Risk Management In Financial Instituions Finance Essay
Today the financial companies function in high complex globally .the ability to control risks across the world, products, asset classes, customer segments and functional department is of greatest value. An irreparable damage can take place when risks are not managed appropriately.
Risk management is a constant challenge in the financial sectors especially after the recent crises which hit the financial sectors badly, and after that the role of risk management is becoming more complex. The research analysis the main risks involved in the financial factors that are responsible for its failure.
Key Words: Risk Management, control risks
INTRODUCTION: P1 (1.1)
In the changing world these days managing risks has become a demanding chore. Risk managers have to find multiple variables and technology solutions to improve risk analysis.
Over the group of ten years ,the market saw a defeat after another ,and each defeat has come up with new lessons of which some of them were the stumbling blocks and other were the stepping stones .
It has become a hot topic now a days that the world is facing terrible financial crises, numerous examples of death experiences of big financial institutions and financial giants going into the state of great confusion, commotion and disturbances are witnessed that despite being officially well capitalized by conventional measures risk management had gone awry .The reason behind this is not assessing and ignoring the possible risks that had to be sensed in the first place.
BACKGROUND: P1 (1.2)
Risk management is a continues challenge for all the financial institutions .Generally the strategies adopted comply of transferring risk ,reducing the negative effect of risk and take the consequences of a particular risk into consideration .
As we all know that the hard rock of recession has hit the world badly. All businesses, financial institutions have been effected by it tremendously .The question here arises that is this failure due to recession or is it because a proper risk analysis and appropriate risk management is not carried out?
RESEARCH SIGNIFICANCE: (A)
The reason of choosing this topic is to address different risks that a financial institution faces and the procedure to overcome these risks. Many financial institutions in great developed markets might have come down because of short of proper risk management which resulted in the failure of that particular institution. Continuing with the thoughts and researches of many researchers and financial columnists’ one of those particular areas that have been ignored by the financial institution which resulted in failure of these institutions was not assessing known risks properly.
PROBLEM STATEMENT: (B)
As the financial institutions are facing a down fall these days, it is important to reach to a conclusion of this down fall. Many researchers found it difficult in the beginning to find out the cause of failure because the financial institutions were reluctant in telling what the truth was? The reason being was if somebody had told or addressed the main reason of failure then the consumer would have drawn a distance in investing next time. Here some questions arise who were responsible and what were the areas left and why and when they were ignored?
RESEARCH QUESTION: (P2) (1.3)
Conducting this research has value and significance as it would help me to get the appropriate solutions to the following questions which would benefit the financial institutions in managing their risks adequately and to take reasonable steps before facing a failure.
(A) What are the different risks a financial intuition must take into consideration? (B) Why and what are the gaps in monitoring and managing these risks? (C) Does this result in the failure of the institutions?
HYPOTHESIS: (P2) (1.4)
In this research I have hypothesized that:
H1-Almost all the Financial institutions have similar main risks.
H2-Failuer of Financial institutions is because of not assessing the risks properly.
H3-Proper implementation is not done on the known risks by the financial institutions.
RESEARCH METHADOLGY: (P3) (1.12)
Risk management itself is a very important topic and when it comes to Risk management in financial institutions it always needs the right person to say on it .The chosen method for this research is qualitative because we need to know where is the gap in risk management and who is responsible for that? And what are the most important known risks that are not properly measured?
RESEARCH AIM AND OBJECTIVES: (P4) (1.5)
Aim of this research:
The aim of this research is to identify the risks that a financial institutions should take into consideration .The research will give a holistic overview of the principles of risk management in financial institutions ,including types of risks ,gaps in monitoring risks and setting up effective risk management system.
Objective of this research:
The present study attempts to achieve the following objectives.
To do a proper study of risk management in the financial institutions
To analyze what risks are there in the financial institutions
To investigate the gaps which results in failure?
LITERATURE REVIEW: (P5) (1.6)
Before going into the depth of the topic, its better to know
WHAT RISK IS ACTUALLY?
Risk is exposure to uncertainty OR
Risk is the probability that a hazard will take its turn towards a tremendous disaster
Risk is a part of human life .From the moment we get up in the morning ,take transport to the office or school to work or study until we get back into our house ,we face different kinds of risks between this time .
WHAT IS RISK MANAGEMENT?
In business terminology risk management is actually identifying, measuring, monitoring and controlling risk. The procedure of managing risks and deciding what needs to be done in order to reduce or eliminate risks and deal with the unpredictable situation is called risk management.
Risk identification is the first and the most important stage in risk management .There are lots of studies on risk identifications in financial intuitions (e.g. Kromschroder and Luck 1998, Tchankove 2002 and Luck 1998 ) .The risk management team should establish a crucial observation inside and outside the corporation.
RISKS INVOLVED IN FINANCIAL INSTITUIONS:
In financial institutions most of the time is spent in explaining what some thing is and what it should be like. In the financial institutions Risk management is basically a measure of all the known and unknown risks, and in the financial institutions it is introduced .
In order to manage proper risks there are some basic principles that each organization should follow.
Identification of the risks
Corporate level policies
Risk management strategies
Independent risk review functions
Tools to monitor risks
Financial institutions can lower some of the risks easily by researching them. For instance credit risk in the bank can be reduced by knowing its borrower. Just like a brokerage firm can lower or reduce market risks simply by getting awareness of the market it is operating in.
MAIN RISKS IN THE FINANCIAL SECTORS:
According to several authors and journals that has been published in the last few years
The main risks that every financial institution covers are:
Credit risks is mainly defined as the possibility of default by the counter party .It arises from borrowing activities, buying stocks or bonds ,invest money in the project and in short buying and selling financial assets on behalf of others. This risk is mainly connected with financing transactions that are
Borrower unable to repay or a default in repayment.
Default in obliging the commitment by another financial Institution in the situation of syndicated arrangements
Managing this risk needs proper assistance as it is the most critical and important risk in financial institutions especially in banks .It also requires the most subjective judgment regardless of constant efforts to make the credit decision process better and quantify.
Market risks basically incurred from the antagonistic, contrary or adverse movement in the market variables that includes interest rates, foreign exchange rate or credit spreads. Market risks can be hedged, for instance, in commercial banks, the market risk of the stable liquidity investment portfolio comes from unsuited pair of assets and their funding.
This risk involves interest rate risks in
The financial institutions should establish a sound and well informed planning to manage market risks .The strategy should be
Determine the level of market risk
Determine the tolerance of risk
Develop a strategy that balances its business goals with the market risk appetite
Liquidity risk is defined as to meet its obligations in a timely manner compensate for a position within the organization ,or In simple liquidity risk is defined that much of the depositors funds might be withdrawn in a very short time period. Sometimes it is also treated as one hand of market risk connected with the financial market. It can also occur when not liquefying the assets at reasonable prices, if necessary.
Liquidity risk can also be divided into two major components
This is the only risk that can come in normal times as well because there is no market that is perfectly liquid, it can also come in crises times where a severe disaster can also be expected .
Liquidity risk can be lowered down in normal times by
Using of derivative instruments
Sensible control on cash flow
Holding reserves according to the banking product prices.
Broadly defining, operational risks are the losses that follow from acts that are neglected in doing different business activities.
After an intensive debate that went on for almost 4 consecutive years THE BCBS provided this definition
‘Operational Risk is the risk of indirect or direct loss resulting from inadequate or failed internal processes, people, and system and from external incidents.’
Four other important categories are clarified as
Due to violation of internal policies by current or past employees this loss comes into existence.
Losses associated due to a deficiency in an existing procedure or in the absence of a procedure.
Losses associated due to breakdown in technology or systems .Most of the time these kinds of losses come unintentionally. If these kind of losses come intentionally that means they will fall in people or external category.
Losses that result naturally or by manly force, or a direct result of a third party action.
Operational risks can be reduced by
Risk quantification and measurement
Risk monitoring and reporting
Risk capital allocation
Risk management and mitigation
Figure: 1: Poll: Which of the above area represents the foremost area of op.risk in your organization? (Source RMA Webpage)
Poll included: investment banking, retail sectors, asset management, brokerage house, corporate finance, trading and sales.
THE GAPS WHICH RESULT IN A FAILURE OF A FINANCIAL INSTITUION:
A financial institution’s success lies in its ability to assume and aggregate risk within tolerable and manageable limits;
Adam Steve (Taking risks)
While understanding the risk management role in the financial institution it is also important to understand the gaps which results in the down fall of an institution.
“Risks are measured with metrics that aggregate various types of risks to help the top management understand the risk position of the firm.”
(Rene M. Stulz) (Risk management failure)
If the risk managers identify and asses the risks that are not suited to the organization’s strategy, risk management can fail before even the computers are turned on.
There are a lot of gaps which are a hindrance in the success of the firm.
MISMEASUREMENT OF KNOWN RISKS:
Now examine the case in which risk managers have picked up the right metrics, but the risks have not been measured accordingly or have been measured incorrectly.
Now, in case of a financial institution with lots of trading positions, though the distribution connected with every position might be assessed or estimated properly, the correlation among the different positions may be mismeasured.
These correlations are very important in risk management in financial intuitions .If the correlation among the different activities income is high, it is like all the activities of the firm will perform badly ,and that will surely lead to great probability of a large loss.
It is now well obvious to the financial institutions that correlation increase in time of crises e.g. result of the experience in 1998 of funds same as LTCM.
In such cases risk managers cannot be expected to expect something particularly like abrupt increase in correlation .But once the shifts in correlation are recognized, they should be taken to account by the risk managers.
RISKS ARE NOT MONITORED AND MANAGED:
The actual fact is that risk management is the one who is responsible that what risks should be taken and not others by the firm, Risk managers as a result should constantly keep an eye and hedge or manage known risks to meet the goals and objectives of the upper management.
This is actually very challenging for the financial institutions .It is a fact that financial firms have many derivatives positions, and this is a problem too. This is because complicated derivatives have a lot of exposure to the facts that are very sensitive to the condition of the market. For instance ,financial firms have some products which can be started the day with high percentage of exposure increase in rate of interest but, as a result in a low percentage of change in interest rates ,end the day with a negative exposure.
Adjusting hedges, for such products just once in a day could end up making great losses, reason being is that the hedge which was best at the beginning of the day could be increasing risk at the end of the day.
PROPER RISK METRICS ARE NOT USED:
The main gap which results the failure of the financial firm an answer of a wrong question by using a risk metric. Now a days VAR (Value at Risk) is the risk metric that is closely associated with the modern risk management.
In financial institutions VaR measure is used on daily basis to assess the risk trading activities.VaR has proven to be the most useful risk measure, only when the answer of a question is well understood.
The drawback is that VaR tells nothing if the distribution of the losses exceeds it, and thus it is determined as the biggest loss the firm expects to incur at a certain confidence level.VaR was never brought to estimate the worst loss that could come in the financial institutions.
For e.g. In November 2008, Goldman Sachs using 95% confidence level computed its VaR.
Consequently a chance of just 5% was there that Goldman Sachs would make a trading loss in surplus of $244 million .Thus this VaR tells nothing if the losses would fall in the range of potential trading and exceeds $244 million.
In short, it is useful for some purposes, and useless for others .Though VaR is used if one wants to understand the behavior of possible catastrophic losses that have a low probability of occurring.
A senior supervisor group stated in a report which includes top regulators from United States, England and Germany
Risk monitoring and management and reduces to the basis of getting the right information, at the right time to the right people, such that those people can make the most informed judgments possible.
Even though a financial institution have a strong risk system, if the risk manager is unable to co-ordinate to the top management the system might do more harm than good.
The role of risk management is to communicate to the top management effectively and timely that allow them to assess the consequences to lower down risks.
RATIONALE: (P6) (1.7)
Worth of risk management in the financial institutions:
The specific reason of doing research on this topic is the failure of financial institutions due to lack of proper risk management .And also the recent crises that the financial institutions had faced in the past few years which has turned into a disaster and made the worth of proper risk management dramatically increase especially in banks ,insurance companies ,stock exchange, credit unions, leasing companies, asset management companies and from microfinance institutions to money lenders resulted in doing research in this particular area .Thus the environment in the financial firms demand more systematic and more risk management approach in order to lower down risks.
REFLECTIONS: (P6) (1.8)
Getting all these facts from different sources have made me stand and stick to my points because the facts are well-backed from the credible sources as told before. The important point to be considered is my own learning and researching skills are improved a great deal.
Before doing my actual research, I only had a clue about what am I going to argue on? To be honest, I started my research with just a few points but after going into the depth and reading other author’s viewpoints I developed my own viewpoints on this topic .and I started looking for the Sources that were authentic and credible enough to support my own view points.
SCOPE AND LIMITATIONS: (P6) (1.9)
This research is all about the types of risks in financial institutions and it also covers a wide area of problems accruing in assessing these risks, more over the research also points out and focuses the gaps that are left which results in the failure of the financial organization.
It also contains a lot of important information for the readers, through which they can easily asses and manage risk management in financial institutions.
BELOW ARE THE TASKS ACHIEVED ON WEEKLY BASIS:
CODE OF ETHICS: (P7)
The manner in which I have conducted this research and analyze the data is in accordance with ethical research guidelines.
I have studied and understood all relevant material by the professionals which has helped me to conduct this research in this particular area. All possible steps have been taken to ensure the authenticity of this research.
JUSTIFICATION FOR USING THIS METHODOLOGY: (P8) (1.12)
There are several reasons why I chose a qualitative approach and further it is discussed in the following research .However, it was chosen because of its potential to provide richness and depth of understanding which pulled me towards it.
“Qualitative research that which is subtle becomes obvious, the invisible becomes visible.Vaneers of phenomenological representations are moved so that we may become acquainted with subjective understanding and the meaning of human interactions”
This research is done in order to find out the measures that are not been taken which results in the failure or to find out what are the known risks and why are they not properly assessed .And for that reviews of the professional who are directly related to this particular area and opinions are either taken or studied .
Further discussions are there in the research.
DATA COLLECTION AND REVIEWING: (P9) (1.14)
I chose to conduct a secondary research because the necessary data was available and was not easy but accessible to me .I gathered the relevant data from the internet ,international journals and publications , web publications, news paper , library research , by reading award winning books on this topic and researches that were conducted by well-known researchers .All this gave me help and support in order to make my research better and accomplished .
REVIEWING AND ANALYSATION: (P10)(1.14)
According to Constas (1992:255)
“A fundamental step of qualitative analysis involves the analysis of the data through development of categories .In order to identify themes the data had to be coded.”
It is important to show the reliability of the research results to be worthwhile.
Although a computer was used to process the data (writing up and editing ).I collected the relevant material which has been discussed in P4 (a) and then broke it into parts .This process involved breaking up the data into meaningful parts and classifying these parts into themes .This thematic analysis is a way of deciphering qualitative information.
RESEARCH DESIGN: (M1) (1.13)
It is wise to find or develop and systematic way of storing the data that should work for the researcher if he is using a qualitative approach and using secondary techniques .In this research the questions were chosen in order to go into the depth of risk management in financial sectors and to find out the problems that lead to the failure.
“The nature of the question leads to an exploratory research study. An exploratory study needs to have a proposition.”
Sjoberg. Williams (1991)
For the real quality data the international publications were studied and found out the findings that really helped the financial institutions .The research data and findings were reviewed constantly and every effort was made to collect the best material available.
FINDINGS OF THE RESEARCH: (P11) (1.5)
Thus far it has been argued that risk and risk management both are an essential ingredients in the financial sectors .and almost all the essential risks that should be measured properly are same in the financial sectors ..
It is noticed that the problem arises to the institution when they don’t measure the risks properly and also when they
Ignore the known risks
Do not asses the risks
Failure in communication with the top management
ANALYSATION INTERMS OF RESEARCH SPECIFICATION: (M3) (1.14)
Recent economic crises have convinced many observers that there are major flaws and gaps in risk management in financial institutions. The research demonstrates the need to distinguish between flawed assessment by risk managers and corporate risk-taking decisions, although resulting in losses.
RELULTS AND IMPLEMENTAION : (M2) (1.15)
In the light of research questions (P2) (1.3) and hypothesis (P2) (1.4) made in this research the statement should be straight and simple.
If in the financial institution the management wants to control risks, they should work on a firm -level risk management system .Its goal must be to identify measure and manage various types of risks to the top management on time and fill up all the gaps in order to save the firm from a big loss.
EVALUATION OF THE RESEARCH: (D1)
Though it was not easy to conduct a research on this topic as it needed every statement and every judgments based on facts and realities and information from reliable sources .Although all the research has been done according to the guidelines and set procedures .A set planning was done to do this research and all the findings is based on logics and evidence. Although it was not easy yet it covered all the points in order to get distinction.
CONCLUSION: (P12) (1.17)
After doing the whole research I have concluded that risk is a continuous process and it demands good risk management to work on it .A number of influential conclusions emerge from the study which are discussed in the above detailed research .In short ,Risk itself is not harmful ,but the risks that are not properly assessed ,mismanaged and misunderstood lead the institution to the failure. In financial institutions it is important to work on the known risks involved, identify new risks which can appear and to eradicate the communication gap between the top management and the risk managers in order to save the firm from a damaging and destructive event.
FUTURE RESEARCH AND RECOMMENDATIONS: (D3) (1.18)
This research has showed that risk management is an important factor which can lead the company to the highest level and can fail the company as well if the risks are not taken on time and not assessed properly .The research also identified the main risks that a financial institution faces .
New quantitative approach researches should also be done in this area and new risks should also be identified because risks are an ongoing process it can change according to the conditions.
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