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
· 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.