Question

Describe financial institution risk exposures and how to manage these risks. Hint: risk exposures show themselves both within quoted interest rates and on financial institution’s balance sheets. The institutions try to manage those risks both on and off the balance sheet. Given the COVID-19 environment, your answer should definitely include a discussion of how default risk has become more apparent in the last couple of months.

Answer 1

What is Financial Risk?

Financial risk is the possibility of losing money on an investment or business venture. Some more common and distinct financial risks include credit risk, liquidity risk, and operational risk.

Types of Financial Risk:

Financial risk involves mainly in two types as Internal & External risk. Internal risk can be including Poor management and lack of Employee/staff coordination, and External risk comes from competition, the overall market and changing customer needs. Operational risk, Credit risk, Market risk & Liquidity risk are the sub parts of Financial Risk.

Major sectors of Finance are as follows:

Central banks, retail and commercial banks, internet banks, credit unions, savings, and loans associations, investment banks, investment companies, brokerage firms, insurance companies and mortgage companies.

How to manage Financial Risk?

1) Write a business plan. The process of writing and putting together a business plan is a vital step to assessing, evaluating and planning for the risks of running a business from the various standpoints of the business. This includes operations, finance and marketing.

2) Depending on the business activities, you need to determine the other types of insurance and obtain the correct coverage for your business.

3) Prepare with business risk management plans. The plan also lists the steps, procedures and ways in which the business intends on dealing with the risk as it arises.

4) To avoid risk and how to manage risk main factor includes is Training employees. Training employees can help the business avoid further damage or exposing itself to risk in the first place.

5) Update plans. Even the best of planning efforts may fall short, so when the business is exposed to a risk, react accordingly and then put a formal plan and procedure in place in case the same risk occurrence happens again.

Effect of COVID 19 on Financial Sector:

Corona virus has had so far on credit risk. We highlight company-, industry-, and country-level dimensions of the pandemic’s repercussions, including both risks and opportunities. In terms of investment ideas, we examine the performance differential between high- and low-EDF bonds in investment grade and high yield, showing that low default risk bonds have strongly outperformed during the international phase of the pandemic. Stocks of low EDF firms also outperform among large cap US and European equities, providing cross-market evidence of the flight-to-credit-quality phenomenon. Finally, we lay out projected paths for default risk conditional on a Pandemic macroeconomic scenario to illustrate which industries are most likely to be affected.

News of the corona virus began to appear in global media in late December, but it wasn’t until mid-January—when reports emerged that the virus was no longer contained within China and had spread to the rest of Asia—that financial markets began to react. Fortune 500 companies such as Samsung and Apple suspended some Chinese production1 and issued profit warnings,2 immediately affecting their stock value. The decline in stock prices has since spread to most public companies across all major economies. The CreditEdge public-firm EDFTM (Expected Default Frequency) model takes a company’s stock price as an input to its credit-risk metrics. The EDF is the CreditEdge trademarked name for probability of default (PD), and we will use the acronyms EDF and PD interchangeably throughout. We are now seeing EDFs rising in response to stock price declines in many countries since around January 20, 2020, when the coronavirus pandemic began to spread internationally.

One key finding of our research is that while the rise in EDFs is broad and troubling, it is not equally deep. The extent of the rise in default risk varies significantly by industry and country, as well as the country’s exposure to the COVID-19 pandemic shock and how risky the corporate sector was before the pandemic.

To place the current situation in context, Figure 1 shows the median EDF for all publicly listed firms, back to 1998. Recent data (as of March 12, after the Dow Jones fell 10%) show a median EDF of 0.74%. This is materially higher than the end-2019 figure of 0.48%, but remains low when when compared to past crises. Indeed, we do not have to look too far into the past to find a period of similar credit stress; in early 2016, in the wake of the oil price bust, the median EDF was slightly higher (0.76%) than it was as of March 12, 2020.