Types of Financial Risks
Asset-backed risk
• Consumers borrow money for purchasing a car (auto loan)
• a house or running a balance on a credit card.
• These loans are treated as assets in the financial books of
the financing entity.
• Bank, non-banking financial institution or a housing finance
company are the financing entities.
Asset-backed risk
• The key value in this asset is captured by the steady stream
of receivables that these assets are expected to receive.
• These are car loan EMIs, mortgage instalments, student
loans EMI or credit card outstanding payments.
Asset-backed risk
• Financing institutions package these assets as asset-backed
securities which are sold to institutional investors like
pension funds and mutual funds
Credit Risk
A credit risk happens when there is a chance that the loan
borrower might skip, delay or default on his/her obligation
to the bank or financial institution that has lent the money.
Credit Risk
Say you were to borrow from a bank.
And they offer you the loan at a much higher interest rate of say, 13%.
This 13% interest rate consists of three parts –
1. Money that needs to be paid to the individual or institution from whom the bank
borrowed the money,
2. Account for the cost of acquiring and servicing the borrower and,
3. Provision for potential delay or default in the repayment of the loan.
Credit Risk
• Management of the credit risk is the primary function of
the financing institution.
• Underwriting the loan is a core responsibility of the
lending institution.
• Offering a lower-than-required interest rate or offering the
loan to a low-capacity-to-repay individual or firm can lead
to tremendous losses and even bankruptcy.
Risk management at financial institutions
Interest rate risk. An increase in interest rates will reduce the marketable
value of these securities. This will tempt borrowers to refinance their
loans at more favorable rates
Term modification risk. Not all borrowers are able to pay per the
agreed schedule.
• they are not willful defaulters and have the intention of paying back.
• To ease the borrower’s path to loan repayment, financiers agree to
mid-term reduction in the loan’s interest rate,
• an alternative loan type,
• extension in the maturity of loan or a combination of all three.
Risk management at financial institutions
Pre-payment risk. This is when borrowers pre-pay their loan. This might
sound good for the financing institution but this puts them up with two
problems:
1. they need to find another person to loan money to and
2. they have to find another investing option that earns them the same
return on investment
Bankruptcy risk. Borrowers may file of bankruptcy which means the
loan too could be lost in its entirety to bankruptcy
Risk management practices against credit risk
1. Obtaining accurate and detailed customer data including income,
financial statements, manner in which loan will be utilized etc.
2. Building the right underwriting and pricing models
3. Being choosy of the customer profile who shall be extended the loan
4. Develop a strong loan collection infrastructure
5. Reviewing, repricing and re-strategizing on the basis of external
factors like interest rate, general economy, competition etc.
Foreign Investment Risk
Foreign investment risk is the financial risk of swift and acute changes in
the value of investments due to external factors like –
1. Changes in accounting, reporting and auditing standards
2. Nationalization. It refers to the transfer of private assets to the
government often with no compensation
3. Changes in taxation rules.
4. Economic conflict. These can be trade wars like the one we see between
the United States and China
5. Political or diplomatic changes.
6. Regulatory issues
Currency Risk
Currency risk or foreign exchange risk can happen when a company is having a
transaction with a foreign company where one currency is stronger than the other.
The two types of currency risks are –
Transaction risk. These are losses that are likely to occur when dealing in different
currency. Example: international food chains like Dominos and KFC face where they
sell locally but report in US dollars.
Economic risk. This refers to risk associated with different political policies, varied
regulations and general state of the economy in the country where business is being
conducted
Liquidity Risk
Liquidity risks are financial risks that a given asset cannot be traded quickly enough to
prevent a loss or expected profit.
Two kinds of liquidity risks –
Asset liquidity. This is where an asset cannot be sold in the market when you want to sell
it.
Funding liquidity. This is where one does not have enough money to pay off a
loan when it comes due.
Stock Market Risk
Stock market risk is the chance that equities (stock prices) in general
and the assumed volatility will change more than expected. These
financial risks is not for any one particular company or industry but for
the entire market as a whole.
There are three primary stock market risks –
1. Volatility
2. Timing – stock tips “buy low – sell high and profit” dream
3. Overconfidence
Interest Rate Risk
Is the chance that an unexpected change in interest rates
will affect the value of an investment.
