Risk in financial services: An Overview
Today financial services companies operate in increasingly complex, competitive and global markets. The ability to manage risks across geographies, products, asset classes, customer segments and functional departments is of paramount importance and inability to manage the risk can cause the irreparable damage and financial risks are increasing day by day especially in insurance, commercial banking and investment banking. The objective of this paper is to give the overview if risk in financial services.
The art of managing risk is more challenging than ever. Risk managers face a wide range of demands, from working with multiple variables to finding technology solutions that generate comprehensive risk analysis. Now question arises
What is risk.
Risk is exposure to uncertainty.
Thus, risk has two components: Uncertainty and Exposure to that uncertainty. In financial services a spectator is like a person who is going to jumps out of an airplane with a parachute on his back, he may be uncertain as to whether or not the chute will open. He is taking a risk because he is exposed to that uncertainty. If the chute fails to open, he will suffer personally. The financial services industry is primarily concerned with financial risk which is financial exposure to uncertainty Types of financial risk
Main types of risk are:
Credit risk : Credit risk is risk resulting from uncertainty in a counterparty's ability or willingness to meet its contractual obligations. A housing finance company extends a housing loan to a client. Because the client could fail to make timely principal or interest payments, the housing finance company faces a credit risk.
Operational risks: During the 1990s, financial institutions started to focus attention on the risks associated with their back office operationsâ€ what came to be called operational risks or operational risk are all risks other than market or credit risks. A broker's back office fails to catch a discrepancy between a reported trade and a confirmation from the counterparty. Ultimately, the trade could be disputed, causing a loss.
Market risks : Market risk is the financial risk of uncertainty in the future market value of a portfolio of assets and/or liabilities. Institutions can actually reduce these risks simply by researching them. A brokerage firm can reduce market risk by being knowledgeable about the markets it operates in.
Market risk exist in many forms.
Financial Institutions : Risks arises from financial transactions entered into for the purpose of facilitating a client's requirements.
Investor : the exposure arises from the risk of loss in value of investments (directly or indirectly through derivative products) from adverse movements in the value of asset.
Manufacturing Companies : the risk relates to the financial attributes of business transactions.
Liquidity risk : is financial risk from a possible loss of liquidity. There are two types of liquidity risk:
Specific liquidity risk is the risk that a particular institution will lose liquidity. This might happen if the institution's credit rating fell or something else happened which might cause counterparties to avoid trading with or lending to the institution.
Systemic liquidity risk :affects all participants in a market. It is the risk that an entire market will lose liquidity. Financial markets tend to lose liquidity during periods of crisis or high volatility.
Role of Technology in Risk Management
For many institutions such as banks, investment management firms, insurance companies, brokerage firms, technology is a critical component of any risk management initiative. For institutions which rely heavily on technology, there is always a risk technology becoming the focus of risk management. It is important to recognize that the risk management is primarily about people â€œ how they think and how they interact with one another. Technology is just a tool. In the wrong hands, it is useless, but applied appropriately, it can transform an organization. A good approach would be to start by planning a risk management strategy focusing on procedural and cultural issues of risk management. Technology can reshape corporate cultures and facilitate innovative procedures. Technology can provide the information but before information can be processed, analyzed or acted upon, the right information must first be made available at the right time to the systems and individuals who need it. So that they can work on that information and avoid the risk
Before an enterprise can attempt to manage risk on an enterprise wide basis, it first must collect and communicate all necessary information relating to those risks. Today, technology makes it possible to effectively communicate information â€œ across desks, across departments and across globe. This technology is called data aggregation.
Now question arises how much risk one is taking:
This question is so simple â€œ and yet so profound. In one form or another, it underlies enterprise risk management. In the past, organizations would look at Profit & Loss statement to answer the question. Volatile profits meant high risk. A problem, however, is that profit & loss is a retrospective and historic indicator of risk. Indeed, for many risks, profit & loss statement may reveal little or no information. In order to manage risks, organizations need to be able to measure those risks prospectively. They need to know, based on their current position, how much risk are they taking. Organizations are addressing this challenge with statistical risk measures. For market risk, value at risk is being used. For credit exposure, measures such as expected exposure or maximum exposure are being used.
Conclusion : Risk management is a continuously evolving mix of science and art. Losses are inevitable, but one must keep learning from the past. Risk itself is not bad, but risk that is misplaced, mismanaged, misunderstood, or unintended is bad. Each institution needs to assess which method best suits its objectives, its business, its view of the world and its pockets. A clear distinction should be made between risk management and risk taking. Risk management oversees and ensures the integrity of the process with which risks are taken. To maintain the objectivity, risk management cannot be a part of the risk taking process. Individuals who manage risk need to be completely independent from individuals who are responsible for taking risk.