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Risks Faced by Financial Institutions

Introduction

Financial risks are probable events that have negative impacts on financial institutions. Risk can therefore be defined as the probability of having different investment return due to loss of original investment share. In some instances, the loss can also be termed as the deviation from the originally expected returns. These events are in most cases engineered by the environmental conditions that are prevailing in the market. Financial risk can be market-oriented or influenced by other numerous factors in the market. Additionally, financial risks can be attributed to the operational or fraudulent behavior of the institution’s personnel. It is important to understand that risk is closely connected to the overall return within an institution, the lesser the risk the lesser returns, and the greater the risk the better the returns. This situation is best stipulated in the free market by the presence of safe and risky investments, whereby the safer the investment the less its potential returns, and the risky the investment the greater the potential returns. This paper seeks to analyze the risks faced by financial institutions.

The financial institution’s risks

Risk is the uncertainty and exposure of a firm to adverse market and operational hardships. We can therefore broadly define risk as a factor that comprises two major components. Risks are however subjective as different institutions experience a different forms of risks depending on the size and operations. It is also important to understand that the risk is a personalized idea, even when it comes to institutions and corporations. This is because the decisions made within the firm are mainly determined and directed either to the executives or the senior management in any given institution. It is, therefore, appropriate to say that the stakeholders are the major contributors to risks.

With the new technology such as e-business and new financial instruments such as derivatives, more risks have emerged as the changes fail to give the institutions enough time to adjust accordingly. Although the advancements have tremendously improved information efficiency in financial institutions, the speed has been a little bit higher thus outmatching the adaptability rate. In general, the financial risks are the unexpected market or situation volatility of the returns which tends to worsen the expected returns in a certain investment. Generally, various international bodies seek to prevent and access the significance of risks in the country’s financial systems. Various governments will tend to have financial stability reports (FSR) which aim at reviewing the financial system conditions within the nation. They, therefore, enable the government to make up, identify and suggest the appropriate policies which should be implemented to address the risks. These reports are usually prepared by the country’s central banks and are released on a regular basis. It is important to note that the financial institution’s risks can either be internally or externally generated. The internally generated risks are mainly contributed by the operational activities within the institution while the externally generated risks are caused by market competition and interest rate changes. The internally generated risks can be prevented by establishing strict guidelines which would be used to regulate and control people working for the institution. The external risks can on the other hand be prevented by strategically marketing the products of the institution in the market. Since it is not possible to regulate or control the interest rate changes as it’s determined by the central bank, the financial institution should ensure that such adversities do not severely affect their operations. The institutions, therefore, end up incurring some economic loss.

The economic loss can be determined in many ways i.e. the loss in the share value of a given financial institution. Institutions have however defined a safer mechanism where they distribute risk into various investment portfolios. Measures like investment diversifications are aimed at reducing the vulnerability of risks in financial institutions. There are various financial risks that affect the effectiveness and efficiency of financial institutions. Financial institutions undergo various different types of risks which are analyzed in the later section. The financial institutions have however established different mechanisms to manage and check the adversities of the above risk. But since the risks are differentiated different risk management operations will be used to address the issue. Below is a detailed analysis of the above financial risks. In the analysis, detailed information on how to handle the risk will be given.

Interest rate risks

This is a risk that is borne by interest-bearing assets such as loans and security bonds. The risk mainly occurs due to the rate variability as time changes. It is believed that the risks vulnerability will usually be higher if the institution has a higher external debt burden or when it has higher foreign investment portfolios. The volatility in the foreign exchange rate and interest rate, therefore, causes mismatches between bank assets and liabilities. It is therefore the earning risk triggered by the interest rate movements. The interest rate movement occurs when the changes affect the net interest income and the market value of the institution’s capital stocks. The interest rate changes also greatly reduce the economic value of the firm as it affects the assets and liabilities. The off-balance sheet contracts are also affected by the rate changes as it becomes difficult to pre-determine the present value of the future cash flows. The interest rate fluctuations greatly influence the prices and value of the institution’s securities such as bonds. It is generally believed that the interest rate rise results in a fall in the price of a fixed-rate bond. This is mostly the case as the risk in bonds is determined by the period over which the bond will be expected to mature.

The level of interest rate risks that a bank is willing to assume will determine the amount of risk likely to be felt during its operations. Some banks seek to reduce their risk exposure by deliberately positioning themselves from a particular interest rate movement. This is mainly done by matching the maturity dates of their various securities. In addition, this can be done by undertaking regular re-pricing of their assets and liabilities. Other banks assume greater levels of interest rates risks by either choosing their interest rate position or leaving it open. To caution themselves from such risks, banks will tend to centralize their interest rate risk management activities. This is mainly done by restricting the position taking to certain discretionary portfolios i.e. the money market and other investment portfolios. To successfully isolate the interest rate risks management from the positioning the banks usually use the fund transfer pricing mechanism. Other banks will tend to decentralize the risk management task to the respective individual profit centers since they are more aware of their performances within their markets. Moreover, some banks tend to impound both their interest rate risks and positioning activities within their trading activities.

Financial institutions can effectively change their interest rate exposure by adjusting their investments, funding, lending, and pricing strategies. This can be done through either managing the maturities or re-pricing their investment portfolios in order to suit the desired risk profile. Other banks use off-balance sheet derivatives such as interest rate swaps to adjust their risk level. But for a bank to use any derivatives, it must understand the cash flow characteristics of the instrument it intends to use. An adequate monitoring process must also be put in place to ensure that the bank attains the desired risk profile. The interest rate changes also have a significant effect on other operations of the financial institutions such as the lending activity. For instance, a rise in interest rate will tend to increase the earning risks of a bank as there will be many defaulters. Loan customers will tend to rise since the principal amount will have significantly increased from their original expectation. To effectively manage loan problems the financial institutions should regularly adjust their loan rates to enhance the clients repay their obligations efficiently. (Nawalkha, Soto & Beliaeva, 2005, p. 15-16).

Credit risks

This is the risk suffered by the financial institutions when their clients default to honor their financial obligations. The loss can however be felt if the client happens to be declared bankrupt or can be due to delays and a complete restructuring of the repayment periods. Poor credit standards for borrowers and counterparts have been the main cause of this risk to many financial institutions. Additionally, banks have chosen to adopt poor portfolio risk management which has, in turn, made it hard for them to identify the potential defaulters in advance. Lack of proper attention on the economic changes and other sensitive circumstances can negatively impact the institution’s credit standing. Banks however undergo some credit risk management to minimize the risk exposure within their financial systems. Different methods are therefore used to assist the financial institutions to maintain the credit risk at the desired profile. Among the methods used by the banks includes CRM and credit analysis. It is important to understand that banks not only face credit risk from the loans but many other financial instruments tend to increase credit risks in financial institutions. These instruments include acceptances, inter-banks transactions, and foreign exchange transactions. The financial futures and swaps comprise of the other instruments which offer the counter-party risks amongst the banks. Since the financial institutions operate interchangeably, their connections pose some credit risk to the parties involved.

Proper measures should therefore be put in place to ensure that the risk does not translate into losses. Useful lessons have been drawn from past experiences. The banks have prioritized the identification; monitoring and control measures that assist them to hold adequate capital to outdo these risks. The financial institutions therefore ought to establish a workable practice that will enable them to mitigate the credit risk and maintain it at a desirable level. Since loaning and advancement of the financial assistances follows a certain procedure the credit risk management process too should be a procedural undertaking (Servigny & Renault, 2004, p. 214). The first step should be to ensure that the financial institution establishes an appropriate credit risk environment. Financial institutions undertake a credit analysis strategy in order to determine and calculate individual or business creditworthiness. This process also assists them to identify business sustainability which helps them reduce the credit risk involved in the lending activities. The analysis also enables the bank to fully understand its client’s condition when it comes to loan repayments and honoring his or her financial obligations. Secondly, the banks should ensure that they operate under an effective credit-granting process. Proper guidelines ought to be established to guide the credit officers in financial institutions. The officers should therefore operate within the rules and guidelines in order to ensure conformity and consistency.

Thirdly, it is important for the management to maintain appropriate credit monitoring and administrative measures which will help them ensure that the process is undertaken smoothly. The monitoring process will also enable the management to detect wrongful steps at an early stage. These should be done through the establishment of a proper supervisory team to effectively oversee the overall lending process in a bank. Complete and accurate recording of the transactions should be encouraged when issuing financial assistance to an individual. Such recording enables the supervisors to detect an error or fraud before it’s too late. Fourthly, the financial institutions must ensure that adequate measures are put in place to mitigate loss and other financial adversities. Although the trend may differ between banks, as the nature and complexity of their activities differ, similar measures should be undertaken to effectively address the credit risk problems. The practice however should be implemented in conjunction with other assessment practices in order to guarantee better results. Different firms have used different assessment techniques but all are aimed at ensuring that the assets are effectively valued. The institutions should also increase their general provisions which safeguard them from risk exposures.

Market risks

This is a risk that threatens the investment value due to the market risk factors. Such risks are mostly incurred due to the institution’s exposure to the market conditions. It is important to differentiate between the trading and investment portfolios. The trading portfolio comprises the assets and liabilities which can be transformed into cash easily. The investment portfolio, on the other hand, comprises illiquid assets and liabilities, which are designed to have a long-term horizon. The market risks are influenced by both the trading portfolios and the investment portfolios. The stock price and the foreign exchange are some of the major market factors which influence the investment trend in financial institutions. The stock prices mainly determine the value of the financial institution. The higher the stock price the higher the value of the investment and the lower the stock price the lower the value. The prices mainly determine the marketability of the firm’s shares in the market. Investors will seek to buy stocks of the institutions which operate under efficient and excellent management. Such efficiency is usually indicated by the rise in the stock price of that given institution. The foreign exchange rate on the other hand influences the market risk of a financial institution as they are unpredictable.

There have been some credit crunches in the financial market which have greatly impacted the trading portfolios. Financial institutions should therefore use the value-at-risk method which will enable them to escape the threat of being insolvent. The institutions can also establish benchmarks to guide their operations and also help reduce the market risks. Firms tend to establish different benchmarks depending on the needs and risk tolerance they choose to undertake. Moreover, the banks should also consider the market condition in which they are operating. some financial institutions have opted to fund their foreign investments with other currencies as a way of hedging their investment risks. The performances of the financial institution are also important as they enable the market prices of the financial instruments to be consistent in the market. The banks should therefore maintain a specific amount of reserves which should be used to cater for the inflation volatility in the market. Also quite important to note is that the market risks are also referred to as systemic risks.

The systemic risks are therefore catastrophic since they affect the entire financial sector in the market. This risk is mainly brought about by the interdependencies and inter-linkages of the financial institutions in the market. The systemic risks are capable of leading the institution into being declared bankrupt. Among the major factors that cause the systemic risks includes the economic difficulties which are either depicted across the board or in the relationship between the financial markets and the economy. Since the overall impact will be felt in the whole financial industry, it might worsen the scenario if not mitigated early. A good example of the condition that gives rise to systemic risk includes the economic recession. Financial institutions can be reduced by avoidance and the hedging practice which assist in risk transfers. The central banks in the various countries may opt to regulate the operations and activities of the commercial banks and other financial institutions to reduce the systemic or market risk (Evans & International Monetary Fund, 2000, p.10-11).

The liquidity risks

This is a financial risk that makes it hard to trade given securities or assets earlier enough before the occurrence of loss in the market. The difficulty to access or covert a given asset or security into cash whenever the need arises generates liquidity risk in financial institutions. There are many ways through which financial institutions might lose their liquidity. Among them include the sudden or the unexpected drop of the credit rating and the unexpected increase of cash outflows. This mostly occurs when the financial institutions lend to other institutions. Financial institutions mostly expose themselves to liquidity risks when they subject their operations to a risky market. It is important to note that the liquidity risk is inseparable from the market and credit risks. It is therefore possible to deal with two or more risks at the same time. For instance, the financial institution may opt to strategically position itself and hedge against market risk which comprises of the liquidity risk. The financial institutions should therefore design a technique that will enable them to solve the simultaneous risk problems. Financial institutions can also use the asset-liability management technique to ensure that their liquidity is maintained at a required level.

The management can be done through regular analysis of the present and future net cash flows within the firm. It is also important for the financial institutions to additionally use the stress testing analysis as it will help them to manage their risks levels efficiently. The stress testing is mainly undertaken by analyzing the net cash flows assuming that the counterpart defaults. This analysis however does not take into consideration the cash flows from derivatives or mortgage-backed securities. In case of complexity, the financial institution may construct a multiple scenario analysis that enables them to determine the liquidity risks they are facing. The scenario analysis mainly overlooks different economic assumptions. It may either consider a strong growth, moderate, or declining economic condition. The different assumptions, therefore, provide the financial institutions with a variety of eventualities on which to base their assessments. They, therefore, establish specific paths and guidelines depending on the different scenarios.

From the differentiated scenarios, the banks may decide on either narrowing the spreads of their risks or even flattening the yield curves to reduce the risk profile. The evaluation and consideration of different scenarios mainly assist the bank or financial institution to be prepared in case such an event occurs in the future (Jorion & GARP, 2009, p. 25). The analysis also assists the institutions to have some probable measures which they can implement in order to overcome the economic and financial hardships caused by the risks. As a result, timely measures are guaranteed in case of a risky event which mitigates the loss incurred. The flexibility of the scenario analysis makes the asset-liability management tool effective. Considering the fact that it uses the past and the current market performances to project future operations, it is a more practical and efficient technique. The scenario analysis also enables the firm to take care of the options risk which is not addressed by the gap and the duration analysis.

Conclusion

From the discussion above it’s clear that financial institutions are faced with many risks. However, different financial institutions have adjusted differently to the risks. Factors such as the size, industry, and operational scope determine the type and kind of measures to be undertaken in each. The interest rate risk which is borne by the interest-bearing assets such as loans and security bonds is heightened by the rate variability as time changes. The banks seek to reduce the interest rate risk exposure by deliberately positioning themselves from a particular interest rate movement. Others prevent it by either managing the maturities or re-pricing their investment portfolios in order to suit the desired risk profile. Other banks use off-balance sheet derivatives such as interest rate swaps to adjust their risk level. The credit risk is the risk suffered by the financial institutions when their clients default to honor their financial obligations. The risk is mainly reduced by undertaking a tight credit risk management process within the firm. Market risk on the other hand is a risk that threatens the investment value due to the market risk factors. This form of risk is reduced by either benchmarking or exercising hedging operations which mitigate the loss levels. Finally, the liquidity risk is a financial risk that makes it hard to trade given securities or assets earlier enough before the occurrence of a loss. The financial institution uses the asset-liability management technique to overcome the liquidity risk.

References

Evans, O. & International Monetary Fund. (2000). Macroprudential indicators of financial system soundness. Washington, International Monetary Fund. Web.

Jorion, P. & GARP. (2009). Financial Risk Manager Handbook. New Jersey, John Wiley and Sons. Web.

Nawalkha, S.K., Soto, G.M. & Beliaeva, N.A. (2005). Interest rate risk modeling: the fixed income valuation course. New Jersey, John Wiley and Sons. Web.

Servigny, A. & Renault, O. (2004). Measuring and managing credit risk. New York, McGraw-Hill Professional. Web.