Risk Management Financial
What is Financial Risk Management
Financial risk management is the process of identifying assessing and prioritizing risks and then taking steps to minimize, monitor and control the probability or impact of adverse events in financial institution (Banks and others non bank financial institutions).
6 steps in risk management process
- Identify existing risks
- Assess the risk
- Develop an appropriate response
- Develop preventive mechanisms for identified risks.
- Arrange training and workshop for that particular risk
- Develop existing manpower to mitigate the risks.
Why Risk Management of Financial Institutions Important
It is crucial for several reasons:
- Protecting assets and resources.
- Ensures business continuity
- Improves decision making
- Enhances reputation
- Compliance and legal obligations
- Increase financial stability
- Supports strategic planning.
Basel iii Framework
- Minimum capital requirement
- Leverage ratio
- Liquidity requirement.
Liquidity Coverage ratio Basel iii
The requirement that banks must maintain a minimum capital amount of 7% inreserve will make banks less profitable. Most bank will try to maintain a higher capital reserve to cushion themselves from financial distress. They will be required to hold more capital against assets, which will reduce the size of their balance sheets.
The implementation of Basel III will affect the derivatives market. Basel III capital requirements focus on reducing counterparty risks.
Capital Requirements Basel iii
- Minimum Capital requirements: The Basel accord raised the minimum capital requirement for banks from 2% in Basel II to 4.5 % of common equity as a percentage of the bank’s RWA( Risk Weighted assets). There is also additional 2.5 % buffer capital requirement that brings the total minimum requirement to 7%.
- Leverage ratio: It introduces a leverage ratio requirement to limit the buildup of leverage in the banking system, ensuring amount of capital against their total assets.
- Liquidity requirement: Basel III introduces two key liquidity ratio:
LCR: Liquidity coverage ratio: Banks to hold sufficient high quality assets to cover short term liquidity needs.
NSFR: Net Stable Funding Ratio ensures banks maintain a stable funding profile in relation to their assets and off balance sheet activities over a longer time horizon.
Risk Management For Financial Institutions
What is Risk Factors
Bank risks included various rich factors that can impact their stability and performance.
Key risk factors include:
Credit risk:
It is the risk of loss due to borrowers failing to meet their loan obligations. This includes default risks where a borrower might not repay their loan and counter party risk where a trading partner fails to fulfill contractual obligations.
Interest rate risk:
The risk of financial loss due to changes in interest rates affecting a bank’s profitability and economic value. This can impact both leading and borrowing activities.
Commodity risk:
It refers to the potential for financial loss due to fluctuations in the price of commodities such as oil, metals, agricultural products and other raw materials.
Commodity risk includes: Price volatility, supply chain disruptions, currency risk, regulatory risk, operational risk, market risk.
Operational risk:
Within a treasury department where large sum of money are handled, many aspects of operation can go wrong. The risk of loss resulting from inadequate or failed internal process, systems, people or external events. This include risks from fraud, system failures natural disasters.
Liquidity risk:
The risk that a bank may not be able to meet its short term financial obligations due to an imbalance between its liquidity assets and liabilities. It can arise from funding mismatches or sudden withdrawal of deposits.
Compliance and regulatory risk: The risk of legal or regulatory penalties arising from non-compliance with laws, regulators and standards. This include risks related to anti money laundering (AML) and data protection regulations.
Foreign Exchange risk:
Foreign exchange is the conversion of one country’s currency into another. Foreign exchange risk or currency risk arises from fluctuations in exchange rates that can impact the value of financial transactions or assets and liabilities denominated in foreign currencies.
Foreign Exchange risk includes-
- Transaction risk
- Translation risk
- Economic risk
- Contingent risk
- Hedging strategies
- Exposure measurement
Treasury Risk:
It refers to the various risks associated with the management of a company’s treasury functions, including liquidity , funding and financial markets risks. Key aspects of treasury risk include:
- Liquidity risk
- Funding risk
- Interest rate risk
- Foreign Exchange risk
- Credit risk
- Price risk
- Operational risk
Effective treasury risk management involves implementing strategies and controls to monitor and mitigate these risks, ensuring that the company’s financial operations remain stable and efficient. This often includes using financial instruments, maintaining adequate liquidity reserves and employing robust risk management practices.
Reputation Risk: The risk of damage to a bank’s reputation due to negative public perception or media coverage which can impact customer trust and business relationship.
Credit concentration risk:
The risk associated with a bank’s exposure to a single borrower sector or geographical region.
