The individuals in charge of this department must make sure that the bank's exposure on loans is never so significant that it would affect operations if a worst-case scenario of multiple defaults occurs. These managers must also be aware that loans are often very profitable for banks, which make money from interest payments, so they must be ready to assume some degree of acceptable risk as the price of doing business.
The best method of managing bank credit risk is to keep close tabs on the individuals or institutions to which a bank might be compelled to lend money. Credit ratings are one way to measure the reliability of borrowers. If a borrower has a particularly troublesome credit rating, a bank would likely pass on offering a loan to this individual, or it would only do so at terms that are extremely favorable to the bank.
Another method available to banks when attempting to lessen bank credit risk is insurance. This is a wise strategy when the bank issues a loan so large that it would cause serious problems if the borrower does not make repayment. If there is no way to secure such a loan with collateral, an insurance policy that covers the bank in case of default can help to mitigate the damage done if repayment is never made.