Management Notes

Reference Notes for Management

Default Risk – Risks in Commercial Banks | Financial Management

Default Risk

Default risk refers to the risk that the deficit spending units (DSUs) will be unable to meet the obligations they have agreed to under the liability they have sold. In other words, it deals with security issuers or the borrower’s failure to fulfill its obligations. As a result, it is closely related to the financial condition of the firm. An investor who invests in a company that defaults may lose all or part of their original investment. If the DSU defaults, the intermediary, whether it is a bank, a mutual fund, an insurance company, is exposed to the risk of default.

Commercial banks‘ primary function is to assess and evaluate the credit risk associated with the purchase of financial claims of DSUs such as firms, individuals, and government entities both domestic and foreign. Banks do this by employing risk assessment experts who are generally better at assessing default risks than individual consumers are. It is not necessary to refuse loans to all borrowers who may default or to avoid investments that could turn sour to manage credit risk. Financial services companies, like other industries, have to take some risks in order to maintain and enhance profitability.

However, the future is uncertain. Unexpected events can turn an otherwise profitable endeavor into a loss and possibly even bankrupt. Thus, a “good” credit risk could be turned into a “bad” investment. No matter how meticulously a borrower plans and how successful their track record may seem, some will still default. On the other hand, some struggling businesses will turn the corner and become quite profitable. Given these facts, financial managers need to lend and invest wisely. Basically, this means providing commercial banks with all relevant information about potential borrowers so that excessive risk is not posed to these institutions.

Balance sheets, income statements, credit checks, how money will be used, and so on should be provided. Recognize that the terns are prudent and excessive and somewhat nebulous. A commercial bank’s management team must establish guidelines that quantify the terms. Management is about setting guidelines. Losses are inevitable. Managing losses through profits from other loans or investments is the trick.

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