Risk Management - Essay Example

?Risk Management Introduction Risk management has become one of the vital elements of management as this concept greatly influences the long term sustainability of the firm. Risk management can be defined as the exploration, evaluation, and prioritization of risks and subsequent application of resources to mitigate, monitor, and control the probability of unforeseen events. The risk management practices also aim to maximize the realization of opportunities. The effectiveness in risk management practices determines the performance level of an organization. Similarly, persons at the helm of affairs of risk management team must be capable dealing with any contingency equanimously. This paper will describe a risk context that may be faced by the top level executive of a bank while marketing it financial services. Risk contexts A bank executive normally faces different types of risks once the bank deals with ranges of transactions and uses a large amount of leverage every day. When a bank’s financial position becomes weak, naturally its depositors may withdraw their savings. Under such a difficult situation, the bank cannot sell debt securities in financial markets; and this condition would worsen the bank’s financial state. For instance, the major cause of 2007-2009 credit crisis can be attributed to the fear of bank failure. According to Pyle (2007), although a bank executive may share many of the same risks of other organizations, the major risks that really trouble an executive are liquidity risk, credit default risks, interest rate risks, and trading risks. Risk Identification and Analysis 1. Liquidity risk In case of a bank, the term liquidity indicates its ability to pay bills and other payables, to repay money to a depositor, and to lend money to a borrower as part of bank’s credit policy. Hence, liquidity is the basic tool that is used to assess the financial viability of a bank. A bank executive faces great troubles while dealing with liquidity management because demands for funds are often unpredictable. Other off-balance sheet risks including loan commitments, letters of credit, and derivatives also constitute liquidity risks. A loan commitment indicates a line of credit that a bank issues on demand. Letters of credit are credit securities by which the bank guarantees that an importer will pay the exporter for imports or a commercial paper of bonds issuer will repay the principal. Finally, derivates are also an off balance sheet risk, which played a crucial role in the collapse of American International Group (AIG). 2. Credit Default Risks Credit default risk occurs when a borrower fails to repay the loan amount. In general practice, loans are written off after a period of 90 days of nonpayment. Law demands banks to maintain a loan loss reserves account to cover the losses arising from unpaid loans. A bank executive or manager has the responsibility to ensure that the borrower has submitted collateral securities that are adequate to cover his loan amount. In addition, the bank executive has the primary responsibility to recover the loan amount from the borrower. Therefore, bank executives would be liable to answer the board of directors when a loan goes unpaid. 3. Interest Rate Risks Banks usually pay lower interests on its liabilities such as deposits and borrowings and charge higher interests on their assets such as loans and securities. Hence, it is obvious that difference in these interest rates is the main source of profit for any bank. However, a bank’s terms of liabilities are usually different from its terms of assets. In other words, interest rate paid on liabilities is highly subjected to short term rate fluctuations while interest rate earned on assets is fixed. Sometimes, the interest rate variation may cause the bank to pay more for its liabilities and thus reducing the bank’s profit rates. Under such circumstances, a bank executive faces interest rate risk. Since the interest rate fluctuations are unpredictable, often a bank executive fails to defend such contingencies effectively. 4. Trading Risk Majority bank executives take greater risks to earn attractive profits. Since the law limits a bank’s leverage ratio, generally bank executives try to earn more profits by trading securities. 2007-2009 credit crisis showed that excessive risk taking practice can lead banks to failure. Mainly, trading risks include foreign exchange risk, sovereign risk, and operational risk. Foreign exchange risk represents currency loss in international trading as a result of global financial market fluctuations. Sovereign risk emerges when a government becomes ‘unwilling or unable to meet its loan obligations’ (Spiro, 2010). A bank executive cannot prevent operational risk in most times since it mainly arises when bank buildings, equipments, and other properties are partially or fully destroyed. Operational risks also emerge as a result of faulty business practices. Selection and Implementation of Treatments Although some of the risks described above are subjected to the happening or non-happening of certain specific future events, majority of them can be effectively prevented if bank executives select and implement potential working strategies. Efficient liquidity management may assist bank executives to manage issues associated with liquidity. This practice includes assent and liability management. By dealing with asset management practices, the bank may be able to keep both cash and liquid assets. It is also advisable for bank executives to work with liability management to increase liquidity by borrowing. According to Madura (2010), a bank executive may reduce the credit default risk to some extent by screening loan applicants, evaluating the value of collateral security, conducting credit risk analysis, and by diversification (p.521). In addition, a bank executive can avoid credit risk elements by lending to bank’s financially potential customers only. In order to overcome the interest rate crises, banks have to determine the degree of fluctuation that an interest rate change would make on their income. A bank executive can prevent interest rate change implications to some extent if he effectively applies gap analysis and duration analysis. Finally, majority of trading risks can be effectively checked by effective strategic tools. For instance, it is recommendable for a bank executive to practice currency hedging to avoid unforeseen currency losses. In the same way, risk factors which arise as a result of property destruction can be covered by insurance as well. Conclusion From the above discussion, it is clear that a bank executive faces an array of risk actors everyday. Usually, liquidity risks, credit default risks, interest rate risks, and trading risk are the main risk elements that challenge the long term sustainability of banks. These risk factors can be successfully prevented if bank executives formulate and practice thoughtful operational strategies. References Madura, J 2010, Financial Markets and Institutions, South-West Cengage Learning, USA. Pyle, DH 2007, Research program in finance working paper RPF-272, Bank Risk Management: Theory, UCBERKELEY Research program in finance working papers, viewed 14 Aug 2011 Spiro, N 2010, Nicholas Spiro- Reassessing sovereign debt, Property EU, viewed 14 Aug 2011 Read More