The types of risks and risk management measures which are needed in a financial institution - Essay Example

 The types of risks and risk management measures which are needed in a financial institution Overview and introduction Recently, there have been several major losses to some of the giant financial institutions and banks due to several reasons such as interest rates and credit exposure. Risk is basically the possibility of a negative outcome from taking an action or decision and a lot of banks and financial institutions need risk management in order to minimize their risks. Risk is always going to be present in a financial institution and the higher the risk, the higher the return that the institution gets. 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 non-performance of a partner involved in trading. This may arise from the counterpart’s denial to an adverse price which might have been cause by several factors such as political and legal constraints. It is somewhat similar to credit risk but is considered to be more towards the financial risk associated with trading activities. Operational risk. This is basically the risk which is caused by the institution itself as a result of poor management. It means the lack of proper operations resulting in specific errors. This is associated with the problems resulting from selling, processing and recording cash transactions. It can also result from computer errors or processing failure. However, operational risk is not faced by most of the institutions and the chances of facing this particular risk has a relatively lower probability but if operation problems arise, it can cost millions of dollars in losses to the financial institution. Legal risks. These are the risks that are associated with the state’s legal decisions and newer and upcoming laws can cause several problems for a financial institution. A common example of this is the law bankruptcy law which was passed in the late 70s and which has caused several problems to the financial institutions in case of a bankruptcy of a client or a borrower. Other types of legal risks are associated within the institute itself and this can be a result of several frauds and law violations caused by the employees of the financial institution. Performance risk. This is a risk which is caused by poor performance and poor monitoring by the employees. There are several problems which an institute might face if the employees are not trained enough to use appropriate methods. Liquidity risk. This is associated with the risk of funds. This is when the institution might not have enough cash funds in order to carry out specific tasks. The assets might be greater overall but a lack of liquid fund can cause several problems for the institution which is why liquidity risk needs to be measured. The banking and finance industry has seen the need of controlling various types of risks. Most of these, however, cannot manage all of these risks but some of the most vital risks are managed according to the policy. Risks such as counterparty risks and legal risks are not of great concern to the financial institution which is why these risks are not that essential to manage. Financial institutions have come across a lot of difficulties since the beginning; however, the most serious problem of these is related to credit. There can be several problems which might be a result of poor credit management against borrowers. Basically, the primary aim of credit risk management is to maximize the institution’s risk associated rate of return by maintaining several credit limiting parameters. These institutions need to manage inherent risk in the portfolio was well as to manage the risk associated with lending to sole individuals. Credit risk management needs to be effective in order for the bank to stay well off and stable financially in the long term. The most common source of credit risk is due to the lending of loans, however, there are other factors leading to this specific risk including the books of the financial institution and the state of financial position. There are other financial activities which lead to credit risk other than loans such as interbank transactions, trade financing, foreign exchange activities, swaps, bonds and equities. Credit risk is the sole leading factor which leads to the major problems faces by most of the banks throughout the world and therefore, bank managers need to use their previous experiences in order to manage this particular type of risk effectively. Several committees and organizations have several programs which emphasize on the need of managing credit risk. The financial institutions carry out different practices in order to manage their risk. Firstly, there is a need to obtain a relevant credit risk environment and the institution needs to operate under a firm credit granting process. They also need to maintain a specific credit administration process along with the measurement and the monitoring processes. Most of the banks need to have a significant control over their credit risk. These areas need to be managed effectively by all the financial institutions even though they have their different approaches towards credit management. The credit risk management system is different for different banks depending on various factors including the size of the bank. The senior professionals at a higher level in the financial institution need to ensure that appropriate management measures are taken depending upon the activities of the business. The larger the bank, the greater will be the measures which are needed for an effective credit management system. The management in the relatively smaller banks also need to ensure that the measures taken by the management in managing credit risk is sufficient enough according to the institution’s activities. Interest rate risk and the GAP analysis Interest rate risk management is another important type of risk which needs to be managed and most of the American and European banks have this risk set as their top priority. Basically, some financial institutions regard interest rates as a type of market risk; however, more active banks have regarded this as a separate major risk which can cause severe problems for the bank in terms of the net income of the bank. Interest rate risk is the problems associated with the adverse changes in the interest rate. Interest rate changes are also known to be a part from which the banks earn a major part of their profits and the increases and decreases in interest rates can help the bank in earning a greater income and capital depending upon its rate sensitive assets and liabilities. The changes in interest rates, however, can also literally hit the banks severely depending upon the assets and liabilities owned by the financial institution. Basically, the cash inflows and outflows are a result of the assets and liabilities of a financial institution and interest rate changes results in a change of these cash flows. This change of cash flows can either increase the net income of the banks or can decrease it. The interest sensitivity gap or a gap analysis is probably the most effective way in managing interest rate risk relating to the income of the bank. This is the first method in determining interest rate risk and is used widely by most of the financial institutions today. Basically, gap analysis takes into account the risk sensitive assets and the risk sensitive liabilities and shows an overall increase or decrease in income. The formula for measuring gap is the changes in rate sensitive assets minus the changes in the rate sensitive liabilities. The rate sensitive assets are the commercial loans and the variable mortgages given to various institutions. These generate a cash inflow for the financial institution. Fixed mortgages have a fixed return and the cash flows are not affected by the changes in the interest rates. The rate sensitive liabilities are the commercial borrowings by the financial institution itself from other banks. The change is calculated by applying the percentage change in the interest rate on both, the assets and the liabilities. The new interest should be used first and then the old interest rate should be subtracted in order to find the interest rate changes. After calculating the changes, the financial institution gets the net change in income resulting from a change in interest rates. This is possibly the best way in interest rate management and in order to look for income losses from the assets and liabilities. Conclusion Risk management is crucial for the stability and the financial success of a financial institution. There should be an entire department within the institution which should specialize solely in risk management. More than fifty percent of the problems faced by major financial institutions all over the world are because of the lack of an appropriate risk management system. With the use of relevant risk management measures, a financial institution is likely to avoid most of its problems and can maximize its revenues and returns while minimizing the risk losing out. Without risk management, a financial institution can go bankrupt as it is not proactive and any sudden changes or movement in the pattern of certain activities can destroy the institution. This might also result in a bail out from the state bank of the specific country. Risk management needs to be taken seriously and with an improper and speculative risk management system; there will be no major solutions to the most common problems faced by the financial institutions. Financial institutions cannot run away from risk and there is risk involved in every part of the institution’s transaction and the entire foundation of these financial institutions is built on risk. Facing a great amount of risk can get the greatest return but the institution needs to undertake only that proportion of risk which it can recover from if the result turns out to be against the institution. References Hull, John. Risk Management and Financial Institutions. Upper Saddle River, NJ: Pearson Prentice Hall, 2007. Print. Grinsven, Jürgen H. M. Risk Management in Financial Institutions: Formulating Value Propositions. Amsterdam: Delft University Press/IOS Press, 2010. Internet resource. Chorafas, Dimitris N. Risk Management in Financial Institutions. London: Butterworths, 1990. Print. Møller, Christensen A. The Real Interest Rate Gap: Measurement and Application. , 2002. Print. Sadr, Amir. Interest Rate Swaps and Their Derivatives: A Practitioner's Guide. Hoboken, N.J: Wiley, 2009. Internet resource. Read More