Risk Facing Financial Institutions Review

Introduction

In any economy the market participants look for the services of the financial institution since they have the ability to provide a detailed knowledge about the market, transaction efficiency, and enforcement of different contractual arrangements. In view of the nature of products being dealt with the financial institutions as also the nature of transactions the institutions are exposed to different kinds of risks.

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The risk management in the financial institutions center round two basic issues as to the impact of risk on the functioning of the financial institutions and the ways in which the institutions can work to mitigate the potential risks involved which form an integral part of the products of the financial institutions (Stulz 1984). The available literature points out four distinct reasons for practicing risk management in any financial institution. They are:

  1. self interest of the managerial people involved in the business processes of the financial institutions,
  2. impact of taxation,
  3. the cost of financial distress and the resultant economic losses
  4. capital market imperfections (Santomero, 1995)

In each of the above instances there is volatility in the profits which may result in a reduction of the firm’s value to some of the stakeholders. Any one of the above reasons would have the effect of motivating the management to make a careful assessment of the risks associated with the different products and techniques for risk mitigation. This paper attempts to identify the various risks facing financial institutions and presents a report on the ways to manage the different types of risks.

Approaches to Risk Mitigation

There are there general methods of mitigating the risks in the financial institutions:

  1. the firms can employ simple business practices which has the capabilities of eliminating or avoiding risks
  2. the firms can try to transfer the risks to other market participants and
  3. there can be an active risk management programs at the firm level

In the first of the above three methods, the practice of risk avoidance reduce the chances of the firms accumulating losses by the elimination of risks which are superfluous to the business processes. The financial institutions follow actions like underwriting standards, hedging to match the assets and liabilities, reinsurance or syndication to spread the risks and due diligence investigation. In these actions the main objective is to make the firm get rid of the risks that are not part of the financial services provided or to absorb only an optimum level of a particular risk.

In the case of systematic risks it is possible to reduce the systematic risks that are not required to continue to do the business can be eliminated. Similarly in the case of operational risks, the firms can adopt different ways to reduce the different kinds of risks including fraud, oversight failure, lack of control and managerial limitations. However it must be noted that aggressive risk avoidance measures in these areas may result in lowering the profitability to some extent but enough cost justification can be communicated to the shareholders for the reduction in the earning.

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Risk transfer is another method of mitigating a substantial part of the risks. Risk transfer is achieved by the firms through transferring the assets created by the financial institutions at a fair market value at the open market. The firms undertake the transfer of these assets if they find no comparative advantage in managing the attendant risks. Usually there exists a market for the claims issued and are assets created by many of the financial institutions and there are individual market participants who undertake to acquire these assets for diversification of portfolios.

There is another set of risks where the risk is inherent in the business activities of the financial institutions and they must be absorbed by the firms themselves. In these cases the firms should practice aggressive risk management techniques and the firms are expected to employ additional resources for managing these risks. These risks possess certain special characteristics:

  1. There are the equity claimants for whom the institutions own a fiduciary liability who own claims that cannot be traded or hedged even by the investors themselves. Example in this connection is the defined pension plans schemes
  2. There are activities that carry risks of complex nature like the case of illiquid and proprietary assets being held by the banks (Santomero and Trester, 1997)
  3. The existence of moral hazard in which the stakeholders’ interests need to be protected by adopting different risk management techniques as part of the operating procedures
  4. Any risk management process is central to the business purposes.

Financial Service Products and Associated Risks

Before an analysis of the risks associated with the financial services products and the ways of mitigating them, it becomes important that an overview of the financial services being provided by the financial institutions is undertaken. The financial services provided by the institutions can be categorized under the following groups (Merton 1993; Merton and Bodie, 1995):

  1. Origination – involving location, evaluation and creation of new financial claims issued by the institutions’ clients. The originator depending on his plans to retain the ownership of the new asset or sell the product he takes the position of the principal while retaining the ownership and an agent as while trying to sell the asset. An example of the originating function is that of the mortgage banker
  2. Distribution – represents the act of selling newly originated products to different customers who have the ability to finance them. The institution may act as a broker or as a principal. In this case the financial institutions do not take the ownership of these assets but acts to place the assets in the portfolio of the potential investors.
  3. Servicing – facilitates the collecting the payments due from the issuers and settling the claimants. The service provider in this process maintains records of payments, monitors the financial contracts, and takes necessary action in case of defaults. This kind of activity is more prominent in the developed nations. Most of the assets in this case are held by the same institution.
  4. Packaging – is of recent origin and involves collection of individual financial assets in to common pools, and then is repackaged with a view to increasing the liquidity or meeting the cash flow requirements of specific customers.
  5. Intermediating – is the most popular financial service undertaken by the institutions which involve the practice of issuing and purchasing of different financial claims to a single financial entity. There are three different kinds of financial intermediating that are common; they are: (i) insurance underwriting (ii) loan underwriting and (iii) security underwriting which involves the acquiring of securities as principal to distribute to different investors.
  6. Market Making – is an activity where a dealer buys and sells identical financial instruments. But the market maker does not become the principal in the transactions. A market maker becomes an intermediary when it finances the transactions by issuing its own claims and acquires financial assets.

In all the above transactions it is important that a distinction is made between the principal and agency activities, since the risks and incentives are quite different for the two positions. While a principal commits a capital risk in terms of both time and money, the agent works for someone and hence there is the risk of time only. In the agency business the capital investment is modest whereas in the case of the principal activity there is a heavy investment of capital outlay.

Since the principal owns a portfolio there is the systematic and idiosyncratic risk. In the case of agency there is only the idiosyncratic risk.

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Kinds of Risk involved in the Financial Service Products

Out of the above classification the originators, distributors, service providers, and packagers can be considered as having the agency characteristics and the intermediaries and market makers represent principal business makers. The agency services act to provide market access to the buyers and sellers of financial instruments and hence expose the service provider to a minimum of risks.

The businesses where the service providers act as principals place a significant amount of capital on the interaction between the buyers and sellers. In fact in these areas that the financial institutions expose themselves to major risks and hence there is the need for an effective risk management program. Both the intermediary and the market maker are not covered entirely for the risks associated with their activities and hence it may be necessary that its investors may have to bear some part of the risks associated with the activities of these financial institutions.

The risks borne by these institutions can be broken down into five general categories of risks:

  • Systematic risks
  • Credit risks
  • Counterparty risks
  • Operational risks and
  • Legal risks

Systematic Risks

Systematic risk is the risk of changes in the asset values which are the result of systemic factors. The institutions can at best hedge against most of these risks but can not completely do away with them. The systematic risks are faced by the institutions as a result of the impact of the economic conditions on the values of assets owned or claims issued by the institutions. The best example of the systematic risk is the change in the values of assets and liabilities as a result of the changes in the interest rates. Due to changes in the market rate of interests, unpredictable changes occur in the value of different assets and liabilities. Similarly large scale changes in weather may influence the value of real estate assets.

The institutions that may experience a significant impact on their balance sheets due to systematic risks try to mitigate these risks by a careful estimation of the impact of the particular systematic risks and limit their sensitivity to these risk factors which can not be avoided. This forces those institutions which are exposed to larger fixed income market take efforts to closely monitor the interest rate movements closely and adjust their exposures accordingly (Esty, Tufano and Headly (1994) and Santomero (1997). They do it more rigorously than those firms which have very little exposures to risks in their portfolios.

Credit Risks

Credit risks arise due to the non-performance of a debtor and these risks usually arise either the debtor is unwilling or unable to perform according to the already committed contract terms. This has its effect on the lender who underwrote the loan, other people who advanced money to the creditor as well as the shareholders of the debtor himself. In fact a major part of credit risk is the culmination of the systematic risks and the unusual losses associated with these risks pose a problem for the creditors in spite of the benefits of diversification from the whole uncertainty. This is applicable especially to the creditors who advance amounts in the local market against the security of the illiquid assets (Morsman, 1993)

Counterparty Risks

The counterparty risks result from the non-performance of a trading partner. The trading partner may refuse to perform either due to an adverse price movement caused by the operation of the systematic risks or due to any other political or legal constraint that was not expected to happen by the actors. The non-systematic counterparty risks can be mitigated by undertaking diversification in a wide scale. Though counterparty risk can be equated with the credit risks, it can be considered as a transient financial risk resulting from a trading activity, different from the default of a debtor. There may be several other reasons for the counterparty risk to arise other than the credit issue.

Operational Risk

The operational risks take the form of errors in record keeping, computing errors in calculating the payments, processing system failures and non-compliance with some regulatory requirements. The operational risks results in issues relating to processing, settling and providing, and securing delivery of trades in exchange for cash. Thus though individual operating issues pose smaller risks to the well managed organizations, they may some times expose these firms to larger exposure of economic losses.

Legal Risks

Legal risks are distinct from the legal impacts of other kinds of risks like credit, counterparty and operational risks dealt with above. These risks stem from the operation of new statutes, court rulings, or new regulations which have the effect of making even the previously properly done transactions to contentious ones. These risks appear even when all the parties who performed well in the past and are able to perform better in the future.

For example the introduction of new bankruptcy laws may create new risks for corporate bondholders. Similarly there may be significant impacts on the real estate values due to changes in the environmental regulations. There is yet another kind of legal risk that may arise due to the institution’s management practices or the action of its employees. Accounting and other frauds, violations of securities laws and other mis-deeds can result in large economic losses.

Risks facing Agency Activities

All of these risks occur in the operation of all financial institutions. However institutions involved in non-principal or agency activities experience primarily the operational risks. This is so because these institutions have not invested capital in acquiring the underlying assets in which they deal. The systematic, credit and counterparty risks arise to those who own the assets. If the asset holders incur a financial loss, they have the option of proceeding against the institutions as agents and this makes the institutions exposed to some legal risks, that too indirectly.

Risks facing Product Diversification by Financial Institutions

The financial system in the United States has traditionally been characterized by segmented product lines. The ability of the financial institutions operating in one of areas of the financial services area to expand its product lines in other areas has been obstructed by the regulatory measures and the regulations imposed by them. The commercial banks are the most affected institutions due to product diversification restrictions. (Chapter 21 – pp 616)

For instance due to the restrictions on the franchise of the banks they had to limit their activities to the traditional deposit taking and commercial lending. This has allowed the non-banking competition from the money market mutual funds which provide high liquidity, stability of value and attractive returns to the investors. The product restrictions have also limited the ability of the managers of the financial institutions to increase their flexibility to adapt their organizations to the changed demands of the consumers to newer products in the financial services industry. (Chapter 21 – pp 617)

Commercial Banking and Investment Banking

The financial services industry in the United States involves themselves in investment banking, insurance and commercial banking. In the case of investment banking area, the Glass-Steagall Act imposed a significant demarcation between commercial banking activities like deposit mobilization and commercial lending and the investment banking activities like underwriting, issue of securities and distribution of stocks, bonds and other securities.

The Act provided for the limitations in the abilities of banks and security firms to indulge in each other’s activities. However the Act permitted the commercial banks to underwrite new issues, municipal general obligation bonds, and private placements of bonds and equities. The commercial banks were subsequently allowed to set up investment banks and finally the Financial Service Modernization Act removed the differences between commercial banking and investment banking.

Commercial Banking and Insurance

Prior to the passing of the Financial Services Modernization Act there existed strong barriers of the commercial banks to enter into the insurance business (Chapter 21 – pp 620). In the analysis of the role of the commercial banks in the insurance business a distinction is to be made between a bank acting as an agent in selling other financial institutions’ insurance policies for a fixed commission and the bank acting as an insurance underwriter and thus taking the risk involved in bearing the underwriting losses. Prior to the passing of the Act the banks were under severe restrictions for selling and underwriting any type of insurance.

The Financial Services Modernization Act, 1999 changed the scope of the insurance activities by allowing the bank holding companies to float insurance companies and underwriting affiliates and financial services holding companies.

Commercial Banking and Commerce

After the passing of the Financial Services Modernization Act there have been a lot of changes in ownership limitations imposed on financial service holding companies. Commercial banks belonging to a financial service holding company can now take part in the activities of a non-financial enterprise subject to certain conditions. This has increased the exposure of the commercial banks to a number of non-banking financial service areas and products.

Issues involved in the Product Diversification

Irrespective of the areas in which the commercial banks would like to expand be it the securities activities, insurance business or other commercial products there are certain issues that the institutions have to face in furtherance of their functions. They are discussed below:

Safety and Soundness Issue

Considering the securities activities of the commercial banks there are two basic issues that have an influence on the risk exposure of the institutions. One is the riskiness of the underwriting of securities and the other issue is that in case there are losses incurred by the securities subsidiary, the impact of such losses on the affiliated bank’s financial standing.

Risk of Underwriting Securities

In any underwriting activity there is a cap on the upside return from underwriting while the risk from downside risk can make the firms incur heavy losses. When the underwriter overprices the public offerings at prices higher than investors’ valuations, the downside risk increases as the firm may not be able to sell the shares during the period the public offering is open. The firm may subsequently have to lower the prices and to get rid of the stock of shares.

The firm has to necessarily do this, as the institution would have financed the stock of shares by issuing commercial paper or repurchase agreements. Under this situation there are a number of reasons for the firm to incur heavy losses. The primary reason is that the institution would have over estimated the market demand for the shares. Secondly there would have occurred, other events that had affected the security values adversely in general.

Impact of the Losses of the Securities Affiliates on a Bank

There are at least three possibilities under which the bank may get financially affected by the losses in the securities affiliate.

  • The financial services holding company would draw capital and funds excessively from the bank by way of dividends and fees which is known as upstreaming. The bank would also have no other alternative except to heed these requests to protect the failing securities affiliate.
  • The second possibility is that the securities affiliate would have induced the bank to provide inter-affiliate loans to keep the affiliate afloat. These loans are considered as excessively risky as there are no guarantees that these will be repaid by the affiliate
  • The third risk the bank is running is through a contagious effect which may affect the confidence of the financial services customers and investors and may provide wrong signal to them about the financial management capabilities of the bank due to the failure of the securities affiliate.

Economies of Scale and Scope

The second issue concerning the expansion of the banks into other areas of activities arises due to the potential for additional economies of scale and scope. After the removal of restrictions in the year 1977 and also after the passing of the Financial Services Modernization ‘Act in the year 1999 the financial services firms in the US have realized greater economies of scope and as such are exposed to larger risks.

Conflicts of Interest

The third issue for the banking companies for expanding into other areas emerges because of the potential for conflicts of interest. There are two basic issues that need to be addressed by the banking institutions in this respect. They are:

  1. Potential conflicts of interest arising from the activities in the securities area
  2. actual conflicts arising because of the incentive structures.

The conflicts of interest may arise due to:

  • The stake involved of the sales persons in selling the non-bank financial service products
  • Stuffing of the fiduciary accounts where the bank would stuff the shares which it has underwritten and unable to sell on to the accounts on which the bank can exercise control
  • Bankruptcy risk transference undertaken by the bank to save a potential insolvent firm by inducing them to issue bonds and underwrite them
  • Third party loans where the bank may advance loans at cheaper rates to third parties with the implied conditions that the parties would use these funds to invest in the shares underwritten by the bank
  • The bank may use its lending power to influence a customer to invest or purchase the products being dealt with by it
  • During the process of dealing in securities the bank may come into possession of certain information about the customers or rivals which it may use for setting the prices of securities.

Deposit Insurance

The deposit insurance is another issue which enables the banks to raise funds at subsidized costs and the funds so raised are used to lend money at cheaper costs to their affiliates. This is a highly risky proposition while the bank deals with the other people’s money.

Regulatory Oversight

Since the banking companies are allowed to enter into a number of other financial services activities the monitoring and control of the conflicts of interest in these firms and other abuses and excessive risk taking have become beyond control and this has resulted in an increased exposure of the financial institutions to various risks.

Competition

Competition in the investment banking product lines has increased the excessive risk taking attitude of the banking institutions. Bank expansion increases market concentration and the monopoly powers of the banks over the customers. There are three factors that enhance the competition among the banks:

  • Increased access of the capital markets by the smaller firms.
  • The reduced rates of commissions and fees.
  • The reduction in the under-pricing of the new issues.

Thus the risks involved in the enhanced activities in the financial services expose the banks and other financial institutions to greater risks.

Geographic Diversification

Just as the product diversification enables the financial institutions to reduce risk and increase return the geographic expansion would also enhance the earning capabilities of the financial institutions. The geographic expansion may relate to domestic expansion as well as expansion globally. Expansion can be effected by the opening and operation of new branches or by the process of acquiring another financial institution. There are various dimensions involved in the risk management strategies of the financial institutions by resorting to the geographical expansion. The domestic expansions are normally effected through mergers and acquisitions. The international and cross border expansions also enhance the capabilities of the financial institutions.

Domestic Expansion

In the United States the efforts of the financial institutions to expand domestically have been subjected to severe legislative constraints. (Chapter 22 – pp 644) While there were no restrictions imposed on the multinational firms and even securities firms, the financial institutions especially the banks have been facing a complex and changing framework of rules and regulations in expanding their business. The attractiveness and the desirability to expand by the financial institutions domestically have largely been influenced by the following factors among other things:

  1. The prevailing current regulations and regulatory frameworks governing the financial institutions
  2. The synergies involved in the cost and revenue of expanding
  3. The factors that are specific to the market and the firms

Based on the above factors the geographic expansion of the financial institutions is controlled and depending on the level of expansion the risk level of these institutions is also increased.

Conclusion

Implementation of a firm-wide risk management practice involves a serious commitment of the top management time and resources of the institutions. The risk management must have a focus on the central business activities, a complete review of lending patterns, trading or market making and intermediating operations of the firm from the angle of risk management. Such approach leads to the construction of a data base and a reporting system that is superior in all respects than the normal accounting and reporting system which may not have the ability to identify the risk factors and their impact on the profitability of the firms.

This process of risk management requires a number of guiding principles that facilitate the smooth implementation of the firm level risk management techniques. This also requires the risk management to be an integral part of the overall business plan of the company.

Any decision of the firm to take up or leave or to focus on any business activity or process needs a careful assessment of the risks to which the firm is exposed as well as the potential returns that the firm can expect by undertaking or discarding the business process or activity. The risk management techniques for each of the business activity that is being continued must be specified and followed. Finally those business activities which are not forming part of the focus of the institution must be eliminated so that the avoidable risks can be eliminated.

References

Esty, B., P. Tufano, and J. Headley, “Banc One Corporation: Asset and Liability Management,” Journal of Applied Corporate Finance, (7)5.

Merton, Robert C. (1993) “Operation and Regulation in Financial Intermediation: A Functional Perspective,” in Operation and Regulation of Financial Markets, pp.17-67, P. Englund (ed.), Economic Council, Stockholm, Sweden.

Morsman, E. (1993) Commercial Loan Portfolio Management, Robert Morris Associates, Philadelphia

Santomero, A.M. (1995) “Financial Risk Management: The Whys and Hows,” Financial Markets, Institutions and Instruments 4(5):1-14.

Santomero, A.M., and J. Trester (1997) ‘Financial Innovation and Bank Risk Taking’ Journal of Economic Behavior and Organization.

Stulz, R., (1984) “Optimal Hedging Policies,” Journal of Financial and Quantitative Analysis 19(2): 127-40.

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