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In the world of finances, risk management refers to the process of identifying, analyzing, and mitigating the uncertainties associated with lending projects. Every lending investment involves some degree of risk and it would not be an exaggeration to say that risk is inseparable from returns.
During their lending processes, financial institutions have to encounter the following 3-main types of risks:
● Credit Risk
● Operational Risk
● Fraud Risk
Other risks like reputational risks, market risks, and geographical risks are also there but the aforementioned ones are the most common. Let’s check the details of the three important risks one by one!
Credit Risk is the financial bout arising out of the scenarios of non-payment of the obligations by the borrowers. This results in irregular credit or non-performing assets for the organization. This ultimately adds to the cost of operation and impacts the bottom line for the Lender.
Loans are offered to the borrower based on their ability and intention to pay back the obligations along with the interest. And, to gauge the ability, lenders go to great lengths to assess the financial health and to minimize the chances of fault. The process of credit risk management can be compartmentalized into two broad categories- Measurement & Mitigation.
Risks are measured through a variety of proprietary tools differing by firms and jurisdictions, based on the type of lending (personal or commercial).
In the case of personal lending, the financial institution will assess the financial situation of the borrower- their assets, liabilities, income, and credit history. Personal guarantees and collaterals are generally relied upon in this lending.
While in commercial lending many more things are put under consideration. Important parameters include analysis of the industrial vertical in which the business operates along with what's going on in the business and the markets. The leading edges, management strategies, management team, ownership, the reputation of executives, and their credit scores- all are considered.
Even after this, risks cannot be effaced completely and if the mitigation strategies are not deployed then the lender can land itself in financial trouble. Strategies include credit structure and amortization period, financial reporting, and collateral security. Sensitivity analysis and portfolio-level controls are also used for mitigating credit risks.
Visual tools like Score card, Risk segmentation of proposals into High, Medium, Low, etc can aid the lender greatly in risk-adjusted underwriting of proposals.
Firstly the risk levels are identified and categorized, and based on the information the mitigation tactics are deployed.
The official definition provided by BCBS for operational risk is, "the risk of loss resulting from inadequate or failed internal processes, people, and systems, or external events.” So, operational risks can arise in many forms viz. business disruptions, system failure, cyber security concerns, third-party risks, and others.
Operational risks are more complex and are harder to measure. An active operational risk management strategy requires advanced visibility into the diverse processes and activities across the organizations.
1. System-defined controls of relevant authorization levels for various sanctions, which ensures no wrong level sign-offs
2. Amendments to policies being simultaneously defined in the system with no time lag.
3. Field-level validations for ensuring the data captured and the documents captured are as per the norms. There are multiple levels of validations like JSON basis, Regex basis, etc.
4. Capturing an audit trail of every activity of user action in the application that ensures a quick cross-check and analysis of the activities.
5. Relevant alerts in the backend to the relevant authorities. If there are exceptions or eccentricities noticed in scenarios like too many applications getting sanctioned after regular office hours, too many applications of high value getting processed in a branch as against the past average, etc.
Then comes the risk of fraudulence, which can either be internal or external. Fraud risks are about the deliberate exploitation of processes involved, misappropriation of funds, information, or documents, violation of roles & responsibilities, etc.
On the grounds of the strong potentialities of these risks, the ROI or the other important metrics for financial institutions like banks would be like risk-adjusted operating profits.
1. Impersonation of Borrowers through false representation of Customer KYC documents
2. Manipulation of the issued documents like Income docs, Bank statements, etc.
3. Deliberately providing false info like claiming regular employment and salary credits, while not employed.
4. Misrepresentation of info like inflation of Salary credits, claiming to reside in an address while physically not staying, etc.
1. OCR is capable of digitally capturing and also facilitating the match scores that are defined as per the threshold of the banks like address match, name match, etc.
2. Alerting facility if the source documents are sensed to be tampered with by any digital tool.
3. Incorporation of multiple and multi-stage authentication rules and triangulation of information among different sources. This can provide insights into any inconsistency, inaccuracy, or inefficiency in information management.
Certain transactions in banking observed on bank holidays, abnormally high Inflows compared to past averages, circular flow of money to common parties, and multiple PAN numbers associated with the same entity in different sources are some common aspects of fraud risks, and with these mitigation strategies, they all can be effectively tackled.
As mentioned previously that there can be no return without the potentialities of risks. But this testament must only be used to make all wary about the risks, not to make them at ease with the risks and losses.
With a proper understanding of the risk factors, the circumstance leading to the risks, the ways to assess the risk probabilities and the mitigation measures, the risks can be eliminated to a great extent and the financial institute can soar high to the skies of growth.
Like the information and insights? Interested to know more about how InteGREAT can solve customer problems in the financial lending ecosystem?
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