Risk management for Financial Institutions

RISK MANAGEMENT:

Risk management is process of Identification, analysing and accept or mitigate uncertaintity in investment decision making.In Risk management fund manager or investor can identify the poterntial loses and take appropriate action in order to minimise it.Inadequate management can lead to suffer heavy loses by firms.For examlpe the recession in 2008 is a example of poor Risk management which lead to default of many financial institutions like Lehman Brothers.

 CLASSIFICATION OF RISK:

1.MICRO RISK

1.1 Liquidity Risk - This is a types of risk arises when any security or share can not traded in a market quikly in order to avoid loses.

1.2 Credit Risk - This is a types of risk in which borrower default to make payment to the lender.In this risk the lender ia unable to recover principal and interest amount which interrupt the future cash flow.

1.3 Market Risk

          1.3.1 Interest rate Risk - It is a types of risk arises when there is a fluctuation of interest rate in     market.This risk affect mostly the bond holders.

         1.3.2 Currency Risk - This is a types of risk arises when there is a fluctuation of one currency against another .This risk is affect mostly the business which run internationally,risk arises if the don't hedge the position in the currency market.

         1.3.3 Equity Risk - This is a risk arises when there is a uncertaintity of fluctuation of shares price or property prices.

         1.3.4 Commodity Risk - This is a risk when there is uncertainties of future prices of commodities,This risk arises when there is a fluctuation of prices of commodities.

 

1.4 Reputation Risk - This is a risk when there is damage of firms reputation due to some issues.

2. MACRO RISK

2.1 Default Risk- This is a risk in which company or individual unable to make payments of debts obligation.

2.2 Legal Risk - This is a risk in which any company or person unable to follow all legal laws or contracts.

2.3 Operational Risk- This is a risk when there is a uncertaintity of losses occured due to operational fault.

2.4 Model Risk - This is types of risk when financial model uses the companies market risk.

2.5 Political Risk- This is a risk arises when there is a fluctuation of government decision on any policy,which affect adversly to firms related to such policy.

 RISK IDENTIFICATION TECHNIQUES:

1. Companies have to do the detail analyse the risk factor associate the business model.

 2. Managers of company have to do the brainstroming on the risks and its factors.

3. Cross Functional Teams of company has to provide multiple viewpoints so that a comprehensive list of risks and their factors is developed.

4.Company has to study the previous risk management plans,so that to identify correct risk of future business plan.

5.Company has to take  advices from stakeholder and domain experts related to the business plans in order to identify coreect risk.

6. Company has to developed the risk parallel with other task and team.

7.Company has to reuse the previous identified risk in order to avaoid its repetition.

MEASURING RISK: Traditional Financial Model

1. Standard Deviation: It shows how much the company share is variate with indexes.

2. Sensitivity analysis: It is a technique used to determine how different values of  independent variable will impact a particular dependent variable under a given set of assumptions.

3. Scenareo analysis:It is a technique use to analyzing possible future events by considering alternative possible outcome.

4. Stress testing: It is a simulation technique used on asset and liability portfolios to determine their reactions to different financial situations.

RISK MANAGEMENT STRATEGIES:

1. Company has to minimise risk by taking insurance of factory or other situation to whome the risk is associate.

2. Companies has to minimise risk by doing hedging in derivatives markets and forward market.

3. Company has to manage its Assets Liability by appointing finance professional.

4. If there is a risk associate to the bank regarding  defaulters then banks has to keep collateral securities against loans. 

TYPES OF RISK MANAGEMENT:

1. Currency Risk Management: RBI has issued the guideline to manage the currency risk in following areas:

1.1 Forward Contract: Banks is  managing risk by entering into forward contract if currency,where banks  has to enter in contract of buying and selling of currency at some specified  future date at the price decided today.

1.2 Hedging: Banks is also manage risk by doing hedging of currency in the international commodity market by entering into the sell position at current rate in order to lock the currency price which protect bank on losses happen on price volatility of currency. For example if bank want to buy dollat in future(after 3 month) from the market than it can enter into the buy position (suppose 60rs) and if after 3 month dollar rises to 62 rs than bank have a profit of 2 rs which is compensate the losses of buying at 62rs.Generallt bank get dollar at 60 rupee after 3 month due to hedging.

1.3 Hedging FDI: Bank also do hedging for there FDI clients in order to minimise losses due to currency risk.Banks has to enter into a contract of buying dollar contract at current rate in commodity market.If in future the value of dollar rises or decline the profitability of clients could not affect. For example if any FDI is entering in india at exchange rate of rs60 per dollar and he/she want to exit from the market after 10 yrs and don't know the exchage rate after 10 year.In such case he need to enter in the long term contract(roll over till 10 yrs) of buying dollar at current rate rs 60 per dollar because he need dollar to take back his country.if after 10 year the dollar decline to rs 50 per dollar than he bear loses in derivative market of rs 10 per dollar,but he can also get opportunity to get dollar at rs 50 per dollar on spot market.So the losses of rs 10 per dollar on commodity would be compensate with the profit in spot market.therfore he take back his earnings and capital in dollar to his country at rs 60 per dollar.

2 Market risk management:

Now a days there is a growing of managing market risk by the corporates beacuse volatility of market adversly affect the financial and capital budgeting of the company.

Market risk are classified into following:

2.1 Interest rate risk: This is a kind of market risk affect mostly to the bond owners or the corporates having heavy debts.Profitablity of the corporates fluctuate as the interst rate fluctuate in the market,so they are unbale to predict accurate profitability.This risk can be manage by doing hedging intrerest rate contract in the market.

2.2 Foreign exchange risk:This is a kind of market risk arises due to the fluctuation of currency values.This risk associate mostly to the corporates doing business internationally.

2.3 Commodity price risk:This is types of market risk arises due to the fluctuation of commodity price.This risk arises to the companies related to the commodity busineses. For example,gold loan companies arises this types of risk because if the value of gold fall than the chances of there NPA's is increases.

2.4 Equity price risk: This is one of the main types of market risk that we regularly hear.With the fall of equity prices than it would affect the overall market sentiments.If companies share value falling depict that the company is suffering some kind of problems and affect it's future capital raising programe.

3.MANAGING LIQUIDITY RISK:

Liquidity risk management means measuring  liquidity position and fund requirement under crises scenario.This risk is arises mostly to the Banks because banks need to manage its assets liability management(ALM).Bank can manage this risk by various ways like taking short term loan from another bank for fullfilling its liquidity requirement.

Liquidity risk has three dimension:

1.Funding Risk:Bank generally face the funding risk of sudden withdrawal of heavy amount then bank faces difficulty to arrange cash/fund for this heavy withdrawal.This can be manage by the bank to arrange cash from the other banks who have sufficient funds.

2. Timing Risk:This risk is faces by banks if it can trade in any security on the bases of future price prediction.

3.Calling Risk:This is a risk associate to the collable bond holder beacuse issuer will  redeem it before the maturity,when the interest rate rises and reissue it at low interest rate.

4.OPERATION RISK MANAGEMENT:

Operation risk is a risk associate with the day to day operation activities  of the Company.It can be manage by the companies by using advance technology to track the day to day operations.Also can be manage by appointing the professional managers to handel day to day operations.

Operation risk management policy framework:

a) The roles and responsibilities of the independent bank-wide Operational Risk Management function and
line of business management.

b) A definition for operational risk, including the loss event types that will be monitored.

c) The capture and use of internal and external operational risk loss data including data potential events (including the use of Scenario analysis).

d) The development and incorporation of business environment and internal control factor assessments into
the operational risk framework.

e) A description of the internally derived analytical framework that quantifies the operational risk exposure
of the institution.

f) A discussion of qualitative factors and risk mitigants and how they are incorporated into the operational risk framework.

g) A discussion of the testing and verification processes and procedures.

h) A discussion of other factors that affect the measurement of operational risk.

 i) Provisions for the review and approval of significant policy and procedural exceptions.

j) Regular reporting of critical risk issues facing the banks and its control/mitigations to senior management
and Board.

k) Top level management board review the bank's progress towards the stated objectives.

l) A system of documented approvals and authorizations to ensure accountability at an appropriate level of
management.

m) Define the risk tolerance level for the bank, break it down to appropriate sub‐limits and prescribe reporting levels and breach of limits.

Risk management system fail because of:

a) There is lack of controling system in the banks/institution,which increase the chances of risk management system fail.

b) Sometime banks does not adequatly recognise the risk of certain product specially new product which sometimes fail risk managent.

c) Sometimes beacuse of  absence/failure of key control structures such as segregation of duties, approvals, verifications, reconciliations, reviews of operating performance etc.

 d) Sometimes banks doen not perform the adequate monitoring,auditing,controlling and communications,which  fails the risk management procedures.