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Financial regulations, risk management and value creation in financial institutions: evidence from Europe and USA

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par Agborya-Echi Agbor-Ndakaw
University of Sussex - Master of Science 2010

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2.5 Types of Risks within Financial Institutions

The main objective of financial institutions is to maximise shareholders value by mobilizing deposits and lending to firms and clients having investment projects. Financial institutions always try to make things possible for the income to exceed the interest paid on deposits, borrowings as well as all operating costs. In an attempt to pursuit the aforementioned

objective, financial institutions are faced with a number of risks of which some include credit risks, liquidity risks, interest rate risks, foreign currency risks, operational risks (mistakes and fraud committed by staffs), technological risks (power and equipment failures that lead to data loss), product innovation risks (new products failing), competitive risks, regulatory risks (sanctions for violations of regulatory norms), etc.

Note that of all the risks types mentioned above, the two most important risks however are the interest rate and the credit risks. This is because problems in these areas often lead to liquidity crisis and bank failures. As such, if an institution happens to face an increase in the interest rates on its liabilities and at the same time, fails to increase its interest rate charged on loans to its clients due to competition, then the said institution can become compromised.

Similarly, if an institution results in a series of bad loans that cannot be recovered, its viability can be threatened. Nevertheless, most of the other risks do not usually pose fatal threats. As a result, many of the other risks would need to be combined in order to trigger a crisis. Because risk is considered to involve elements such as feelings of control and knowledge, it is understood that risk perceptions are influenced by socio-cultural factors including trust and fairness. Statistics have proven that the business world (market) is never perfect, that explains the reason of the introduction of the SWOT(Strength, Weaknesses, Opportunities and Treats) analysis since any imperfection caused by any individual will merely be used as an opportunity for some body else (Chromow and Little, 2005).

Some economists claim that one of the causes of the outbreak of the 2007-2009 global financial crises was as a result of some risks taken by financial institutions and banks. As such, because of this crisis, banks have become reluctant to lend to other banks because they are not ready to pay the price for any risk what so ever within the financial sector. As a result of this behaviour, it will be ideal to get an in-depth knowledge of the different risks types existing within financial institutions. Some of the risks faced within financial institutions include:

· Systematic (undiversifiable) risk: this risk type is caused by changes associated with systemic factors. As such, this risk type can only be hedged but cannot be diversified. This risk type come in many different forms, for example, changes in interest rates and government policies.

· Credit risk: This risk arises as a result of the debtor's non-performance. This may arise either from the debtor's inability or unwillingness to perform in the pre-committed contract manner. This is because many people will be affected, that is, from the lender who underwrote the contract to other lenders to the creditors as well as to the debtor's shareholders. Credit risk is diversifiable but difficult to perfectly hedge.

· Counterparty risk comes from the non-performance of a trading partner. This may be as a result of the counterparty's refusal to perform due to adverse price movement caused by some political constraint that was not anticipated by the principals. Diversification is the main tool for controlling counterparty risk.

· Operational risk is the risk associated with the problems of accurately processing, settling, taking and making delivery in exchange for cash. It also arises in record keeping, computing correct payments, processing system failures and complying with various regulations. As such, individual operating problems are small but can easily expose an institution to outcomes that may be very costly.

· Legal risks are endemic in financial institutions. This is in the sense that financial contracting is separate from legal ramifications of credit risk, counterparty risk as well

as operational risk. New statutes and regulations can put formerly well established transactions into contention.

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