Management Risks in Financial Institutions - Essay Example

Basically, risk and return are related in the same direction. A minor example of this would be a bank charging different interest rates on different individuals who have opted for the same loan. The individual who has a relatively poor credit history is likely to receive a higher interest rate as there are chances of him/her not paying the loan bank. Therefore, there is a higher risk and the bank gets a higher return through the higher interest rate charged. However, risk needs to be managed and there can be several huge losses if the financial institution is not ready to deal with it.

Risk management is a type of strategy which every financial institution needs to have at its core and there are several parts involved in this including monitoring the risks, measuring these risks and controlling risks. It is the analysis of risk mixed with the element of quality risk controls. Risk management is required by banks and financial institutions as a safety measure to protect the institution from any major financial problems. The uncertainty and the potential inherent risks that come with the financial markets makes it important for most of the financial institutions and banks to use risk management.

The risk management controls are one of the major determinants of the financial stability of a bank. The most common types of risks faced by most financial institutions There are several types of risks involved with financial institutions and these risks are as follows: Systematic risk. This is also known as diversifiable risk. Basically this particular type of risk means the risk of the change of asset value associated with systematic factors. Therefore, the risk cannot be fully diversified.

There are several subcategories under systematic risks and there are various ways in which the value of an asset can be affected. The determinant of the change in the value of the assets owned by the institution and it depends upon natural and economic factors including interest rates affecting the value of the assets, an increase in inflation might cause an increase in fuel prices which might affect transportation and stock value and changes in economic conditions which may cause several changes in the value of assets.

Interest rate risk is one of the major parts of systematic risk and the institutions needs to measure the variation and the responsiveness of the rate sensitive assets towards the changes in interest rates. Commodity price risk and foreign exchange risk are other risks which come under systematic risks that many investors try to measure and try to minimize these. Credit risk. This is the risk which is related to the payment by the debtors. Credit risk is the risk which all the banks face and they need to manage this in order to be proactive against any future losses.

Basically the bank is the lender and is the creditor for the borrower and the risk is that the borrower might go bankrupt and might not be able to pay the bank back. This seems as a pretty low type of risk if a sole individual is involved, however, credit risk also involves borrowings worth millions of dollars by huge businesses. Even if the business is popular and has a good credit history, it can go bankrupt which might result in a loss of millions of dollars to the bank. In other words, it means that the company or the individual defaults which is why this risk is also known as default risk.

Counterparty risk. This arises from the