In this course, credit risk is defined as the risk a bank won’t receive money lent and interest earned on its loans. Repayment of funds and accompanying interest must occur if a bank is to succeed. If the loan principal is not returned, the bank will quickly fail. If the bank does not receive interest earned, its failure will be slower, but just as sure. As a seasoned bank examiner put it, “The process takes longer, but the end is no less certain.”

As noted in the bank performance section, “The Financial Report,” banks are in the risk management business – they assess, assume and manage risk. Those that do it well succeed and prosper. Those that do not manage risk perform poorly and in some instances, fail.

The primary source of credit risk to a bank is its interest earning assets. Earning assets typically make up more than 90 percent of a bank’s total assets (See the chart labeled Asset Composition of U.S. Banks, below). Of these assets, it is the bank’s loans and their associated credit risk that receive the most attention. The reason for this is quite simple. A bank’s loans constitute about 60 percent of its assets and interest income from those loans provides around 70 percent or more of the bank’s total income (See the chart labeled Bank Revenues by Source, below). As a result, even small lending mistakes can have severe consequences for earnings and capital.

Have you ever considered the consequences of lending mistakes in your bank? To gain insight into the importance of lending authority granted to each level of the lending function, review the “Try This At Your Bank” exercise, The Cost of Mistakes in Lending.