Risk Management in Financial Institutions - Research Paper Example

Risk Management in Financial s of the Table of Contents Introduction 3 2. Types of Financial Risks 3 3. Implementation Issues in Measurement of Risk 6 3.1. Volatility Estimation 6 3.2. Delta vs. Full Revaluation Calculation of Var 6 4. The Significance and Recent Changes in Risk Management 7 5. Steps to Risk Identification and Measurement 9 5.1. Risk Management Steps 10 6. General Approaches to Effective Risk Management 12 7. New Regulations Formulated for Risk Management and Its Success 14 8. Conclusion 15 References 17 Appendices 19 1. Introduction Managing risk is a component of an organizations strategic and operational actions and evaluating financial risks is a vital part of a manager’s task. Risk management can be defined as the process of examining risks and developing strategies to minimize their harmful impact. On the other hand, financial risk can be defined as the task of screening financial risks and controlling their impact on business (Borio, 2014). Financial risk management comes within various financial functions of an organization and is an indication of changing nature of this function with time. Traditionally, the financial function was seen in respect to financial reporting and control. The modern theory of risk management reflects on the financial function in respect of financial policy and financial decision making. This comprises an organizations operational, business and economic risks. There are various risks that are unacceptable which includes insurance risks, capital market risks, a market for replacing and equalizing such risks has been developed (Adams, Füss & Gropp, 2014). The paper identifies the issues in the risk management and its significant impact to the financial decisions of the manager of an organization. The paper also identifies the relevance and approaches to the risk management practices. Additionally, the impact of the new risk management regulations is critically evaluated. 2. Types of Financial Risks There are mainly two types of risk in finance namely, systematic and unsystematic risks. Systematic risks are the one which are uncontrollable by the organization and unsystematic risks are the ones which are controllable by the organization. Interest risks, market risk and inflationary risks come under systematic risks and liquidity risks, credit risks and operational risks fall under unsystematic risks (Edgar financial market analysis, 2015). Various risks faced by managers of the organizations are descried under in details. Figure 1: Types of Financial Risks (Sourse: Investing bonds and markets in depth, 2015) Market Risk- This type of risk deals with unfavorable price or instability that affects the assets contained in an organizations portfolio (Edgar financial market analysis, 2015). It can be explained as the doubt of a financial institution’s earnings which arises from changes in the market conditions like the price of an asset, interest rates and market liquidity. Credit risk- This kind of risk takes place when one falls short to realize their commitments towards their counter parties. Sovereign risk and settlement risks are types of credit risk (Federal Reserve financial market analysis, 2014). Sovereign risk takes place due to difficult foreign exchange policies. On the other hand, settlement risks takes place when a party makes the whole payment if another party fails to meet the obligations. Operational risk- This type of risk takes place due the operational failures of an organization such as mismanagement or technical failures. Scam risk and model threat are two types of operational risk. Scam risk takes place due to lack of control and model risk arises due to inefficient model application in an organization (Edgar financial market analysis, 2015). Interest rate risk- This type of risks arises out when the fluctuations in the interest rates results to financial losses to asset or liability management (Federal Reserve financial market analysis, 2014). It is calculated by past and present instability and the profile of the assets or liabilities of a financial institution. Liquidity risk- This type of risk takes place due to a financial institutions ability to carry out transactions. Asset liquidity and financial support liquidity risks are two types of liquidity risk. Asset liquidity risk either results out of the deficient buyers or sellers against sell orders or buying orders correspondingly. Legal risk- This type of financial risk takes place due to legal restrictions such as lawful proceedings. Whenever a financial institution faces financial losses out of the legal proceedings, it can be called a legal risk (Investing bonds and markets in depth, 2015). Foreign exchange risk- This risk arises from the fluctuations in the foreign exchange rate that cause the foreign exchange dominated assets to drop in value or the foreign exchange conquered liabilities to increase in value. Capital risk- This type of risk takes place if a financial institution has inadequate capital for addressing losses that can lead to bankruptcy or regulatory closure (Standard and poors, 2015). It has a sub optimal equity-debt funds profile which pessimistically affects the market price of its stock. 3. Implementation Issues in Measurement of Risk 3.1. Volatility Estimation The volatilities of market risk play a vital role in market and credit risk measurement. The volatility or standard deviation of the prices in a financial market provides the center for determining the exact amount of price change for incorporating into VaR measurement, particularly in those calculations that depend on distributional assumptions namely the normal distribution (Bloomberg, 2012). Despite of the vital role of this parameter, the methodologies of risk management rarely consider the complexities of volatility estimation. While it is quite general for the risk managers to compute a systematic set of volatilities from a particular sample of historical data on financial market prices, updated at some defined regular interval. Such a method generally ignores the economic causes that state the appropriate data management choices for distinct contracts and market conditions. 3.2. Delta vs. Full Revaluation Calculation of Var The traditional and computationally proficient VaR calculation for a particular derivative contract is the product of three components namely, its current value, its delta or sensitivity to an undesirable marginal fluctuation in the market risk factors on which it depends and the total change in risk factor that can take place at the stated confidence level (Cornett, McNutt, Strahan & Tehranian, 2011). While this calculation is widely used to assess the risk of swap contracts and other two sided derivatives and has advantages of effortlessness implementation, it can be ambiguous in some circumstances. The estimated change of the risk factor is huge and the convexity or gamma effect results the original data to understate the VaR. The outstanding issues need to be addressed for the methodology to be efficient and estimate the future correlation structure among risk factors accurately. 4. The Significance and Recent Changes in Risk Management Increased regulatory requirements and analysis over the risk management and governance has led the financial institutions to amplify their risk management budgets, according to a current global survey conducted by Deloitte Touche Tohmatsu Limited. By conducting further survey on global risk management practices, it was found that about two- thirds (65%) of the global financial institutions reported their increased expenditure on risk management and compliance, which was 55% in 2010 for addressing risk concerns (Aebi, Sabato & Schmid, 2012). Financial downturn has led to the far-reaching transformation in financial institutions risk management practices, with stricter regulatory necessities demanding increased attention from management. Approaches to risk management practices have risen significantly but according to a survey, operational risk (a vital component of BASEL II bank capital requirements) has been an enduring challenge for the financial institutions. Along with Deloitte services and major banking associations, only 46% of the worldwide institutions rate themselves as exceptionally efficient in operational risk management (Billio, Getmansky, Lo & Pelizzon, 2012). Figure 2: Operational risk management methodologies used by global financial institutions (Source: Arena, Arnaboldi & Azzone, 2010) Evaluating the recent trends in risk management, it is observed that there lies a divergence when it comes to the spending patterns of different sized financial institutions. The largest and important financial institutions have had many years of regulatory scrutiny and prolong their focus on various areas such as risk governance, risk exposure, capital sufficiency and liquidity. Financial institutions with assets of less than $10 billion are now focusing on developing capabilities to deal with a number of new regulatory requirements, which were initially applied by the large institutions and now are tumbling down the ladder (Arena, Arnaboldi & Azzone, 2010). The figure below depicts the percentage of respondent organization that identifies each item as extremely challenging. These percentages were calculated based on the organizations that provide investment management services. It also represents how challenging various risk management functions is within various organizations globally. Figure 3: Global risk management survey (Source: Nijskens & Wagner, 2011) 5. Steps to Risk Identification and Measurement Financial risk identification follows a logical process which involves three steps: an awareness of the risks that a financial institution is exposed to, measurement of the risks to determine their impact and risk adjustment through development of policies or a set of actions to direct and diminish the risks (Nijskens & Wagner, 2011). Risk awareness- Being aware of the risks is a continuous process that requires to be repeated at regular intervals in order to capture changed conditions. This is because various diverse financial markets have different degrees of efficiency, market transparency and development. Risk measurement- Risk measurement fixes up what is difficult to gauge into quantifiable risks. The major task is to model risk in order to calculate its impact. Once the degree of the exposure has been dogged, decisions regarding the desirable course of action can be made (Akhtar, M. F. & Sadaqat, 2011). Risk adjustment- It involves transforming the nature of risk from an undesirable level to suitable level. Two different approaches exist which includes elements of risk pooling and transfer. The first one includes insurance where risk is transmitted to another party who are better able to take on the risk. Another approach is hedging which involves offsetting one risk with an opposite position in the identical risks. 5.1. Risk Management Steps The risk management literature widely implements a stage model which is depicted in the figure below. These steps along with required analysis, policy formulation and operational measures can help to efficiently manage and control the ongoing risks of a financial institution (Demyanyk & Hasan, 2010). Figure 4: Risk management steps (Source: Edgar financial market analysis, 2015) Identification of the source of risk exposure- It involves identification of profile of business risks and classification of exposures by materially ranking them. Formulation of risk management planning- It involves integration of strategic objectives and establishment of responsibilities. Policy implementation- It involves exposure management methods, transaction execution and reporting (Martínez-Jaramillo, Pérez, Embriz & Dey, 2010). Control and evaluation- It involves reporting of exposures and evaluation of performance audit. Ongoing review- It involves re-evaluation in light of performance, changing environment and changing business. 6. General Approaches to Effective Risk Management Top down approach and bottom-down approach are the two renowned risk management approaches that are employed by the financial institutions to measure operational risk. Top down approach is an investment strategy that selects a range of sectors or industries and attempts to achieve an equilibrium in an investment portfolio (Martínez-Jaramillo, Pérez, Embriz & Dey, 2010). This approach analyses the risk by cumulating the impact of internal operational failures. It appraises the variances in the economic variables that are not enlightened by external macro-economic factors. As such, this approach is straightforward and not data intensive. The top-down approach relies largely on historical data and is opposite to the bottom-down approach. Figure 5: Top-down and bottom-down approach (Source: Edgar financial market analysis, 2015) On the other hand, a bottom-down approach is an investment strategy that relies on the assortment of individual stocks. This approach observes the management and performance of financial institutions and is not general economic trends. This approach evaluates individual risk in the process by employing mathematical models and is therefore data intensive (Edgar financial market analysis, 2015). This approach also does not depend on the historical data. It is a highly developed approach unlike the top-down model, which is backward looking. Equity value is an additional approach of financial risk management. In a financial market it is analyzed that the liquid capital markets are information proficient, that is the prices of the financial instruments reflects the facts about the issuer. The market price of a security is an indication of the consensus inspection on the value of the asset. As any new information arrives, market participants modify their assessment based on the new information and initiate actions accordingly (Bloomberg, 2012). This will result to the movement of prices that are to reflect the impact on the new information on the financial institution or the scrutiny’s cash flows. This fact can be used to measure the consequence of changes to the equity values from institutions risk factors employing standard statistical methodologies. The more the price fluctuation for a given trend in the risk factor, the greater will be the markets estimate of the financial institutions exposure to the specific risk. Such estimates are historical in nature because they determine the impact after the fact. 7. New Regulations Formulated for Risk Management and Its Success Contingency funding plan- It is an efficient technique to manage liquidity risk in the financial institutions. This planning is done as a directive for future emergency and stands prepared to be referenced on a future date as a response plan and possible forecast of how a distant liquidity event may unfurl (Bloomberg, 2012). This planning sets out a financial institution’s strategies in order to deal with liquidity shortfalls in emergency situations. This approach is widely accepted as a modern approach to risk management and its relevance will increase in future because of its ability to prevent extreme events to take place by ensuring moderate liquidity. Derivatives- These are another modern approach to financial risk management. A derivative approach is increasing in importance due to the recent trends in financial crisis. These are specific types of instruments that originate their value over time from the performance of underlying assets namely, equities, bonds and commodities (Investing bonds and markets in depth, 2015). In an interest rate swap, when the interest rates increase, the discount rate used in calculating the net present value of liabilities increases so that the NPV of those liabilities is limited and the funds funding ratio is enhanced. Derivatives can be used in risk reduction and effective portfolio management. The main starting point is to establish an efficient overlay strategy defining the associated costs. Interest rate swap and inflation rate swap is proving to be an efficient approach in managing and controlling financial risks and therefore are increasingly used now-a-days by many large financial institutions (Investing bonds and markets in depth, 2015). 8. Conclusion The paper focused on the assessment of various kinds of financial risks but the recent trends in the financial markets are liable to change the perceptions regarding important risks. In the recent years, operational, business and systematic risks are gaining increased importance among the shareholders of large financial institutions that exist today and their risk management functions, whose primary objective is to allocate internal resources proficiently. Much of the literature stresses on just one of the sources of model risk in the risk capital models such as the errors resulting from improper risk factors assumptions. There are many other sources of model risk including other financial risks in the risk capital models that need to be examined for gaining more detailed view on risk assessment. For the purpose of risk management, all the approaches are subjective and the analysis needs to be more elaborate. From the evaluation of various aspects of risk management it can be concluded that it is essential that all the financial institutions define in a clarified and ambiguous manner limits to the financial risks that can be accepted. These should then be converted to limits applicable to the individuals accountable for controlling specific risks. Moreover, the calculation of risk measures such as VaR always needs to be considered by the financial institutions so that they can obtain an understanding of the things that can go wrong and gain efficiency in risk management. References Adams, Z., Füss, R. & Gropp, R. (2014). Spillover effects among financial institutions: A state-dependent sensitivity value-at-risk approach. Journal of Financial and Quantitative Analysis, 49(03), 575-598. Aebi, V., Sabato, G. & Schmid, M. (2012). Risk management, corporate governance, and bank performance in the financial crisis. Journal of Banking & Finance, 36(12), 3213-3226. Akhtar, M. F., Ali, K. & Sadaqat, S. (2011). Liquidity risk management: a comparative study between conventional and Islamic banks of Pakistan. Interdisciplinary Journal of Research in Business, 1(1), 35-44. Arena, M., Arnaboldi, M. & Azzone, G. (2010). The organizational dynamics of enterprise risk management. Accounting, Organizations and Society, 35(7), 659-675. Billio, M., Getmansky, M., Lo, A. W. & Pelizzon, L. (2012). Econometric measures of connectedness and systemic risk in the finance and insurance sectors. Journal of Financial Economics, 104(3), 535-559. Bloomberg. (2012). Interest rate fluctuation and inflation. Retrieved from http://www.bloomberg.com/markets/rates-bonds/government-bonds/us. Borio, C. (2014). The financial cycle and macroeconomics: What have we learnt?. Journal of Banking & Finance, 45(5), 182-198. Cornett, M. M., McNutt, J. J., Strahan, P. E. & Tehranian, H. (2011). Liquidity risk management and credit supply in the financial crisis. Journal of Financial Economics, 101(2), 297-312. Demyanyk, Y. & Hasan, I. (2010). Financial crises and bank failures: a review of prediction methods. Omega, 38(5), 315-324. Edgar financial market analysis. (2015). Challenges to financial market and management techniques. Retrieved from http://www.sec.gov/cgi-bin/srch-edgar. Federal Reserve financial market analysis. (2014). Banking information and regulation. Retrieved from http://www.federalreserve.gov/releases/h15/update/. Investing bonds and markets in depth. (2015). The securities industry and financial market. Retrieved from http://www.investinginbonds.com/. Martínez-Jaramillo, S., Pérez, O. P., Embriz, F. A. & Dey, F. L. G. (2010). Systemic risk, financial contagion and financial fragility. Journal of Economic Dynamics and Control, 34(11), 2358-2374. Nijskens, R. & Wagner, W. (2011). Credit risk transfer activities and systemic risk: How banks became less risky individually but posed greater risks to the financial system at the same time. Journal of Banking & Finance, 35(6), 1391-1398. Standard and poors. (2015). Credit rating history and ratings definition. Retrieved from http://www.standardandpoors.com/en_US/web/guest/home. Appendices Appendix 1: Global financial crisis Read More