Free «Risk Management» Essay
Every company faces risks of different degrees in the course of its operation. Financial institutions, including banks, are not an exception. Banks encounter different types of financial risks. Thus, they should be prepared to manage them. Taking risk is essential for any firm, because risks usually lead to profits. Banks encounter different risks in their activity. Organizations operate in the changing environment, and it often brings different challenges that require fast decisions. Management should acknowledge the nature of the risks they take in order to prevent, minimize or manage efficiently. Different risks have various levels of significance and potential damage on the organization. Thus, the firm should be prepared to estimate the potential severity of the occurrence as well as likelihood of various events to impact on the organization (Andersen, 2006). Usually, risk estimation is not an exact science, because many risk-related activities do not correspond to measurement in figures. Therefore, firms measure them based on estimates and proposals of professional in the indsutry (Andersen, 2006). The current paper investigates the nature of risk management and the risks in the banking industry.
The common risks for banking organizations have several components. The first component is the probability of default. In the financial industry, the default component is the crucial factor to evaluate, because it directly correlates to firm’s profitability. The factor commonly includes the probability of default on paying obligations; thus, banks should estimate their risks carefully in order to minimize profit losses (Frenkel, Hommel & Rudolf, 2004). The second component is a loss given default. It corresponds to the expected economic loss unit exposure that a bank bears in case of a default. Loss given default can vary depending on circumstances and external conditions (Frenkel, Hommel & Rudolf, 2004). Other components of risk for a bank include time to maturity, total annual sales, and exposure at default. The three aforementioned factors contribute to the possibility to encounter unexpected losses for a financial institution (Frenkel, Hommel & Rudolf, 2004).
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Financial risk management started with the development of trade of commercial land in the 1970s, when G10 countries focused on regulation of banking risks (Corelli, 2014). The growing globalization brought about additional risks for banks, because many large financial institutions operate on the international market. The global exposure and multinational presence leads to additional financial risks. Moreover, many banking operations and the vast variety of offered products and services maximize the possibility to encounter risks. Therefore, professional risk management is a vital component of contemporary banking industry (Dun & Bradstreet, 2006). In general, risk management for banks has important benefits. Firstly, it introduces a clear and understandable system for measuring and minimizing the damage. Each potential risk has assigned value, which easies the management due to prioritization. Secondly, the strategy improves risk awareness, and banks can determine extreme situations in time to react. Finally, professional risk management results in increased valuation, reduced capital cost, and risk-adjusted capital used by the bank (Dun & Bradstreet, 2006).
The financial risk is a type of risk that stem from the situations of lending the money to a person or organization, and the borrower fails to meet their obligations of repaying the loan or investment. For instance, in case with a bank, financial risks result from the failure of a borrower to repay the loan (The Free Dictionary, n.d.). Financial risk in the banking industry has three types. Credit risk is a chance that a contractual party fails to meet its obligations according to the agreed terms. Credit risks have three main characteristics. The first factor is the exposure that entails a possibility for the party to default or suffer changes in the performance stability. The likelihood that the party will default is the second element. The third characteristic is recovery rate, which calculates the possible returns if a default occurs (Brown & Moles, 2014).
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Commodity risk means the possibility that the price of a production input will adversely influence the producer of commodity. It usually includes seasonal, political, regulatory, technological, and market effects (Business Dictionary, n.d.). As banks often operate in different environments, they face community risks. Finally, operational risk is also a factor for the financial institutions. The phenomenon includes all possible losses that result from improper or faulty internal processes in the organization, the mistakes of employees, and failures of the systems. Various external events can cause and contribute to the operational risk. Operational risk do not include reputational ones, which are related to all banking products and banking activities. The operation group of threats is crucial in all industries, because it includes many human and non-human factors. Moreover, they have become more powerful due to the growing complexity of operations and globalization of the financial system (European Banking Authority, n.d.). However, the challenges of industry growth should not intimidate the human resources, but rather encourage them to prepare for risks and mitigate the effects.
Banking system is a risky sector, because it operates with money and different value commodities. Moreover, the logistics chain incorporates different people, organizations, and complexity of operations. It is necessary to manage the credit, commodity, and operational risks to minimize the losses. In conclusion, all organizations face different risks that come both from external and internal environment. Thus, banks are not exception. In particular, the banks have to deal with financial risks and obligations due. It is important to control and regulate the possible threats through risk management to minimize losses.