Pin down Regarding the Risks Associated with the Day to Day Operations of the Bank - Essay Example

Running Heads: Risks by Banks Risks by Banks [Institute’s Executive Summary Financial s are the back bones for any economy. The essence of financial institutions is very important for the long term growth of an economy. The main function of the bank is to stabilize the money circulation within the country. Apart from this function, the banks also lend money and earn interest on it which is the main source of earnings for them. The main prospective of this study is to pen down regarding the risks associated with the day to day operations of the bank. There are a number of risks associated with the day to day operation of the bank and the bank regularly tries to minimize it. The researcher will talk about 4 types of risks in this assignment and the strategies they used to overcome these risks from their day to day business. The researcher has a planned approach to complete this piece of work as first a short and snappy description is included regarding the term ‘risk’ and its management and then shift his gears towards defining the 4 types of risks involved along with the strategies used by the banks professionals to overwhelm the hazards of the risk. The idea behind describing each and every thing is that, the researcher wants to educate its every reader equally. Definition of Risk Risk is the name of uncertainty. Actually, one has no single definition lies on this earth. Risk can be defined as a probability or chance of occurrence or non occurrence of a thing. The fields of investment, research and analysis are totally based on the concept of risk and probability or risk. Banks are also lies on the concept of risk. This particular field is now very common and extensively used in banks and investment companies. From the last decade, risk management is the most researched and exciting area in the financial industry as it elaborates how to minimize and avert the hazard of risk from the portfolios of different assets and from the operations of a financial institutions. Regulators and depositors are mainly emphasize on the risk management, as per them risk management is an essential ingredient to enhance the value of shareholders and increase their level of confidence (Christoffersen, pp. 48, 2003). Risk management is the assessment of risks to mitigate, monitor and control the probability or impact on uncertain events. Risk management methods and nature varies from industry to industry like it cannot be same for project management, industrial process and financial portfolios. Risk management is an important tool, which is used in decision making because it is systematic and well structured. For better utilization of risk management in management’s decisions, risk analyst’s reports must be based on the latest and best available information. The 4 types of risks which we have selected on which this entire assignment has based on are market risk, exchange rate risk, credit risk and operational risk. Under each subsequent heading, the researcher will define about the particular risk along with the strategies to overcome it and why it is necessary to overcome on these risks for the performance of banks. Market Risk The risk which arises from the fluctuation of securities prices in which the banks invested their money is called market risk. Usually treasury and corporate finance department of a bank encounters with that type of risk frequently (Jorian, pp. 24, 2008). According to financial gurus, market risk arise from the fluctuation of the security prices and these security prices including the treasury bills (T-Bills) are subjected to the fluctuation in monetary policy of the country. Treasury experts and bankers usually makes portfolio to diversify risk by allocating their investment in different securities. A large part of bank’s earning is based on the fluctuation of the security’s market price so this particular risk leaves a real influence on the performance of the bank. Exchange Rate Risk The risk which arises from the fluctuation of the currency rates prevailing in the country is called exchange rate risk (Cinnamon, pp.56, 2006). Banks that open LCs and involves in the export and import stance are very cautious about this particular risk because any increase or decrease in the exchange rates will resultantly increase or decrease the payment and earnings. Let’s say, Company A from India do export in Saudi Arabia. Indian company decides to pay US$ 1000,000 on the current exchange rate. Suppose, after the payment adjustment the exchange rates in India increased but Saudi’a bank gets the same payment and incurred a sort of loss from the increase fluctuation of the exchange rate of Indian rupees again US dollars. Banks can save them from risk by entering in to the derivative contracts. Credit Risk Credit risk is the risk of losses due to the fact that the counterparties may be not intended or probably unable to fulfill its financial promise or contractual obligation (Shirref, pp.102, 2004). For instance, Jorion (pp. 248, 2009) uses the example of “a trader who purchases 1 million worth of British pound (BP) spot from Bank A. The current rate is $1.5/BP, for settlement in two business days. Therefore our bank will have to deliver $1.5 million in three days in exchange for receiving BP 1 million. Suppose that on the next day, Bank B goes bankrupt. The trader must now enter a new; replacement trade with Bank C and now the bank sell its remaining BP. If the spot rate has dropped further from $1.4/BP to $1.35/BP, the gain of $50,000 on the spot sale with Bank B is now at risk. The loss is the change in the market value of the investment, if positive.” Thus, there is interaction between market and credit risk. Experts have clarified that Herstatt risk is another term in use for the term ‘credit’ due to the incident of defaulting of a German bank in the year 1974 that resulted in the weakening of the monetary systems (Jorion, pp. 525-555, 2009). Derivatives contracts are the only solution to minimize credit risk. Credit risk can dwindles the position brutally in either side so banks have to be very cautious while manage this particular risk because it can harm its financial position. OPERATIONAL RISK: The risk of loss which may be faced by the financial industry by the failure of insufficient internal process, system and people, or from external events is known as Operational Risk (Reuvid, pp. 78, 2008). Again consider the same example in order to assess how operation risk occurs. Suppose that “our bank wired the $1.5 million to a wrong bank, Bank D. After two days, the management realizes the mistake of the operation and fortunately our back office gets the money back, which is then wired to Bank A plus compensatory interest. The loss is the interest on the amount due” (Jorion, pp. 562-580, 2009). This particular risk may or may not occur regularly subjected to the staff and the supervisors are clever enough to get the idea that some transaction wrongly taken place. The banks have to be stringent if they wish to stop such mistakes because these things may harm the credibility of the banks pathetically. Conclusion Risk is always dangerous. In this assignment, we have seen different types of risk associated with the day to day operations of banks. The banks can reduce these risks with the strategies which we have incorporated in this assignment but can not eliminate completely. References Christoffersen, P. 2003. Elements of Financial Risk Management. Academic Press USA. Cinnamon, R & Larsen, B. H. 2006. How to understand Business Finance. British Library Publications. Jorion, Philippe. 2008. “Value at Risk”, 3rd Edition, McGraw Hill Publications. Reuvid, J. 2008. Managing Business Risk. Korgan Page Limited, USA. Shirref, D, 2004. Dealing with Financial Risk. Profile Books Limited. Vernimmen, P. 2000. Corporate Finance Theory and Practice. British Library Publications. Read More