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3 Types of Risks Financial Institutions Face

3 Types of Risks Financial Institutions Face
The Siliconreview
23 November, 2020

Individuals, organizations, commercial entities, and even government bodies turn to financial institutions when they require support for various projects and activities. As such, the establishments that make up the financial sector are seen by the general public as a reliable source of funding.

It’s good to remember, however, that banks and other financial institutions are, at their very core, also businesses themselves. This means that they, too, are exposed to different types of risks as they earn a profit from their operations. Just like other types of commercial establishments, financial institutions have to ensure that they employ sound enterprise risk management solutions for the following:

Credit Risks

Credit risk refers to the possibility that the borrower will default on their loan; hence, the term is also known as default risk. It generally means non-payment on the part of the borrower, but it can also cover delayed payments. Often, the borrower is unable to fulfill their obligations to the bank or their lender because they lack the assets to do so.

A non-paying borrower can significantly affect the profits of a lender. To minimize the credit risk they are undertaking, banks and other lending firms must sift through all potential borrowers as soon as these clients submit their applications. Lenders typically rely on credit rating agencies as well as enterprise risk management software to carefully and efficiently scrutinize the large number of loan applications that they receive on a daily basis.

There’s a wide variety of methods that lenders can use to limit their company’s credit risk. Banks, for example, require borrowers to submit documents that prove that they are capable of paying back their loan within the agreed-upon terms. They can also look into an applicant’s credit score and history to see if the borrower has defaulted on a loan or if they’ve been delinquent with their payments in the past. Banks can also opt to offer loan products only to borrowers who have an existing account with their company. These requirements are crucial in determining a borrower’s creditworthiness, and they play a huge role in whether or not the lender will grant the loan application.

Market Risks

Financial institutions not only deal with cash, but they also handle securities. These are tradable assets that are used to raise capital in private and public markets. Securities come with their own set of risks, as any movement in the market may cause the value of these assets to appreciate or depreciate.

There are different types of market risks. Interest risks are caused by interest rate-related fluctuations, while equity risks are due to changes in the prices of stock investments. Commodity risks are caused by the changing prices of goods, and currency risks are tied to the differences in the exchange rates of the currencies that the bank uses. 

Financial institutions commonly mitigate market risks by hedging contracts. The parties that enter into this type of agreement minimize market risks using swap, exchange, forward, floor, cap, and other similar means. 

Liquidity Risks

If depositors want to withdraw their money from the bank, will the bank be able to fulfill its obligations? Liquidity risk refers to the inherent possibility that an establishment will not be able to meet its expected and unexpected cash flow and collateral needs. More often than not, a financial establishment’s liquidity is dependent on the level of trust that the depositors have in the company.

It is common knowledge that only a portion of the money entrusted to a bank is stored in its reserves, as the remaining amount is used to create and fund the bank’s loan products. If the depositors lose faith in the company as a whole and withdraw their funds, then the bank will run out of money to sustain its operations.

Thanks to centralized banking, liquidity risk is not as much of a concern for today’s banks. With the help of a centralized financial risk management software, financial firms can easily pull additional resources from other branches and redirect funds to a branch that has increased liquidity risk. Aside from fulfilling the demands of the depositors, this accomplishes a secondary purpose of earning the trust of the bank’s clients. If the firm’s clients can see that the bank has enough funds to fulfill the company’s obligations, they’ll feel more confident about entrusting their finances to the said bank.

While these risks might not be eliminated entirely, keeping them at a manageable level can help ensure the smooth day-to-day operations and long-term success of trusted banks and other financial institutions. Financial firms need to take every effort and explore new technologies that will help them mitigate the risks that they face. By doing so, they can continue supporting a growing economy and providing quality services to their clients.