Question

How are financial institutions profitable from risk management ?

Answer 1

Introduction to risk management:

Financing is an intrinsically risky activity. Without taking risk, there is little possibility of reward. We thus need to treat risk management as a critical component of the financing process. Hence taking risk is an inherent part of financing business.

Risk Management enables management to deal with risks by reducing their likelihood or downside impact. It aims to protect the value already created by the organization, but also its future opportunities.

How are the financial institutions profitable by using risk management techniques:

There are many risk that a financing company needs to address/ mitigate to avoid adverse consequences due to unfavourable event. Following are some examples of risks to financial institutions and its mitigation techniques:

1. Credit Risk: It consists of the probability of default in repayment of loan of advances or the unwillingness of the customer or counterparty to meet their commitments given.

• This risk is also related to recoveries in the event of default, which in turn depends upon various factors such as quality of guarantee provided by borrower, and other surrounding circumstances.

How to Mitigate: -

1. Collateral: The assets/security which are retained or deposited with bank against grant of any loan advances, debt or credit lines. The typical examples are
   • Cash or cash equivalents – Cash or Hand loans
   • Gold Pledging
   • property including land and building
2. Risk-based pricing: Where the lender feels that borrower is more likely to do default, the lender may increase the interest rate.
3. Credit insurance: The lender may purchase the credit insurance under which the risk is transferred from lender to the issuer on payment of certain amount. The best example is the housing loan insurance.
4. Third Party Guarantee.

2. Market Risk is pricing risk determined by supply and demand and includes interest rate risk, exchange rate risk, equity price risk, and commodity price risk. It may be appropriate to measure market risk in terms of changing market value. It is the largest component of risk for a financing company. Market risk is the possibility for an investor to experience losses due to factors that affect the overall performance of the financial markets in which he has invested money.

How to Mitigate: - The financial institution can use various derivative strategies including the use of exchange rate derivatives, interest rate derivatives including CDS and interest rate swaps, forward contracts and also some forms of insurance instruments are also available in the market to protect against some of the above losses which impact profitability.

3. Liquidity Risk :(market liquidity risk) As financing companies invest a part of the available funds in securities there is the possibility of sustaining significant losses due to the ability to take or liquidate a position quickly at a fair price – (reasons being - adverse bid-ask spread, during crises – not able to sell stock/ or sell at huge discount). It can be difficult to measure because liquidity can appear adequate until adverse events occur.

How to Mitigate: - Mitigating these risks also require the use of derivative instruments such as futures and options on stocks prices to avoid the downsizing risk including stock price swaps.

4. Operational Risk- risk associated with the operations of an organization. It is the risk of loss resulting from failure of people employed in the organization, internal process, systems or external factors acting upon it to the detriment of the organization. It includes Legal Risk and excludes strategic and Reputational Risks as they are not quantifiable

How to Mitigate: - These risks can be mitigated by using strong internal controls on the processes and by using insurance instruments

Some other forms of risk which also require close consideration and mitigation are:

5. Fraud risk – risk of control failures, management override and deliberate acts of omission and commission that lead to financial losses

6. Compliance Risk – It includes material financial loss or loss of reputation which may occur as result of its failure to comply with the laws includes, regulations, rules, related self-regulatory organization, standards and code of conduct applicable to its business activities.

7. Technology risk – risk of not keeping pace with the fast changing technologies for business operations. Usage of outdated technologies could impact the business operations adversely thereby resulting in loss of reputation, market share, customers, etc.

By keeping on these risks in check at appropriate levels by using various risk mitigation techniques the financial institution is able to avoid/ reduce the impact of significant loss in case an adverse event occurs. As a result of risk management the financial institution can avoid/reduce catastrophic impact of the above risk on the functioning and profitability of the organisation.