Risk Management Plan Outline for Loan Default Risk Faced by Lenders

Identification

The first step in any risk management plan is to identify the risks that need to be managed. In the case of loan default risk, lenders need to identify the factors that could lead to a borrower defaulting on a loan. These factors can be categorized into two main groups:

• Borrower-related factors: These factors include the borrower’s credit history, income, debt-to-income ratio, and employment history.
• Loan-related factors: These factors include the loan amount, interest rate, term, and purpose of the loan.

Understanding

Once the risks have been identified, lenders need to understand the nature of the risks and how they interact with each other. This can be done by analyzing historical data on loan defaults. For example, lenders can look at the default rates for different borrower characteristics, such as credit score or debt-to-income ratio. Lenders can also look at the default rates for different loan types, such as mortgages or credit cards.

Data Preparation

Once lenders have a good understanding of the risks, they need to prepare the data that will be used to model and manage the risks. This data can come from a variety of sources, such as the lender’s own credit database, credit bureaus, and public records. The data needs to be cleaned and normalized so that it can be used by the risk models.

Modeling

The next step is to develop risk models that can predict the probability of a borrower defaulting on a loan. These models can be developed using a variety of statistical techniques, such as logistic regression and machine learning. The models should be trained on historical data on loan defaults. Once the models have been trained, they can be used to score new loan applications and to identify borrowers who are at a high risk of defaulting.

Application

Once the risk models have been developed, they need to be implemented and applied to the lender’s lending process. This may involve developing a new credit scoring system or integrating the risk models into the lender’s existing credit scoring system. The lender also needs to develop policies and procedures for how to use the risk models to make lending decisions.

Monitoring and Review

The final step in the risk management process is to monitor and review the risk models and the lender’s lending process. This is important to ensure that the risk models are still accurate and that the lender is effectively managing the risk of loan defaults.

Sources

• Basel Committee on Banking Supervision. (2011). Principles for the management of credit risk.
• Board of Governors of the Federal Reserve System. (2013). Supervisory guidance on credit risk management.
• Office of the Comptroller of the Currency. (2011). Risk management guidance for banks.
• Federal Deposit Insurance Corporation. (2013). Guidelines for managing credit risk.

Additional Considerations

In addition to the five steps outlined above, lenders should also consider the following when developing and implementing a risk management plan for loan default risk:

• Risk appetite: Lenders need to define their risk appetite, which is the amount of risk that they are willing to take on. This will determine how the lender uses the risk models to make lending decisions.
• Portfolio management: Lenders need to manage their loan portfolios to reduce their overall risk of loan defaults. This may involve diversifying their portfolios by lending to different types of borrowers and for different purposes.
• Stress testing: Lenders need to stress test their risk models and lending processes to see how they would perform under different economic conditions. This will help lenders to identify potential weaknesses in their risk management systems.