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Key Risks in Financial Institutions

Financial institutions face various risks including default, market, liquidity, interest rate, foreign exchange, operational, and insolvency risks. The COVID-19 pandemic has heightened risk aversion and shifted asset preferences towards safer investments, although the Philippine financial market remains stable without a liquidity squeeze. Regulatory reliefs are crucial for navigating the economic disruptions, but authorities must also prepare for a post-COVID-19 environment, balancing relief efforts with potential fiscal policy adjustments.

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Rey Angelo Pagatpat
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29 views2 pages

Key Risks in Financial Institutions

Financial institutions face various risks including default, market, liquidity, interest rate, foreign exchange, operational, and insolvency risks. The COVID-19 pandemic has heightened risk aversion and shifted asset preferences towards safer investments, although the Philippine financial market remains stable without a liquidity squeeze. Regulatory reliefs are crucial for navigating the economic disruptions, but authorities must also prepare for a post-COVID-19 environment, balancing relief efforts with potential fiscal policy adjustments.

Uploaded by

Rey Angelo Pagatpat
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd

MODULE 7 – RISK MANAGEMENT IN FINANCIAL INSTITUTIONS

Risks Incurred by Financial Institutions


Risk Management of Financial Institutions
All FIs face a variety of risks, but generally speaking all FIs face:
o Default risk on at least a portion of their assets
Default risk, refers to the likelihood that a borrower will fail to fulfill their financial obligations.
o Market risk, or the risk that the value of FI investments may change
Market risk is the risk of losses on financial investments caused by adverse price movements.
o Liquidity risk, due to a mismatch in maturity of assets and liabilities,
Liquidity risk is the possibility that an individual, business, or financial institution cannot meet its short-
term debt obligations due to an inability to convert assets into cash without incurring a substantial loss.
o Interest rate risk due to the same mismatch above
Interest rate risk is the probability of a decline in the value of an asset resulting from unexpected
fluctuations in interest rates.
o Foreign exchange risk due to foreign currency assets and liabilities or changing competitive conditions with
foreign FIs as currency values fluctuate
Foreign exchange risk is the possibility for a company to be affected by a variation in the exchange rate
between its local currency and the currency used in a transaction with a foreign country.
o Operating cost risk because there are fixed costs involved in providing all financial services
Operational risk is defined as a type of risk that arises from the day-to-day operations of an organization. It
is the potential for loss that comes from faulty or absent internal procedures, people, and systems, as well as
external events.
o Insolvency risk, any of the stated risks may result in insolvency at a FI.
Insolvency risk is the probability that one or more of your customers will be unable to meet their financial
obligations to you within a given timeframe. It is sometimes known as bankruptcy risk or credit risk.

Some FIs face:


o Sovereign risk on overseas investments
'Sovereign risk', or country risk, is the risk that a government could default on its debt (sovereign debt) or
other obligations.
o Off balance sheet risks due to contingent assets and liabilities
Off-balance-sheet risk is the risk posed by factors not appearing on an insurer's or reinsurer's balance sheet.
o Technology and Operational risk due to either overinvestment in a technology relative to customer demand,
or a failure of technology respectively.
Technology risk is any potential for technology failures to disrupt your business such as information
security incidents or service outages.
In the Philippines, COVID-19 has put a strain on the public health infrastructure, and the stay-at-home preventive
measure has disrupted people’s usual day-to-day practices. The government has responded with an income
augmentation and subsidy program, supported by the early action of Congress in crafting the Bayanihan to Heal as
One Act (Republic Act 11469).
As adversely affected as the economy has been, there are no indications that the financial market is in peril. Risk
behaviors have shifted though, as risk aversion has been heightened, asset prices have fallen, and risk premiums
have increased. Across borders, a rebalancing of portfolios has been noted towards safe-haven, liquid, and often US
dollar (USD)-denominated assets, just as there is evidence that shifts in asset holdings have transpired within
jurisdictions.
For the Philippine financial market, the preference for money market instruments has been notable although one
cannot say that this has been “funded” by withdrawals in other asset classes. There is also no evidence of a liquidity
squeeze, either in Philippine peso (PHP) or dollar terms, and the PHP/USD rate has remained relatively stable. Yet,
risk premiums have risen and the impact of the recession on financial markets will depend on how (and how
quickly) the country can resolve the public health issue, bolster family incomes, and re-ignite business activity. Over
the near term, it is reasonable to expect increased difficulty with debt servicing in the formal market as business
activity has been put on hold and, arguably, in the informal market as household cash flows have been disrupted .
The regulatory reliefs on credit are critical and important, but authorities also have to look ahead as the business and
income dislocations may take time to normalize.
What is to be avoided is a financial accelerator type of amplification. On this point, authorities should manage risk
premiums to eliminate as much of the panic add-on, which is the antithesis of stabilization and recovery. In parallel,
there is value to pricing risks off forward markets and then back to spot rates, rather than rely on spot rates that
price-in an unanchored future.
Soon, authorities will have to think of the post-COVID-19 environment. At this juncture, it is difficult to imagine
returning to the old status quo. The economy has to be re-fitted into the social distancing guidelines, as well as
preventive measures that rely less on face-to-face interactions. While governments are in the best position to absorb
the current burden of the relief efforts, sooner or later, the potential overhang of increased national debt may require
fiscal policy adjustments.

Common questions

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Interest rate risk impacts asset valuation by altering the present value of future cash flows. When interest rates rise, the present value of fixed-income securities typically falls, leading to a decrease in the asset's market price. Conversely, when rates decrease, asset values rise as the present value of cash flows increases. Therefore, financial institutions must manage their exposure to interest rate fluctuations to stabilize asset valuations and protect their earnings from volatile interest rate environments .

Maturity mismatches between assets and liabilities contribute to liquidity risk as short-term liabilities may not be met if the institution cannot convert long-term assets into cash without incurring a loss. This situation can result in a liquidity crunch if investors suddenly demand repayment. These mismatches also cause interest rate risk, as fluctuations in interest rates can affect the cost and availability of refinancing options, impacting both asset values and income derived from interest rate-sensitive products .

The COVID-19 pandemic has heightened market risk perception in the Philippines, as evidenced by increased risk aversion and higher risk premiums. Investors have shown a greater preference for liquid, USD-denominated safe-haven assets, reflecting uncertainties in the market. These changes imply that investment strategies may shift towards more conservative portfolios, focusing on asset preservation rather than high returns, and incorporating hedging techniques to cushion against potential market volatilities .

Foreign exchange risk affects a financial institution's profitability by impacting revenues and costs from international operations as exchange rates fluctuate. Adverse movements can increase the cost of foreign liabilities or reduce the value of foreign assets, affecting financial results. This risk also influences competitive positioning; institutions that manage it effectively can maintain stable pricing and profitability, while those that do not may face reduced competitiveness due to cost volatility and uncertain financial outcomes .

Regulatory reliefs on credit in the Philippines have been vital in reducing immediate financial pressures, providing temporary relief to businesses and households, and ensuring liquidity in the market. By easing credit terms and offering moratoriums, these measures aim to support economic recovery and maintain financial stability. However, their long-term effectiveness hinges on how quickly the economy can resume normal activity. If business and income dislocations persist, these reliefs may only serve as a stopgap, possibly postponing more severe financial distress unless complemented by other fiscal and monetary interventions .

The Philippine government's fiscal response included income augmentation and subsidy programs under the Bayanihan to Heal as One Act to alleviate economic strain caused by the pandemic. These measures helped maintain financial stability and supported affected sectors. However, the increase in national debt due to these relief efforts suggests that future fiscal policy adjustments may involve budget restructuring, potential tax reforms, or cuts in public spending to manage the fiscal deficit and ensure long-term sustainability .

Sovereign risk poses significant challenges to overseas investments, especially during macroeconomic crises, as governments may default on debt obligations due to financial distress. This can result in substantial losses for financial institutions with exposure to sovereign assets, increased risk premiums, and reduced investment attractiveness. In times of crisis, such risks can destabilize markets and lead to re-evaluation of investment portfolios, prompting institutions to reduce exposure in vulnerable countries and redirect investments towards more stable regions .

Liquidity risk is crucial for financial stability because it affects a financial institution's ability to meet short-term obligations and can trigger a liquidity crisis if not managed properly. It can be mitigated through strategies such as maintaining adequate levels of liquid assets, securing credit lines, and conducting stress tests to assess the liquidity under different scenarios. Institutions should also manage asset-liability maturity mismatches to ensure smooth cash flow management .

Financial institutions manage market risk by diversifying their investment portfolios, employing financial hedging strategies, and using instruments like derivatives to mitigate adverse price movements. Failing to effectively manage market risk can lead to significant financial losses, erosion of investor confidence, and potential solvency issues, which may ultimately affect the overall stability of the financial institution .

COVID-19 has heightened risk aversion in the Philippine financial market, leading to shifts towards safe-haven and liquid assets primarily denominated in US dollars. This change in asset preference reflects increased uncertainty about the economic outlook and fears of market volatility. Additionally, there has been notable inclination towards money market instruments, indicating a move towards lower-risk, short-duration investments. The pandemic has also raised risk premiums, signaling an increased perception of investment risk .

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