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Risk management, as a concept, is studied and implemented across all industries. Over the years, even companies with the most mundane business have started implementing risk management practices. However, there is no denying the fact that risk management as a discipline is more applicable to the financial services industry than to any other industry. The nature of the activities performed by these companies is such that the quantum of risk becomes extremely high.
In this article, we will have a closer look at why the financial services industry faces a higher risk and how risk management practices can be used to ensure that the industry functions effectively. Let’s start by understanding how the basic activities of the firm generate more risks than the average business.
Mobilization of Funds: Banks, credit unions, and other financial services industries raise money from people. This means that they routinely collect money from people in the form of term deposits or demand deposits. The quantum of funds mobilized by banks is much more than the equity that they have on hand.
It is not uncommon for banks to have a leverage ratio of 40! This means that for every $1 that the bank has in equity, they have $40 in debt! The case with brokerages is also the same. Often, they help their clients buy contracts with borrowed money. The client only provides the margin money whereas the rest is arranged by the broker. In such cases, the basic business model is such that excessive amounts of leverage are a part of the day-to-day operations.
In normal industries, a leverage ratio of 5 would also be considered very high but that is not the case in the financial services industry. Thus, financial services companies are forced to take on excessive risks while raising capital.
Investing Funds: Once the firms mobilize funds, the next step of the process is to invest these funds. Banks and other financial institutions are required by law to invest a certain sum of money in government securities. However, the balance funds can be used to lend money to corporations as well as individuals. Here too, financial institutions are forced to take excessive risks.
Financial companies have to deal with a wide variety of borrowers and customers. Oftentimes, they do not have the correct information on these borrowers. As a result, they face an information asymmetry and end up giving loans to the wrong people. This means that there is always an inherent loss of bad debts.
The financial institutions have started sharing data and created a system of credit ratings to better gauge the creditworthiness of borrowers. However, once again the element of risk is higher as compared to other businesses.
Payment Systems: Banks and financial companies all over the world use payment systems to help their clients transfer money to different places. Once again, the quantum of money being transferred is several times larger than the net worth of several banks.
Also, millions of transactions happen every day. Hence, the possibility of error is also present. This is where the risk increases manifold for financial services institutions. Companies that engage in other businesses do not have to face such risks.
Foreign Exchange Risks: While facilitating payments for their clients, banks and financial institutions are forced to connect with institutions from other countries. They are also required to deal in other currencies and as a result, have to hold certain reserves of these currencies. The end result is that the financial institutions are exposed to counterparty risks as well as currency risks on a large scale. Compared to other industries, these risks are higher in financial services industries.
Bank Guarantees: Financial institutions also enable trade between parties by providing bank guarantees. This means that if two parties don’t trust each other, they can still trade. This is because, in effect, both of them are trading with the financial institution. Hence, the creditworthiness of the other party shouldn’t matter. However, the end result of these bank guarantees is that the bank ends up becoming a counterparty in many transactions. This increases the amount of risk on its books. It is true that banks have systems to manage these risks. However, on paper, there is always a danger of bankruptcy or grave financial loss because of claims arising from these guarantees.
From the above-mentioned points, it is obvious that risk management activities are central to the existence of banks. Poorly executed risk management policies could threaten the survival of banks or at least lead to lowered profitability.
Another important point to note is that the financial services industry is adversely hit by the change in market rates such as interest rates. They are always borrowing and lending money and earn from the spread between the two. If interest rates change, their entire calculation of interest receivable and interest payable changes! This is the reason why the financial services industry has always been at the forefront of the evolution in risk management practices.
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