The Historic Role of Credit Risk

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To understand the role of credit risk in modern times, we need to take a look at its origins. Credit risk can be traced to have come into being based on the Hammurabi’s Code, about 4000 years ago, in Mesopotamia. At that time, there were no defined rules about borrowing; however, failure to pay back a debt as a best practice was considered a serious crime and a fraud.

Back in time, defaulters were faced with penalties and were ceased by the creditors and sold into slavery. If defaulters died without paying back, the children and wife were ceased to serve as slaves for the creditors. At various stages in human history, credit defaulters or their descendants and wives have been punished with mutilation, torture and even death. The main reason for going to these lengths was that people lent money and expected a pay back with an interest. When they were caught by the government through best practices, both the creditor and the lender had penalties to face for going against the teachings of the church. Although this form of usury goes against the Biblical teachings, people had to get into debt and creditors wanted to borrow to make some extra money.

The same is the case today. Now most times, business owners borrow money from banks and other financial institutions to establish their business as a best practice. Credit risk is a financial phenomenon which came into existence long before financing of business ventures became a best practice. However, today the good thing is that the debtor and credit face less harmful consequences. There is no mutilation, torture or death sentence. Business people borrow money and invest it into production or services for best practices. The consumer only pays for these products and service upon receipt to ensure best practices. This means the debtor (business person) cannot pay up his or her debts unless and until the consumer pays.

Credit risk has become an important consequence of a vibrant economy with best practices at a global scale. It is important to understand that credit risk and payment delays cannot be avoided completely, at least not without making a negative impact on the economy. Businesses involved in complex production processes have to wait for payments until their goods or services are successfully delivered to the consumer. This is an important best practice in business. Now when there is failure in the pay back process, banks and intermediaries like mints can transfer the payment delays. Furthermore, these intermediaries can work on reducing the delays through fractional reserves and diversification of the amount of risk attached.

There was a period when there was limited information about credit rating and risk and how it can be managed. With time, through best practices credit rating companies began to establish their presence and there was more exposure to debtors. There was improvement in management of creditors and financial risk management became more effective with best practices.

Therefore, credit risk is an important feature of a vibrant economy.

Further reading: Corporate Governance | Audit | Performance Improvement

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