Credit risk is the risk to earnings or capital of an obligor’s failure to meet the terms of any contract with the bank or otherwise fail to perform as agreed. Credit risk is found in all activities where success depends on counterparty, issuer, or borrower performance. It arises any time bank funds are extended, committed, invested or otherwise exposed through actual or implied contractual agreements, whether reflected on or off the balance sheet.
Credit risk poses the most significant risk to banks involved in credit card lending. Since credit card debt is an unsecured line of credit, repayment depends primarily upon a borrower’s capacity to repay. The highly competitive environment for credit card lending has provided consumers with ample opportunity to hold several credit cards from different issuers and to pay only minimum monthly payments on outstanding balances. As a result, borrowers may become overextended and unable to repay, particularly in times of an economic downturn or a personal catastrophic event.
The majority of credit card programs are priced at a variable rate, which causes minimum payment requirements to fluctuate as rates change. Any significant increase in interest rates may expose the bank to additional credit risk as a marginal customer struggles to make an increased payment.
In addition to credit risk posed by individual borrowers, credit risk also exists in the overall credit card portfolio. Relaxed underwriting standards, aggressive solicitation programs, inadequate account management, as well as a deterioration of general economic conditions, can increase credit risk. Changes in product mix, and the degree to which the portfolio has concentrations, geographic or otherwise, can impact a portfolio’s risk profile.
Banks control credit risk through coordinated strategic and marketing plans. They also have comprehensive policies and procedures that include strong front-end controls over underwriting standards, well-defined account management processes, strong back-end controls for effective collection programs, and good management information systems.
Examiners assess credit risk by evaluating portfolio performance, profitability, and customer profiles by business lines, products, and markets. They also consider changes in underwriting standards, account acquisition channels, credit scoring systems, and marketing plans.