Question

If considering managers of financial institutions, shareholders and creditors of financial institutions, and public society as a whole, who should bear financial risks, and who should not? Your answer should specify the various risks that arise in financial services.

Answer 1

8 main types of risks involved in Financial Services are as under

• Credit risk - The potential that a bank borrower or counter party will fail to meet its obligations in accordance with agreed terms.
• Market risk - Market risk is the possibility of an investor facing losses due to factors that affect the overall performance of the financial markets in which he or she is involved. Market risk, also called "systematic risk," cannot be eliminated through diversification.
• Operational risk - The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk but excludes strategic and reputation risk
• Liquidity risk - It is the risk that the bank may not be able to meet short term financial demands. This usually occurs due to the inability to convert a security or hard asset to cash without a loss of capital and/or income in the process.
• Business risk - Business risk is the risk arising from a bank’s business strategy in the long term. When a bank fails to adapt to the changing environment as quickly as their competitors, it faces the risk of losing market share, getting acquired, or shutting shop.
• Reputational risk - It is defined as the risk of possible damage to Bank’s brand and reputation, and the associated risk to earnings, capital or liquidity arising from any association, action or inaction which could be perceived by stakeholders to be inappropriate, unethical or inconsistent with the Bank’s values and beliefs.
• Systemic risk - Also known as Market Risk or un-diversifiable risk, is the uncertainty inherent to the entire market or entire market segment.
• Moral hazard - It's a situation in Banking wherein borrower get involved in risky event knowing that he is protected against the risk and the bank will bear the cost of it.

In an idealistic Society, risks of the financial institutions should not be borne by the Society. They should be borne by the Shareholders and Creditors respectively. The Management of the Institution should also be made to bear the consequences of these risks in the form of withheld bonuses, Pay Cuts etc.