Explain the importance of credit risk management.
Credit risk is the probability that a borrower will not be able to pay accrued interest or repay the principal amount of a loan according to the terms specified in the credit agreement. It is the core risk in banking and the primary source of bank failures.
Why Credit Risk Management is Important
- Credit is the main source of earnings and cash flow for a bank. If the quality of bank credit declines, it adversely affects income, cash flow, and capital adequacy.
- Cash flow problems from poor credit quality may lead to a credit crunch and failure to pay depositors on time. Erosion of depositor confidence may invite bank failure.
- Credit risk not only includes default risk but also downgrade risk — even a decline in a borrower’s credit rating reduces the value of the bank’s loan portfolio.
- As a result of excessive credit risk, a bank’s profitability, capital adequacy, and cash flows are all adversely affected simultaneously.
- Bangladesh Bank’s Credit Risk Management guidelines require banks to have a board-approved Credit Risk Management Policy — updated at least annually — to ensure disciplined credit risk-taking across all business lines.
