Risk Estimation by Financial Institutions - Term Paper Example

Topic: risk management Risk management in big companies is a strategy to minimise the financial losses and increase profits. Key risk management decisions are taken in all business and industry sectors; it happens particularly in financial markets as doing business of financial products and services is fraught with risk. A financial company estimates financial risks, which can be detrimental to its success in the marketplace. There are different types of financial institutions operating at national and global level. Before delving deep into the vulnerable decisions made by financial institutions, it is important to know what types of companies should be called the financial institutions. These are banks, insurance businesses, mutual funds, securities firms, investment banks and finance companies. A financial institution collects funds from private as well as public investors to use them in financial assets. Financial institutions play the role of mediators in share markets and debt security markets. Financial activities may include bonds, debentures, stocks, loans, risk diversification, insurance, hedging, retirement planning, investment, portfolio management, and many other related functions. Through these functions, funds get transferred to different tiers of economy for positively performing a business function (Babbel & Santomero 1997). When financial companies such as banks and insurance companies sell their products, they cover the risks which could be short-term or long-term risks. There are other companies called “Reinsurance companies” that sell policies to insurance companies to cover risk factors and save from big losses. Generally, reinsurance companies are big players and can write insurance risks directly. There is another type ‘captive insurance company’ that serves the limited aim of financing the risks of a parent company (Wikipedia 2010). Financial activities are risky business. From management perspective, some financial risks can be such that can be removed by following standard business practices, some risks can be shifted to other participant , and some financial risks must be managed proactively by the institution itself. Financial companies have their own financial risk management systems involving risk management techniques (Babbel & Santomero 1997). Generally, financial institutions, being the principal functionaries, use their own balance sheets to realise a transaction and mitigate the risks involved. Thus, most of the risks are for on-balance-sheet businesses. Financial institutions estimate risks for different product portfolios like interest rate risks, credit risks, foreign exchange risks and liquidity risks. Let’s take the example of interest rate risks to estimate the costs and benefits attached to such risks (Babbel & Santomero 1997). Interest Rate Risks The interest rate risks are estimated as per different practices of financial institutions like commercial banks and investment banks. Commercial banks differentiate between their trading activity and their balance sheet interest rate exposure. Mostly, investment banks view interest rate risks as a definite market risk and have developed comprehensive trading risk management systems to estimate interest rate risks. Some banks practice Value-at-risk model, which is yet not fully developed way, as in-between banks employ real-time systems. This system is OK for banks with little trading activity, but for banks involved in a big way doing trading activity on behalf of their clients, Value-at-risk is the standard approach. This system takes into consideration the daily, weekly and monthly volatility of the market value of fixed rate assets. It includes estimating the total portfolio risk analysis besides estimating risk attached to equity market and foreign-denominated assets (Babbel & Santomero 1997). Banks don’t make use of market value reports or guidelines for estimating the effect of interest rate risks on balance sheet; rather they depend on cash flow and book values at the cost of market value. This is known as “gap reporting system”, where asset cash flows are reported in different re-pricing timelines, as there is a mismatch in the revaluation of assets and liabilities that creates a gap. Banks estimate this gap in ratio or percentage terms over a definite period of time, which can be one month or one year. Banks add duration analysis of the portfolio to “gap reporting system” to reach at an approximate value of the risk. Some assumptions are taken while moving from cash flows to duration. Some problems are surfaced with asset categories not having fixed maturities and core liabilities like retail demand but overall estimates are taken accurately, including both on-and-off-balance sheet exposures in reporting ways (Babbel & Santomero 1997). All banks don’t follow the above methods; banks have gone a step further to analyse their balance sheet interest rate risk management processes by taking into consideration the volatile nature of banking market where assets and liabilities shift centre over time and spreads. They are applying balance sheet simulation models that require related information on re-pricing timelines, guesses on prepayment and cash flows. For re-pricing, the banks assume the movement of interest rate for simulating pricing decisions for local and national franchises in their related environments. For making guesses on prepayment, exact prepayment models on proprietary products such as middle market loans, residential mortgages or consumer debts, are required. Any deviation in earning from the resultant analysis is considered by the management if it is above the limit set by bank management. When not fully satisfied with the analysis, treasury officials take help from cash, swap, and futures market to minimise the intended risk in rate exposure. It depends on individual banks, however, to set assets’ limits and put restrictions to the treasury’s initiatives to participate in cash and futures market as per a bank’s investment policy. Derivative activity is accepted but not swaps caps and floor market to rein in sudden ups and downs. Banks manipulate by keeping alternatives open in investment and hedging to avoid interest rate risks (Babbel & Santomero 1997). Hedging is a risk managing tool, practiced by corporations as well as governments, big and small, so that companies don’t become bankrupt due to losses and governments’ foreign exchange resources are not drained, affecting the whole economy (Investopedia 2010). Managing risks in the volatile oil prices has become necessary after the deregulation of the 1970s. Now-a-days, oil futures contracts are traded on NYMEX, as oils futures contracts are managed by exchanges – the latest in line being Singapore International Monetary Exchange (SIMEX) and others launched in Tokyo and Hong Kong. Volatility in oil prices in 1999 in comparison to 2000 was $10/bbl to $35/bbl respectively. It indicates that market price of oil products is sensitive to demand and supply shocks (Tunaru & Tan 2002). Direct costs and benefits of risks – the example of airlines industry Cost of Jet fuel forms 10-20% of airline costs and a 5% change in cost can affect an airline’s profit to a great extent. It is not possible for airlines to stock jet fuel due to financial constraints, storage charges and space crunch to refuel the airplanes. Before analysing the risks to airlines industry through hedging for reducing risk factors, it is important to know what hedging is and how it works (Tunaru & Tan 2002). Airlines can practice hedging techniques by trading in risk minimising instruments like futures, swaps or options. Hedging is like insurance -- insuring against negative happenings. It is practiced in almost all industries. Negative occurrences happen but their impact is minimised by hedging. To make it easy to understand what hedging is -- it is like house insurance. Just as buying house insurance saves from fires, break-ins and other future tragedies, hedging saves from the severe financial losses resulting from volatility in jet fuel prices. Hedging techniques minimise airline risks. In financial markets it is not as simple as insurance, as instruments in market are used to set off the risks of negative price tendencies (Tunaru & Tan 2002). Hedging, in technical terms, is investing in two securities with negative correlations. Of course, it comes by paying in some form or the other. We can not save ourselves from risk-return tradeoff, as hedging is not a technique of making money but a way of minimising future losses. Mostly, hedging techniques require the usage of complicated financial instruments, known as derivatives; options and futures are the most commonly used derivatives. With these instruments, trading strategies are developed whereby a loss in one investment is compensated by profiting in a derivative (Investopedia 2010). Indirect Costs Hedging has indirect costs attached to it. Before taking a decision to practice hedging, it is important to estimate the benefits to vindicate the costs. In the context of hedging, one important thing to understand is the purpose of hedging, which is not making money but to save oneself or the company from losses. We can say hedging is a sort of guarantee, which has a cost, the cost of the hedge. It could be the cost of an option or unrealised earning for not remaining on the right side of a futures contract. You cannot delay the cost of not being sure of future happenings (Investopedia 2010). Life insurance services include life insurance, annuities, and pension products. General insurance includes non-life i.e. property/casualty and other insurance services. Life insurance services are long-term and provide risk coverage for decades but general insurance products are short in span. If we compare hedging with insurance business, insurance is comparatively accurate than hedging. Insurance comes with a total reward for the damage. For customers of insurance companies also, it is a reward when regular payments of instalments guarantee and cover the risk. For example, a health insurance covers the risk of health by paying a stipulated monthly or quarterly instalment. Customers of health insurance companies select a suitable cover based on their earning capacity. Whenever they are hospitalised for health reasons, the insurance company pays a customer’s hospital bills. In this regard the cost and benefits to the customers are very much clear. He or she has to pay to the insurance company a definite amount, which is the cost to the insured person. It is a direct cost to the insurer that provides direct and indirect benefits in case of any hospitalisation and treatment (Babbel & Santomero 1997). Without a health insurance, a person cannot cover the risk; therefore, a health insurance covers the risk of the amount for which insurance is made. Estimation of the costs and benefits in the context of an insured person depends on the earning potential and health condition among other factors. A person in the higher income bracket has a higher capacity to cover risk. Thus, insurance of any type comes with the benefit of total compensation for the loss. The business of insurance companies in all types of insurances is on the rise because there is huge earning potential in comparison to the cost. Hedging is more risky than insurance business. Things don’t turn positively always in hedging. Risk managers strive to achieve the perfect hedge which is not an easy game (Babbel & Santomero 1997). There are non-financial risks, which are different in nature from the risks specified above. As they are not financial in nature and outgrow from the business itself, their estimation process takes place by applying standard risk avoidance techniques. Some of these risks include operating risks and market risks, known also as system risks. Operational risks are related to processing, settling, taking or making delivery on dealings in return for cash. Organisational risks can also be pertaining to record maintenance, checking system failures, and follow-up on regulations. Non-compliance to such risks can be costly. Tested business acumen is applied to minimise the cost of risk expenditure that accrues on its cost and benefits besides checking operational errors in the area of market risk and operational risks (Babbel & Santomero 1997). General practice with commercial banks is to form a risk management committee at the organisational level. An officer is designated as Senior Risk Manager to reduce the cost by controlling overall operational risk to the bank and take measures to mitigate such risks by employing set techniques. The committee transfers the responsibility on line managers to manage risks and improve performance in that area. Instead of giving sales incentives, which are based on business volume, performance rewards on overall profitability are provided to staff (Babbel & Santomero 1997). Off-balance sheet risk, as is the tendency with banks, can better be taken care of when intended risk of managing activities is involved into total risk management and strategy formation. Government regulations and banks’ accountability by following standard regulatory practices helps in gaining knowledge and making risk measuring activities transparent (Babbel & Santomero 1997). Banks cannot completely do away with market or systematic risks; they can hedge them to a certain degree only. Actually, by their nature, market risks can be segmented. In banking sectors market factors affect the range of interest rates and comparative value of currencies. Banks try to measure the impact of market risks on their performance and hedge accordingly so as to control its touching range in non-diversifiable factors. Banks monitor their susceptibility to interest rate variations and foreign exchange risks and try to manage and capture their influence (Babbel & Santomero 1997). If estimates of taking risks in investment go wrong, as it happened in the global melt-down of financial markets in particular, results could be catastrophic. The whole world had to pay the cost of taking undue risk of providing loans to home borrowers in the US without proper verification of the borrowers to repay the loans, resulting in the home-loan mortgage fiasco. Let’s elaborate on what went wrong in estimating and managing the risks associated with financial institutions by taking the example of HSBC Holdings plc. The bank was highly exposed to credit risk during 2008 because of incessant downturn in credit environment prevalent in the US mortgage market. In the commercial real state sector, personal lending portfolio was the most affected with 85 percent loan impairment charges, which were 94% in 2007. In commercial banking, the rate of loan impairment was 9% in 2008 as compared to 6% in 2007. Both balance sheet and off-balance sheet, exposure to credit risk was tremendous. Financial assets on the balance sheet showed equation in exposure to credit risks and the amount they carried. For financial guarantees, the bank was to pay the maximum amount if they had been invoked. For loan commitments, the bank was to pay total amount of the home loan as committed, being irrevocable over their life period (HSBC Holdings Plc. 2008). Precautionary measures had to be taken to save costs. The HSBC, in North America, reduced mortgage lending by 15%. The bank reduced its risk in consumer lending portfolio as a precautionary measure. The bank sold its mortgage portfolio of US$7.0 billion in the year 2008 in secondary markets. Further decreasing its risk hunger, it closed its whole sale and third party prime mortgage business in November 2008. HSBC restructured its lending business in the US by enlarging its sub prime credit range for government sponsored entities and conformed loan products. By February 2009, HSBC ordered closure as soon as possible branch based consumer lending finance business in North America. So we can’t say that risk management is always a profitable venture, as the whole world has to pay huge indirect and direct costs by bearing the recessionary trends with the healing process still going on (HSBC Holdings Plc. 2008). References HSBC Holdings Plc. Annual Report and Accounts, 2008. HSBC Holdings Plc. Available from: http://www.hsbc.com/1/PA_1_1_S5/content/assets/investor_relations/hsbc2008ara0.pdf [Accessed 3 December 2010]. Investopedia Staff, 2010. A beginners guide to hedging. Investopedia. Available from: http://www.investopedia.com/articles/basics/03/080103.asp [Accessed 3 December 2010]. Judge, A 2003. Why do firms hedge? a review of the evidence. Middlesex University Business School. The Burroughs, Hendon (London). Santomero, Anthony M. & Babbel, David F. 1997. Commercial bank risk management: an analysis of the process. The Wharton School, University of Pennsylvania. Available from: http://fic.wharton.upenn.edu/fic/papers/95/9511.pdf [Accessed 3 December 2010]. Tunaru, R., Tan, M 2002. Minimizing risk techniques for hedging jet fuel: an econometrics investigation. Middlesex University Business School (London). Wikipedia 2010. Insurance companies. Wikipedia. Available from: http://en.wikipedia.org/wiki/Insurance#Insurance_companies [Accessed 3 December 2010]. Read More