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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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2.7 Reasons for Risk-taking in Financial Institutions

In spite of the dangers associated with risk-taking and the procedures involved in measuring and managing these risks, some if not all financial institutions still take on to these risks. The question now wondering in our minds is why these institutions need to take on those risks. In order to answer this question, it will be good for us to look into the reasons for financial institutions taking risks. Because this will help us to better understand the need for taking such risks.

It will be ideal to begin by discussing the place of risks and risk management within financial institutions. This can be done by stressing on why `risk' matters and what approaches can be taken to eliminate or reduce these risks. Understanding these, will very much help managers and investors who are faced by these challenges within the financial sector.

The prime goal of every manager is that of profit maximisation. This implies managers ought to maximize their expected profits regardless to the variability of the reported earnings. However, today, there is a growing literature on the reasons for managerial concern over the volatility of financial performance within financial institutions. This is justifiable with the following reasons because any one of these reasons is sufficient enough to motivate management to concern itself with risk and embark upon careful assessment of both the level of risk associated with any financial product as well as any potential risk mitigation. Managerial self-interest, tax effects, the cost of financial distress and capital market imperfections are all potential risk mitigation techniques.

Note that managers have limited ability when it comes to diversifying their investment. This fosters risk aversion as well as a preference for stability. The progressive tax system takes care of the tax effects. This is because, with this system of taxation, the expected tax burden is reduced by reduced volatility in reported taxable income. Financial distress on its own is

costly and the cost of external financing increase rapidly when the financial institution viability is in question. Accepting the fact that the volatility of performance has some negative impact on the value of these financial institutions, leads managers in considering some risks mitigation strategies. Some of these include:

· Risks being eliminated by simple business practices- here the practice of risk avoidance involves actions to reduce the chances of idiosyncratic losses by eliminating such risks that are superfluous to the institution's business purpose.

· Risks being transferred to other participants-there are some risks that can be eliminated or reduced through the technique of risk transfer.

· Risks being actively managed-here there must be good reasons existing for using further resources to manage risks. This is because risk management is central to its business purpose.

In each of the above cases, the goal of the institution is to get rid of the institutions' risks that are not essential to the financial services provided. Financial institutions take such risks because they know how to deal with them either through eliminating, transferring or actively managing the risks. Remember, risks and returns are directly proportionate, the higher the risk the higher the expected return. All in all, precaution is taken that the risk is absorbed and the risk management activity monitors the business activity efficiently as far as risk and return are concerned.

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