Answer to Question #170344 in Finance for innocent kampumba

Question

a).       Outline and discuss the main risks faced by financial institutions and how they manifest giving practical examples.                                                                                                            (10Marks)

b).       Discuss how these risks can be mitigated and managed. 

Answer 1

a)

market risk

It is the risk of losses on financial investments caused by adverse price movements. Examples of market risk are: changes in equity prices or commodity prices, interest rate moves or foreign exchange fluctuations.

operational risk

It is defined as the risk of loss resulting from inadequate or failed internal processes, people, controls, systems or from external events.

credit risk

Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet contractual obligations.

Liquidity risk

This is a risk occurs when an individual investor, business, or financial institution cannot meet its short-term debt obligations.

Insolvency risk

The risk that an individual or especially a company may be unable to service its debts. Bankruptcy risk is greater when the individual or firm has little or no cash flow, or when it manages its assets poorly.

b) 1) market risk

Banks for example try to mitigate the impact of risk by creating reserves and limits. Market risks are booked in the trading book. Banks tend to inflate reserves for credit risk, to provide cover for market risks that may be hidden.

2) operational risk

Financial institution has to train its employees to prepare for what could go wrong. That is especially true when one of the financial institution’s business units is about to do something new, such as change a customer interface, roll out a new product or service, or outsource its business processes.

3) credit risk

Banks can mitigate the risk by taking steps to strengthen its lending program such as thoroughly check a new customer’s credit record, set a credit limit for a new customer by checking his credit history reports and make sure the credit terms of your sales agreements are clear to your customers.

4) Liquidity risk

Liquidity risk can be mitigated by forecasting cash flow regularly, monitoring, and optimizing net working capital, and managing existing credit facilities.

5) Insolvency risk

Financial institutions should Focus on cash flow, reduce business expenses, Keep creditors in the loop and get good financial and legal advice.