A Critical Analysis of Risk Management at Financial Institutions

Financial institutions exist to improve the efficiency of the financial markets. If savers and investors, buyers and sellers, could locate each other efficiently, purchase any and all assets costless, and make their decisions with freely available perfect information, then financial institutions would have little scope for replacing or mediating direct transactions. However, this is not the real world. It seems appropriate to begin the discussion of the place of risk and risk management in the financial sector with the two key issues, viz., why risk matters and what approaches can be taken to mitigate the risks that are an integral part of the sector's product array. Understanding these two issues leads to a greater appreciation of the nature of the challenge facing managers in the financial community. Specifically, it explains why managers wish to reduce risk, and approaches taken to mitigate something that is an inherent part of the financial services offered by these firms. According to standard economic theory, firm managers ought to maximize expected profits without regard to the variability of reported earnings. However, there is now a growing literature on the reasons for managerial concern over the volatility of financial performance, dating back at least to 1984. Alternative theories and explanations have been offered to justify active risk management, with a recent review of the literature presenting four distinct rationales. These include: (i) Managerial self-interest (ii) Tax effects (iii) The cost of financial distress (iv) Capital market imperfections In each case, the volatility of profit leads to a lower value to at least some of the firm's stakeholders. In the first case, it is noted that managers have limited ability to diversify their investment in their own firm, due to limited wealth and the concentration of human capital returns in the firm they manage. This fosters risk aversion and a preference for stability. In the second case, it is noted that, with progressive tax schedules, the expected tax burden is reduced by reduced volatility in reported taxable income. The third and fourth explanations focus on the fact that a decline in profitability has a more than proportional impact on the firm's fortunes. Financial distress is costly and the cost of external financing increases rapidly when firm viability is in question. Any one of these reasons is sufficient to motivate management to concern itself with risk and embark upon a careful assessment of both the level of risk associated with any financial product and potential risk mitigation techniques. Accepting the notion that the volatility of performance has some negative impact on the value of the firm leads managers to consider risk mitigation strategies. There are three generic types: (i) Risks can be eliminated or avoided by simple business practices, (ii) Risks can be transferred to other participants, and, (iii) Risks can be actively managed at the firm level. The importance of managing credit risk for banks is enormous. Banks and other financial institutions are often associated with risks that are facing particularly financial. These institutions must balance the risks and returns. Consumers have a basis for a large bank that has credit products that are quite reasonable. However, when low interest rates on bank loans and also suffer losses. In terms of equity, a> Reserve Bank must have a significant amount of capital for him, but not too much that is non-investment income and not too little, which leads to financial instability and the risk of non-compliance. Management of credit risk, the financial terms, refers to the process of risk assessment, which comes in a plant. The risk is often investing and capital allocation. Risks must be assessed in order to develop an informed investment decision. Similarly, the assessment of risk in coming to, risks and rewards of the assets is essential. Banks are increasingly faced with risks. There are some risks in the process of granting loans to certain customers. There may be more risk if the loan is extended to worthy borrowers. Some risks may occur even if banks offer securities and other investments. The risk of losses that is in default by the debtor a kind of risk that is expected. Because of banks' exposure to many risks, it is only reasonable bank, hold significant amount of solvency capital to protect and preserve for its economic stability. The second Basel Accord provides statements of its rules for the regulation of the Bank in relation to the level of risk the bank is exposed to the allocation of capital. The larger the bank is exposed to the risks, the greater the amount of capital is required if comes to its reserves to maintain the solvency and stability maintained. To determine the risks that come with investment and lending practices, banks must assess the risks. Credit Risk Management must therefore play its role of banks in accordance with Basel II and other regulatory authorities. Management and risk assessment for banks, it is important to ensure monitoring of the estimate, the conduct and performance evaluations of the lead bank. But because banks in the practices of credit and investment, it is important to make evaluations of credit and to ask questions and analyze portfolios. Loan reviews and portfolio analysis are crucial in determining the risks of lending and investment. The complexity and the emergence of various securities and derivatives is a factor that banks must be active to take risks. The management system of credit risk used by many banks today, the complexity, however, there may in assessment of risks through the analysis of aid Loans and determine the likelihood of errors and risk of loss. Credit Risk Management for banks is a very useful, especially if the risks are consistent with the survival of banks in business.

Cite this page