Custom «Risk Management by Financial Institutions» Essay Paper Sample
Risk may be defined as the probability of occurrence of a loss or losses that results from exposure to unfavorable conditions or environment. Risk is a measure of the possibility of an outcome of an action or occurrence that would have adverse impacts of the normal operations of a business entity. For financial institutions, such outcomes may result in either direct or indirect loss or consequent reduction in earnings or imposition of hindrance to the institution’s ability to meet its goals and objectives. Most often risks will reduce the opportunities for a business to succeed. Sometimes losses that result from risky occurrences may be expected, for example, default loans. Generally risks are defined by the adverse impact on profitability of the business and their uncertain sources. Risks can thus be classified as credit, market, liquidity or operational risks.
Financial institutions, like any other business need to practice effective and efficient risk management and mitigation techniques so as to maximize their trade-off between various risks and the rewards obtained. Such institutions similarly need to engage in business transactions that imposes less risk upon them. In these institutions, risk management takes place at three distinct levels, that is, the strategic, middle and operational levels (Hull, 2009). Moreover, the need for effective risk management in financial institution has been necessitated by emergence of new financial products, complexity of the financial environment, swelling sizes of businesses and increased levels of competition. Financial institutions thus require effective management policies and procedures for monitoring and controlling risks.
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As stated earlier, risks faced by financial institutions can be broadly categorized as credit risk, market risk, liquidity risks and operational risks. First, credit risks refer to risks that arise from intentional or unintentional failure by an obligor or creditor to honor his obligation in relation to money lent or general trade, thereby resulting into an economic loss to the organization. Credit risks originate from the organization’s dealings with its customers. For most financial institutions, loans advanced to clients form the largest and most apparent source of credit risk. Credit risks may be costly to the institutions as they encompass opportunity costs, debt collection expenses as well as becoming non-performing assets (Grinsven, 2010). Credit risks in financial institutions can be controlled by clear oversight by the management that would formulate strategies and credit policies to govern lending of money. The top-level management should ensure that credit risk exposure of the institution is reduced and maintained at sensible levels in line with the organization’s objectives. Similarly, the management should ensure that people concerned with credit control possess adequate expertise and sound knowledge in credit management. Managers should make sure that appropriate policies and procedures are in place govern credit issues to clients and that sound principles for identification and evaluation creditworthy clients are adopted.
Secondly, we have market risks. These refer to risks faced by an institution due to changes in the market rates or prices of such rates as foreign exchange rates, interest rates charged and general change in commodity prices that would result into losses in returns from capital investments. Such risks usually result from portfolio investments, that is, investments in financial securities, differences in interest charged on loans and interests paid on bank deposits, or due to variations in foreign exchange rates. In most cases, interest rate risks arise from changes and lags between cash-flows timings or range in maturity periods of securities, foreign exchange rate risk will arise from movements in currency exchange rates whereas equity price risks arise from changes in values of different investment portfolios. These market rate risks do have immediate negative impact on the net income of these financial institutions and usually reduces the net worth of the organization in terms of its capital investments, total assets and net liabilities it has to pay. To effectively manage market risks, the management of financial institutions must perform detailed analysis and assessment of the prevailing market rates before loaning its clients or paying interests on cash deposits. Similarly, great care should taken when transacting in foreign currencies, to help reduce foreign exchange rate risks. Capital investments should be made cautiously in order to maximize returns. Accurate and timely measuring of markets risk is vital for proper risk control and profit maximization. Where possible, capital should be diversified into different portfolios or securities in to spread risks in each investment.
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Thirdly, financial institution may encounter liquidity risks. Liquidity risk is the possibility of loss incurred by an institution due its inability to pay its debts in time or inability to finance decrease in values of its assets without incurring additional depreciation expenses. This can be considered the most important risk to financial institutions since it also measures the amount of money readily available in the institution to compensate for its day-to-day operations and expenses. Liquidity risk is usually high in financial institutions that heavily depend on clients’ deposits, and have less capital investments. According to Schroeck, liquidity risks often triggers all the other financial risks, for instance credit risk and market risk. High liquidity risks reflect that an institution will have to incur heavy costs in settling its obligations thus resulting into loss of the business’ profits and earnings (Schroeck, 2002). Liquidity risks can be mitigated by the management formulating effective assets and liabilities control guidelines. The financial institution can as well diversify its liabilities to avoid lump-sum withdrawal of funds to settle debts at a single period.
Lastly but not least, we have operational risks that result from inadequacies in internal processes or systems of the institution. Such risks are caused by human errors or system failures due to poor control. Such risk cause poor financial services offered to customers, which may lead to customer dissatisfaction, thus driving them away. Operational risks are controlled by proper coordination of all process, people and systems within the organization.
In conclusion, it is the sole responsibility of each financial institution to identify and take control of all risks it may face in the course of its business.
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