Taking risks is an essential element of banking business. Credit risk is, perhaps, one of the most significant components of risk faced by banks. Credit risk is the risk of loss to the banking resulting from borrower’s inability to meet payment obligations.
When credit quality of a borrower deteriorates, the loan becomes more and more risky. A borrower rated by bank as good may turn into bad over time due to several reasons. Before a healthy person becomes sick, we can see some symptoms of sickness with that person. Similarly, before quality of credit deteriorates, we may see some symptoms signifying borrower’s declining positions.
Banks design Early warning systems with an objective to provide warning, of possible and imminent problems in borrowers’ business, which may cause deterioration in credit quality. The need for early identification of problem loans is one of the principles of the Basle Committee for the management of credit risk.
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