Financial Institutions: Common Risks
There are various forms of risks that usually face small as well as large financial institutions. Historically, the risks facing financial institutions were classified into two: market risks and credit risks. Whereas credit risks were related to how trustworthy the counterparty was, on the other hand, market risks were due to the market activity of an organization. Nonetheless, the classification of risk in financial institutions was not as exhaustive as would have been expected. Over the last decade, regulators and firms dealing with finances were apparently emphasizing more on other risks, besides the credit and market risks (Carey & Stulz, 2006, p. 8). This latter group of risks was later on collectively referred to as operational risks. The category takes into account systems failures, employee errors, floods, fraud, fire, as well as losses entailing physical assets, amongst others. One of the problems that characterize operational risk, as it affects financial institutions, is the inability of specialists to agree on the elements that should be included here, and those that should be left out. A number of these elements are large enough to warrant the establishment of an entirely distinct risk category. For instance, concerning the spate of corporate scandals that have affected financial institutions, due to fraud, in addition to other forms of criminal activities, it has become necessary that financial institutions should protect themselves from fraud. The broad nature of this form of risk warrant special skills and as a result, there is the need to characterize it as a separate risk with its individual metrics.
On the other hand, operational risks, as they impact financial institutions, are further grouped into two broad classes, on the basis of the frequency with which they occur as well as the number of losses that the financial institutions incur due to their occurrence. Accordingly, the operational risks that occur frequently are characterized by modest losses to the financial institutions. On the other hand, the operational risks that occur rarely are more likely to result in considerable loss to the financial institutions. Both the financial press and academic literature have increasingly placed more emphasis on reputational risk. However, there is limited evidence in the literature that documents the losses that financial institutions have incurred due to reputational losses. Despite this revelation, equity markets have been known to be affected by such reputational events as the revelation of fraud. A survey that was undertaken by Price Waterhouse Coopers (2008, p. 4), and which had financial institutions as its subject of the study reported reputational risk as to the leading impending threat to the institution’s market value, in comparison with other risk classes. Operational risks are characterized by another peculiarity, in that they could vary from one financial institution to the other. For example, the risks associated with a company renting its premises differ from those of one owning a building. Therefore, aside from the typical and common risks, an individual financial institution, for example, shall be characterized by unique operational risks.
Reputation risk is also characterized as a form of operational risk. Reputation risk entails the prospect of an organization’s public image becoming dented by a certain piece of information or the occurrence of some event. When an institution is faced with a bad reputation, this eventually results in financial losses, owing to its client base reducing. There is a need to appreciate the fact that even the best client could be forced to abandon one financial institution for another as a result of its bad publicity. This only serves to worsen an already bad crisis. On the basis of such reasons, there is a need to ensure that financial institutions do not appear to underestimate this risk. Even as reputation risk has proved quite difficult to measure, nonetheless, it can still be managed. One way through which financial institutions endeavor to reduce this particular risk is by way of ensuring that codes of conduct and ethics are adopted in the organization (Saunders & Cornett, 2008, p. 26). In addition, financial institutions have also attempted to engage in diverse projects that bear social significance, such as in charity donations. This is with a view to creating in the minds of the society an image of an organization that has the needs of the community at heart, effectively reducing the risk. The best strategy to manage many of the operational risk is right from their origins, that is, handling the risk as they arise from individual departments. The rationale behind such an approach is that such departments are well versed with the issues affecting the department in question. Nonetheless, there is the need to coordinate and control the management of such risks from a centralized position for purposes of harmonizing actions, and to ensure that these actions are executed based on the existing risk management framework of the organization in question.
Credit risk or default of assets is yet another common risk amongst financial institutions. A default risk usually occurs at a time when the assets value of an issuer is way below the value attached to the payment promised. On the other hand, financial institutions are wary of credit risk, encase of a default (Danielsson, Shin, & Zigrand, 2004, p. 1071). Financial institutions are also concerned about interest rate risk as a result of maturity variances between, on the one hand, liabilities and on the other hand, assets. Liquidity risk is another concern for financial institutions. These organizations are skeptical about the ability of a certain asset or security to become subjected to quick trading within the market, lest it fails by the institution to realize a profit.
Financial institutions rank amongst the sectors of the economy that are most regulated, globally. This is because they are often crucial in ensuring that the other sectors of the economy operate harmoniously (Houston & Stiroh, 2006, p. 12). When financial institutions are successful, they act as source finance to the other sectors of the economy, translating into economy growth and by extension, enhanced transactions within the economy. Consequently wealth accumulation and trade are facilitated. Financial institutions have imposed various types of regulation and protection for purposes of their soundness and safety. First, it is a requirement that financial institutions diversify their assets. For instance, a single borrower may not receive a credit worth above 10 percent of a bank’s equity. Secondly, there is a certain capital amount that financial institutions have to maintain, at a minimum. For banks, the requirement by Basle standards is that at the very minimum, they need core as well as supplementary capital equivalent to 8 percent of assets, after risk adjustment. In addition, such guaranty funds as BIF have already been established by commercial banks regulators for purposes of protecting individual investors. Insurance firms also have state guaranty funds to serve the same purpose. Furthermore, periodic surveillance and monitoring of the financial institutions by regulators are geared towards ensuring their safety, as well as that of the investors. For example, regulators could undertake on-site examinations of a financial institution, or even request to be supplied with information on their operation, from time to time.
Carey, M. S., & Stulz, R. M. (2006). The risks of financial institutions. Chicago: University of Chicago Press p. 8-11
Danielsson, J., Shin, H. S., & Zigrand, J.P. (2004). The impact of risk regulation on price Dynamics. Journal of Banking & Finance, 28(5):1069-1087
Houston, J. H., & Stiroh, K. J. (2006). Three decades of financial sector risk. Staff Reports 248. Federal Reserve Bank of New York.
PWC. (2008). Operational risk: an alternative challenge. Web.
Saunders, A., & Cornett, M. M. (2008) Financial institutions management: A risk management approach. (6th Ed.) New York: McGraw Hill/Irwin ISBN