Default Risk Management - Research Paper Example

Introduction Managing risk for any business is important. Banking industry has been under the focus of many economists, analysts, and investors, particularly after the financial crisis of 2007. It is because of the risks that have not been identified by the financial institutions and analysts, the world economy is suffering from the crisis and the impact of this crisis has increased in different countries of the world (McLaney, 2009). Only if the financial institutions and analysts identified the market trends and analysed how the market would perform then they would be able to predict such a crisis, and, therefore, steps would be taken accordingly. However, this has not been the case and today the financial institutions are trying their best to minimise the impact that has been caused by the crisis, and they are evaluating and trying out different strategies to improve their financial position so that they can meet their financial obligations. Identification of risk is one of the major steps that businesses need to focus on. If the risks are not identified, then they cannot be mitigated or their impact cannot be minimised, and this is the reason why the businesses need to analyse different trends in the market and then take actions accordingly. Risk is defined as uncertainty, and it is important for management to analyse and identify trends in the market to identify such uncertain situations. Risks – Definition and Types Businesses are able to reduce different threats that they face from external environment by identifying the risks they face and then taking steps to mitigate them. Financial institutions face four major types of risk and these risks are: Market Risk Liquidity Risk Credit Risk or Default Risk Operational Risk One of the major risks faced by financial institutions is the default risk. Default risk is the risk that the firm faces when it is not able to meet the financial obligations when they are due. Default risk is also named as credit risk as the firm does not have the ability to pay off its creditors. However in case of a financial institution like banks, the scenario may be complex, as these banks give loans to different creditors which, in turn, can face default, and this could affect the liquidity position of the banks as they do not have funds according to what they expected and thus can increase the default risk of banks. Market risk is the other type of risk faced by the firm, and it is because of fluctuations and conditions in the market. Market risk could be because of fluctuations in currencies, exchange rates, interest rates, volatility in other markets, etc. that could influence the future cash flows of the firm (Khan, 1993). It is important for the financial institutions to analyse different market trends and the risks that could arise because of changes in the market and then take actions or steps to minimise the impact of these types of risks accordingly. There are some risks, such as chances in the exchange rate, that cannot be eliminated; however, if the management of the bank is able to predict such trends in advance, then they can minimise the threats from such fluctuations. Operational risk refers to the risk faced by the firm because of operations of the financial institutions. It is important for firms to have strong internal audit and processes to evaluate the operations of the business so that operational risks can be mitigated (McNeil, Frey, & Embrechts, 2005). Liquidity risk is the risk that a bank or any other firm faces because of having insufficient capital to meet the needs of day to day operations. Businesses need to keep a sufficient amount of funds for their daily expenditure so that they are able to minimise liquidity risk. The Complexity of Default Risk in Banks Default risk refers to the risk that one faces when it is unable to pay its obligations. Banks also need to pay to different investors, creditors, and other vendors; however, banks do give loans and credits to different people and these creditors can get default and might be unable to pay off their liabilities, which could hurt the banks. If creditors are not able to pay their financial obligations to banks, then it can result in hurting the expected cash flows and, therefore, can influence their liquidity and funds on hand and thus create default risk or creditor risk. Banks also need to pay to depositors and meet their other obligations; therefore, they too require sufficient funds, and if creditors are unable to pay off their liabilities then it can hurt them, and this circle can hurt the whole economic condition (Djiné, 2011). Why Default Risk Is Important and Why Banks Need to Manage this Risk Default risk can be critical for the firms and, therefore, financial institutions like banks need to manage such risks. Banks give loan to different creditors, and if these loans are not paid by creditors, then it could result in default risk. Default risk in banks will emerge, as the creditors that are supposed to pay their obligations might not be able to pay to the bank, and, therefore, the expected cash flows of the bank will reduce and thus it will increase the chances of the bank to be default and to fail meeting its financial obligations. A bank that is not able to meet its financial obligations will suffer from the default risks, and, therefore, it is critical for banks to identify different expenses and financial obligations that they have to meet and then keep sufficient funds on hand rather than expecting every creditor to pay their financial obligations in time. Identification of required funds could be helpful for the firms as this allows them to know what kind of funds are required, and they are able to arrange these funds in advance. It is critical for banks to manage the risks they face, particularly the default risk. As mentioned in the previous section, the default risk is when banks are not able to meet their obligations, and, therefore, if the banks are not able to meet their financial obligations, then they are not able to meet their obligations at all and will not be able to operate their day to day routine processes in the same manner, and thus could influence their growth and it might even influence their ability to survive. How do banks manage this risk? There are different techniques and methods that different financial institutions including banks use to mitigate default risk and some of the techniques that banks use to mitigate risk have been described below: Credit Ratings One of the widely used techniques that banks have adapted is of credit ratings. Banks evaluate the history of the creditors before paying them loans. Ratings are assigned to creditors according to their history and good creditors are assigned higher ratings and vice versa. Creditors with good credit ratings are given the opportunity to pay lower interest rate whereas creditors that do not have good credit ratings are charged higher interest rates because of lack of their trustworthiness. Therefore by not giving loans to lower ratings creditors, bank is able to reduce its default risk. Risk Based Pricing: This concept can be very much similar to creditor ratings. When banks are giving loans, they evaluate the amount of risk they face to creditors and then interest rate is charged accordingly. Creditors with higher risk are charged more amount and vice versa. Credit Insurance One of the techniques that banks use is credit insurance. By doing so, the risk is shifted from lenders to the insurance company. Diversification Another technique that has been used by different banks is to diversify their loans to different creditors. Banks divide customers or creditors on the basis of their trustworthiness and then diversify their portfolio by giving loans to people in different segments or groups so that they are able to have a diversified portfolio of clients and at the same time they are able to earn good return and still recover money from the creditors. Also, banks diversify their risk by giving small credits to more people rather than giving too much credit to one creditor. This also helps banks to diversify their risk. Examples of banks that have been in TROUBLE BECAUSE of lack of proper management OF DEFAULT Risk Managing credits or a default risks is very critical for the survival of any organisation. Banks do have a complex structure which increases their risk, and thus it is important for the survival of these banks to reduce such risks. There have been many banks that have been revoked because of having poor liquidity. According to a research conducted by the NDIC (Nigeria Deposit Insurance Corporation) and CBN, most of the problems related to the insolvency and failure that the bank faces is because of advances and bad loans. In order to mitigate such risks, central banks in different countries have increased the minimum capital requirement ratio so that banks could have sufficient cash to meet their needs and there are fewer chances of banks being default or bankruptcy. There have been many examples of banks that have failed because of facing high credit or default risks. One of the recent examples of the banking industry that failed is of Washington Mutual, Inc. as after the financial crisis the bank did not have sufficient cash to meet their needs and therefore suffered from the default risk (Levy and Hester, 2008). Another example is of The Bank of New England Corporation that had suffered from liquidity issue as well. The bank suffered many losses because of its loan portfolio and in 1991 the bank had to announce bankruptcy. Payments to the creditors were made in the year 1998. Full payments were given to the secured creditors whereas 34% of the amount were given to the unsecured creditors (Branch, Ray, Russell, 2007). There have been many other banks that have suffered from insolvency and default risk. However, such risks can be mitigated if the bank is able to take actions accordingly and be proactive rather than reactive. It is also important for banks to learn from the mistakes of other banks and try to diversify their portfolio of loans rather than giving higher loans to fewer customers. Also, the other important techniques that have been used by banks around the world need to be learnt by banks to reduce the default risk. References Branch, B., Ray, H., & Russell, R. (2007).  Last rights: liquidating a company. Oxford: University Press US. Djiné, L. (2011). Assessing the risk of bank failure in Cameroon: a z-scoring approach. International Research Journal of Finance and Economics, 77, 114- 130. Khan, M. (1993). Theory & Problems in Financial Management. McGraw Hill Higher Education: Boston. Levy, A. & Hester, E. (2008, September 26). JPMorgan buys WaMu deposits; regulators seize thrift. Retrieved from http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aWxliUXHsOoA&refer=home McLaney, E. (2009). Business Finance: Theory and Practice. Pearson Education: New Jersey. McNeil, A., Frey, R., & Embrechts, P. (2005). Quantitative Risk Management: Concepts, Techniques, Tools. New Jersey: Princeton University Press. Read More