Explain credit risk appetite. What are the factors to be considered while deciding credit on risk appetite?
Introduction
According to Joseph (2013), the credit risk appetite of the bank or any financial institution is dependent upon various factors like human, financial, and operational resources of an organisation. By defining credit risk, Joseph (2013) argued that credit risk appetite is the type, amount, nature, and extent of credit risk the banking institution will be willing to underwrite given the type of its resources. In preparing the credit risk appetite of the organisation there are various factors that need to consider, which include the target market, minimum credit standards, the sectors as well as the products offered by the specific client. These various factors will be explained below.
Target Market
In offering credit to the clients, the financial institutions will have to decide on their target market based on their financial and non-financial resources. Understanding the firms’ target market plays a greater role in the provision of credit. The importance of understanding the target market comes in the sense that, the management and employees of the financial institution will be able to ensure that strategies and financial products to be tailored to the specific target market. According to Joseph (2013), “the market criteria ensure that no opportunities are missed in the identified target markets and conversely they will screen out the market segments, where the organization has no risk appetite.”
Minimum Credit Standards
Joseph (2013) argued that the setting of credit risk appetite tends to set the prescribed minimum acceptable standards of credit risk that will be required when building the business. These minimum standards will be used to manage the level of credit risk, which the financial institution will be willing and able to handle and take.
Sectors
Joseph (2013) argued that credit risk appetite will result in conscious avoidance of certain sectors while the sectors with an acceptable risk profile may be preferred. At the same time, care must be taken to ensure that it does not result in concentration on a few attractive sectors, inviting sector concentration risk. He went on and said that the firm has to make a study of the various major sectors and identify the sectors the organization will be willing to go after. In short, the bank should prefer sectors with good potential and shun those sectors which tend to be more risker. The level and attractiveness of risk appetite will vary from one sector to another. Joseph (2013) highlighted how the risk appetite of the bank might look like, as follows:
- ‘No Appetite/Reduce’ – least attractive sector.
- ‘Grow’ – a sector with good potential.
- ‘Selective Growth’ – sectors that hold reasonable potential.
Products Offered
As stated above, setting the credit risk appetite of the bank will assist the financial institution in developing the type of credit products that the organisation has to develop based and in line with the risk appetite of the organisation. Setting the risk appetite will also be important in the pricing of these products.
Conclusion
It is important to take note that, the risk appetite of the organisation varies from one organisation to another, and there are various factors that determine how risk appetite will be designed and set in an organisation.