In an ever-evolving financial and economic landscape, a bank’s loan book is exposed to different types of direct and indirect risks, which can deteriorate their asset quality and adversely impact the bottom line. This means that a proactive approach to credit risk management is not just a priority but a necessity.
For financial institutions, maintaining a healthy loan portfolio while minimizing defaults is critical to safeguarding financial success. The ability to identify potential risks early on and mitigate any threats can make all the difference in preventing loan defaults and ensuring sound decision-making.
Managing credit risk in dynamic environments
Risk managers face the complex task of monitoring a multitude of factors that could affect borrowers’ repayment capacities. These factors could include changes in market conditions, macroeconomic factors, financial troubles for borrowers’ employer, borrowers’ financial health as well as past repayment behaviour, and emerging trends that might signal potential defaults.
Risk assessment practices are most often limited to the evaluation of creditworthiness of loan applicants during the underwriting stage. However, once credit facilities are approved and disbursed to the applicants, they are not as rigorously monitored to look for early signs of deteriorating asset quality.
Without proper credit monitoring practices, risk management tend to become more reactive and less agile. In the absence of pre-emptive alerts and insights on deteriorating asset quality, banks risk being blindsided by credit impairments that could have been prevented if detected early.
The importance of such proactive measures can be understood by looking at the changing regulatory guidelines with regards to the adoption of an early warning system. While in certain jurisdictions like India, the central banks have mandated the financial institutions to implement an automated early warning system, there are many developed economies like the US where it still is not a mandatory requirement.
A framework for proactive supervision
An automated system, like the G2 Risk Solutions’ Early Alert System (EAS), provides a structured approach to tackle the intricate challenges and workflows associated with borrower risk assessments. Such a system can streamline risk assessment processes by:
- Defining Key Risk Indicators (KRIs) and their underlying risk score logic
- Pulling the latest data to calculate risk scores for each KRI
- Assigning risk scores to borrowers
- Sending early alerts if borrowers’ risk scores breach the predefined risk threshold
- Triggering and assigning corrective actions to assess and analyze underlying causes
By leveraging well-defined KRIs and automated alert generation mechanisms, banks can shift from reactive responses to a proactive risk management approach. Here are six key features of how such an automated risk assessment system can enhance risk monitoring:
- Defining KRIs: These risk indicators, often referred to as early warning signs, help highlight vulnerabilities in borrowers’ repayment capacities. KRIs should be defined through careful analysis of factors, including the bank’s borrower profile, product offerings, and any other relevant factors. KRIs can pertain to multiple subject areas, such as:
- Delinquency (e.g., borrower becomes delinquent within 3 months of loan approval)
- Financial Data (e.g., consecutive decline of more than 20% in quarterly net profit)
- Collateral data (e.g., High LTV ratio, increase in LTV ratio)
- Credit bureau report (e.g., 20% decline in credit score)
- Portfolio-level KRIs (e.g., high average delinquency)
- Defining risk score logic for each KRI: To calculate KRI risk scores, a rule-based logic or formula is required, which depends on acquiring data from a wide range of sources:
- Internal data: Various source systems within the bank can provide borrower-specific financial information, such as loan positional data, transactional data, delinquency data, and customer data.
- External data: Supplementary insights from data sources that exist outside banks’ IT infrastructure enhance the assessment by providing a holistic credit risk view. This could include data from credit bureaus, macroeconomic data, financial reports, and annual reports from the public.
- Calculating risk scores: Risk score calculations start at the KRI-level. At the start of each reporting period (typically monthly), the latest data related to the KRIs is fetched from internal and/or external sources, and risk scores for each KRI are calculated using predefined logic or formulas. Additionally, risk thresholds are predefined for each KRI to identify high-risk scenarios that warrant closer attention.
- Generating alerts: For each borrower, if a KRI’s risk score crosses its (configurable) threshold, email, and in-app alerts are sent to the designated users, usually risk analysts or relationship managers. These alerts often act as a trigger for further investigation and timely intervention.
- Facilitating collaborative analysis: Upon receiving an alert, risk managers and relationship managers follow a pre-configured automated hierarchical workflow to analyze the underlying data and understand the reasons behind the alerts. Best practices recommend that borrowers across different pools be pre-assigned to a multi-hierarchical workflow based on factors like outstanding dues and customer type. This aims to resolve issues by creating an effective risk mitigation strategy.
- Aggregating risk scores: Each KRI could be assigned a risk weight based on its relevance and importance as a predictor of eventual credit impairment. A weighted average of all KRIs is used to calculate individual customer risk scores. These customer scores can then be aggregated to determine the risk profile of the entire portfolio.
G2RS’ EAS employs multiple models to optimize KRI risk weights and perform back testing to ensure minimum false positives.
EAS key benefits
- Timely intervention: Early identification of potential defaults enables banks to take corrective actions before risks escalate.
- Enhanced decision-making: Data-driven insights allow risk managers to make informed decisions that safeguard the loan portfolio.
- Comprehensive risk monitoring: A holistic view of risks at both borrower and portfolio levels ensures that no critical factors are overlooked.
- Improved collaboration: Cross-departmental tools encourage
- Regulatory compliance: A transparent and systematic approach to risk monitoring ensures banks stay aligned with regulatory requirements.
Transforming risk management practices
Adopting an EAS can fundamentally transform how banks manage credit and fraud risk. By proactively identifying and addressing potential risks, banks not only minimize defaults or frauds but also strengthen their overall financial health and borrower relationships. Proactive supervision is key to staying ahead in today’s dynamic and interconnected financial as well as economic environment.
While many institutions have yet to explore such solutions deeply, your bank can earn a competitive edge by incorporating a proactive risk management culture early. To help banks like yours, we’ve developed a comprehensive EAS Solution to streamline and enhance this process.
G2RS’ EAS Solution comes pre-packaged with a set of KRIs, internal/external data source connections, and pre-configured risk score logic. Depending on the client’s needs, they can activate or deactivate KRIs that they want to track using the onscreen configuration setting. By leveraging advanced modules like Customer Trigger List, Customer 360° Dashboard, and Automated n-level Workflows, our solution eases the complexities of risk-monitoring processes and fosters collaboration across multiple teams.
To learn more about how our Early Alert System (EAS) can benefit your institution, contact us for more information.