Chapter 2

FINANCIAL RISK MANAGEMENT

“Genuine risk management makes a neutral, well-informed assessment of the risk the business entails. It
looks for ways to shed or mitigate the unwanted risks and to retain and manage only the risks that are
necessary or desirable to take.”1

Learning Outcomes
1. Discuss understanding on the nature and purpose of financial risk management.
2. Related financial risk management from the general concept of risk management.
3. Explain the context of Modern Portfolio Theory.
4. Discuss the role of a financial risk manager and the different types of financial risk management;
and the different asset classes’ strategies.
5. Cite and explain the different approaches to the risk management.
6. Cite and discuss the different types of financial institutions and the corresponding financial risk
they are experiencing.

2.1 FINANCIAL RISK MANAGEMENT

Financial risk management is a process that describes the practice of identifying, measuring, and
controlling the financial risk carried by an organization.2 Financial risk management is the practice of
protecting economic value in a firm by managing exposure to financial risk - principally operational risk,
credit risk and market risk, with more specific variants as listed aside. Financial risk management requires
identifying its sources, measuring it, and the plans to address them.3
In those definitions, financial risk management is described both as a process and a practice. A process is
an ongoing activity. One cannot simply set a process in motion and let it go. There is no autopilot setting
in financial risk management and in most other processes. Financial risk must be actively and continually
managed. Financial risk management is also a practice.4
Professionals such as physicians, dentists, and attorneys are said to practice their professions. This
characterization recognizes and implies that perfection is never achieved, but that serious professionals
are constantly honing their skills by facing different scenarios that require their knowledge, judgment, and
experience.5 This is indeed what good financial risk management entails.
Notice also that financial risk management is described in terms of three activities:
1) Identifying risk
2) Measuring risk
3) Controlling risk
These actions combine to form the process of managing risk. First, we can hardly manage risk if we do
not know what risks we have. Hence, we must identify the risks. But identifying risk does not mean one

1
Dan Borge, Risk magazine, June 2009, p. 56
2
World Scientific (2009). Financial Risk Management: Introduction and Overview. https://www.worldscientific.com.
3
Peter F. Christoffersen (2011). Elements of Financial Risk Management. Academic Press. ISBN 978-0-12- 374448-7
4 Ibid.

5 Ibid.
knows how much risk there is. For example, a person with a family history of colon cancer would
probably know that he has a greater than average risk of contracting the disease. But how much greater
than average is this person’s risk? On average one out of every 20 people will get colon cancer in their
lifetimes. Is this person’s risk two out of 20? Three out of 20?
Good risk management in health and in finance requires knowing how much risk there is. And knowing
what the risk is and how much risk there is does not mean controlling it. The person with the high risk of
colon cancer could choose to eat a low fat diet and get frequent examinations as a means of controlling
this risk. Or, as all too many do, he could hope that the bad luck will bypass him, a poor risk management
strategy indeed with a very costly penalty if an adverse outcome occurs. Identifying, measuring, and
controlling financial risk are the primary top-down activities of financial risk management. There are
other activities, some that come before, some that come after, and some that come in between. In this
course we will study these activities in great detail later in this book.
2.1.1 Why we call it Financial Risk Management
Notice that the focus has been stated as financial risk. Most all risks, even health risks, ultimately have
financial consequences. This point is particularly true in a business, government, or non-profit
organization. But some risks are typically viewed as financial risks and others as non-financial risks. For
example, for a manufacturing firm, the risk of factory accidents is typically viewed as a non-financial
risk. The risk of a product recall is usually viewed as a non-financial risk. But both of these events have
enormous financial impacts.
Financial risks, however, are normally thought of as risks that are associated with movements in interest
rates, exchange rates, stock prices, and commodity prices, along with the risk of credit loss. In addition,
there are some other risks related to activities closely tied to these sources of risk that typically come
under the umbrella of financial risk management. For example, the banking industry is required by
regulators to manage its operational risk, which is the risk of hazards such as terrorism, losses caused by
nature, computer viruses and hackers, fraud, etc. There are also risks associated with processing
transactions and risks associated with liquidity where markets can dry up and almost cease to function at
the very time when an entity needs to sell an asset. There are also risks associated with legal, accounting,
tax, and regulatory matters that would not, in a strict sense, be viewed as financial risks.
But the current state of knowledge of managing all of these types of risks has benefited greatly from the
body of knowledge of the management of traditional financial risks such as interest rate risk, exchange
rate risk, and credit risk. Much of what are now known about managing risk has evolved from research on
managing financial risk. As noted earlier, the banking industry is the leading provider of financial risk
management products and has led the way to understanding the management of these other types of risks.
2.1.2 Risk Management
With that in mind, it is tempting to just call this activity risk management. Risk management is a term that
has been used for many years to describe the insurance business. In fact, there are a number of insurance
textbooks already that use the term risk management in the title.6 Risk management is certainly a more
general and accurate term. What you are going to learn is with the term financial risk management.

6
World Scientific (2009). Financial Risk Management: Introduction and Overview. https://www.worldscientific.com.
Financial risk management is the practice of protecting economic value in a firm by managing exposure
to financial risk - principally operational risk, credit risk and market risk, with more specific variants as
listed aside. Risk management is more general. Financial risk management requires identifying its
sources, measuring it, and the plans to address them.7

2.1.3 The Modern Portfolio Theory

Financial risk management as a science can be said to have been born8 with modern portfolio theory
particularly as initiated by Professor Harry Markowitz in 1952 with his article, "Portfolio Selection".9
The modern portfolio theory (MPT) is a practical method for selecting investments in order to maximize
their overall returns within an acceptable level of risk. This mathematical framework is used to build a
portfolio of investments that maximize the amount of expected return for the collective identifying its
sources, measuring it, and the plans to address them. American economist Harry Markowitz pioneered
this theory in his paper "Portfolio Selection," which was published in the Journal of Finance in 1952.10 He
was later awarded a Nobel Prize for his work on modern portfolio theory.
A key component of the MPT theory is diversification. Most investments are either high risk and high
return or low risk and low return. Markowitz argued that investors could achieve their best results by
choosing an optimal mix of the two based on an assessment of their individual tolerance to risk. 11
The modern portfolio theory argues that any given investment's risk and return characteristics should not
be viewed alone but should be evaluated by how it affects the overall portfolio's risk and return. That is,
an investor can construct a portfolio of multiple assets that will result in greater returns without a higher
level of risk. As an alternative, starting with a desired level of expected return, the investor can construct
a portfolio with the lowest possible risk that is capable of producing that return. Based on statistical
measures such as variance and correlation, a single investment's performance is less important than how
it impacts the entire portfolio.
The MPT assumes that investors are risk-averse, meaning they prefer a less risky portfolio to a riskier
one for a given level of return. As a practical matter, risk aversion implies that most people should invest
in multiple asset classes. An asset class is a grouping of investments that exhibit similar characteristics
and are subject to the same laws and regulations. Asset classes are thus made up of instruments that
often behave similarly to one another in the marketplace.
A portfolio is a range of investments held by a person or organization. Examples of common asset
classes include equities, fixed income, commodities, and real estate. The expected return of the portfolio
is calculated as a weighted sum of the returns of the individual assets.
For example, if a portfolio contained four equally weighted assets with expected returns of 4%, 6%,
10%, and 14%, the portfolio's expected return would be:
(4% x 25%) + (6% x 25%) + (10% x 25%) + (14% x 25%) = 8.5%
(Note: n=100 / 4 = 25%)

7
Peter F. Christoffersen (2011). Elements of Financial Risk Management. Academic Press. ISBN 978-0-12- 374448-7
8
W. Kenton (2021). "Harry Markowitz", investopedia.com.
9
Markowitz, H.M. (March 1952). "Portfolio Selection". The Journal of Finance. 7 (1): 77–91.doi:10.2307/2975974. JSTOR 2975974.
10
What is Risk? Definition of Risk, Risk Meaning, Indiatimes.com, https://economictimes.indiatimes.com.
11
Ibid .
The portfolio's risk is a function of the variances of each asset and the correlations of each pair of assets.
To calculate the risk of a four-asset portfolio, an investor needs each of the four assets' variances and six
correlation values, since there are six possible two-asset combinations with four assets. Because of the
asset correlations, the total portfolio risk, or standard deviation, is lower than what would be calculated
by a weighted sum.
To calculate the portfolio variance of securities in a portfolio, multiply the squared weight of each
security by the corresponding variance of the security and add two multiplied by the weighted average of
the securities multiplied by the covariance between the securities.12
The general formula is13

Portfolio variance = w12σ12 + w22σ22 + 2w1w2Cov1,2

Where:

 w1 = the portfolio weight of the first asset

 w2 = the portfolio weight of the second asset
 σ1= the standard deviation of the first asset
 σ2 = the standard deviation of the second asset
 Cov1,2 = the covariance of the two assets, which can thus be expressed as p(1,2)σ1σ2, where p(1,2) is
the correlation coefficient between the two assets

Sample Calculation14
For example, assume you have a portfolio containing two assets, stock in Company A and stock in
Company B. While 60% of your portfolio is invested in Company A, the remaining 40% is invested in
Company B. The annual variance of Company A's stock is 20%, while the variance of Company B's
stock is 30%.

The correlation between the two assets is 2.04. To calculate the covariance of the assets multiply the
square root of the variance of Company A's stock by the square root of the variance of Company B's
stock. The resulting covariance is 0.50.

The resulting portfolio variance is 0.36, or ((0.6)^2 * (0.2) + (0.4)^2 * (0.3) + (2 * 0.6 * 0.4 * 0.5)).

Financial Risk Management, as a discipline can be qualitative and quantitative. As a specialization of risk
management, however, financial risk management focuses more on when and how to hedge.15 A hedge is
a way of protecting oneself against financial loss or other adverse circumstances, often using financial
instruments to manage costly exposures to risk.16
In the banking sector worldwide, the provisions of Basel Accord (I, II, & III) are generally adopted by
internationally active banks for tracking, reporting and exposing operational, credit and market risks.17

12
Steven Nickolas (2022). How Can I Measure Portfolio Variance? https://www.investopedia.com.
13
Ibid (Steven Nickolas, 2022).
14
Ibid.
15
Does Corporate Risk Management Create Value? in Capital Budgeting Applications and Pitfalls. Ch 13 of Ivo Welch (2022). Corporate
Finance, 5 Ed. IAW Publishers. ISBN 978-0984004904.
16
Allan M. Malz (13 September 2011). Financial Risk Management: Models, History, and Institutions. John Wiley & Sons. ISBN 978-1-
118-02291-7.
Within non-financial corporates,18 the scope is broadened to overlap enterprise risk management, and
financial risk management then addresses risks to the firm's overall strategic objectives. In investment
management risk is managed through diversification and related optimization; while further specific
techniques are then applied to the portfolio or to individual stocks as appropriate.
In all cases, the last "line of defence" against risk is capital, "as it ensures that a firm can continue as a
going concern even if substantial and unexpected losses are incurred".19
2.1.4 What is a Financial Risk Manager?
As you might have guessed, a financial risk manager is a professional who practices financial risk
management. Such a person would have extensive knowledge of how to identify, measure, and control
risk. A person holding the position of financial risk manager will have normally had extensive experience
in financial markets and securities, and perhaps taken some specialized university, continuing education,
or professional development courses. She could be a member of professional organizations and have
completed certification programs on financial risk management. But the title of financial risk manager is
typically found only in large financial institutions, such as banks, who offer financial risk management
products and services to their customers.
Nonetheless, it is important to understand that one can practice financial risk management without being a
financial risk manager. Just as in one’s personal life, he can and hopefully will manage his own personal
risks without being a trained risk manager. In fact, most corporations, governments, and non-profits
cannot afford an extensive investment in financial risk management personnel or technology. In
organizations other than large financial institutions, financial risk management must typically be practiced
by financial managers, who have other responsibilities as well. A typical financial manager will not have
the knowledge to compete on an even keel with the specialized expertise of financial institutions who are
offering their financial risk management products for sale. The pressure to buy products and manage risk
in the manner recommended by the financial institution puts most corporations at a severe disadvantage,
often resulting in the purchase of snazzy products when simpler and less expensive ones will do the job.

2.1.5 Types of Financial Risk Management20

There are several different types of risks that finance mangers need to account for before proposing
investment strategies. Discussed below are few of them:
1) Financial Risk Management #1: Operational Risk
Operational risk – as defined by the Basel II framework – is the risk of indirect or direct loss caused by
failed or inadequate internal people, system, processes or external events. It includes other risk types such
as security risks, legal risks, fraud, environmental risks and physical risks (major power failures,
infrastructure shutdown etc.). Unlike other types of risk, Operational risks are not revenue driven,

17
Van Deventer, Donald R., and Kenji Imai. Credit risk models and the Basel Accords. Singapore: John Wiley & Sons (Asia),2003. Drumond,
Ines. "Bank capital requirements, business cycle fluctuations and the Basel Accords: a synthesis." Journal of Economic Surveys 23.5 (2009):
798-830.
18
John Hampton (2011). The AMA Handbook of Financial Risk Management. American Management Association. ISBN 978-0814417447 //
Jayne Thompson (2019). What Is Financial Risk Management?, chron.com
19 Market Risk Management in Non-financial Firms, in Carol Alexander, Elizabeth Sheedy eds. (2015). The Professional Risk Managers’
Handbook 2015 Edition. PRMIA. ISBN 978-0976609704.
20
Stafford Global (2023). “What is Financial Risk Management? The 4 Types of Risk”. accessed at https://www.staffordglobal.org. on
June 15, 2023.
incurred knowingly or capable of being completely eliminated. As long as people, processes and systems
remain imperfect and inefficient, the risk remains.
However, in terms of Financial Risk Management, Operational risks can be managed to within acceptable
levels of risk tolerance. This is done by determining the costs of proposed improvements against their
benefits.
2) Financial Risk Management #2: Foreign Exchange (FX) Risk
Foreign Exchange Risk is also known as currency risk, FX risk or exchange rate risk. It is incurred when
a financial transaction is made in a currency other than the operating currency – which is often the
domestic currency – of a business. The risk arises as a result of unfavourable changes in the exchange rate
between the transactional currency and operating currency.
An aspect of Foreign Exchange Risk is Economic Risk or Forecast Risk; the degree to which an
organisation’s product or market value is affected by unexpected exchange-rate fluctuations. Businesses
whose trade heavily relies on the import and export of goods, or who have diversified into foreign
markets are more susceptible to Foreign Exchange Risk.
3) Financial Risk Management #3: Credit Risk
Credit risk is the risk that a borrower or client defaults on their debts or outstanding payments. With
borrowed money, in addition to the loss of principal, additional factors such as loss of interest, increasing
collection costs etc., must be taken into account when establishing the extent of the Credit Risk. Financial
analysts use Yield Spreads as a means to determine Credit Risk levels in a market.
One of the simplest ways of mitigating Credit Risk is to run a credit check on a prospective client or
borrower. Other means is to purchase insurance, hold assets as collateral or have the debt guaranteed by a
third-party. Some methods corporations use to mitigate Credit Risk arising from non-payment of client
dues, is to request for advance payments, payment on delivery before handover of goods or to not provide
any lines of credit until a relationship has been established.
4) Financial Risk Management #4: Reputational Risk
Reputational Risk is also known as Reputation Risk and it is the loss of social capital, market share or
financial capital arising from damage to an organisation’s reputation. Reputation Risk is very difficult to
predict or realise financially, as Reputation is an intangible asset. It is however intrinsically tied to
Corporate Trust and is the reason why Reputation damage can hurt an organisation financially. Criminal
investigations into a company or its high-ranking executives, ethics violations, lack of sustainability
policies or issues related to safety and security of a product, customer or personnel are all examples of
what can damage an entity’s reputation.
The growth of technology and the influence of social media can now amplify minor issues on a global
scale. This has led to boycotts as a form of consumer protest. In extreme cases, Reputational Risk can
even lead to corporate bankruptcy. For this reason, more organisations are dedicating assets and resources
to better manage their reputation.

2.2 ASSET CLASSES21

21
Akhilesh Ganti (2023). “What Are Asset Classes? More Than Just Stocks and Bonds”. Investopedia.
As earlier discussed, an asset class is a grouping of investments that exhibit similar characteristics and
are subject to the same laws and regulations. Asset classes are thus made up of instruments that often
behave similarly to one another in the marketplace.
The most common asset classes are:
1) Cash and Cash Equivalents: Cash and cash equivalents represent actual cash on hand and
securities that are similar to cash. This type of investment is considered very low risk since there
is little to no chance of losing your money. That peace of mind means the returns are also lower
than other asset classes.
Examples of cash and cash equivalents include cash parked in a savings account as well as U.S.
government Treasury bills (T-bills), guaranteed investment certificates (GICs), and money
market funds. Generally, the greater the risk of losing money, the greater is the prospective
return.
2) Fixed Income: Fixed income is an investment that pays a fixed income. Basically, you lend
money to an entity and, in return, they pay you a fixed amount until the maturity date, which is
the date when the money you initially invested (the loan) is paid back to you.
Government and corporate bonds are the most common types of fixed-income products. The
government or company will pay you interest for the life of the loan, with rates varying
depending on inflation and the perceived risk that they won’t make good on the loan. The risk of
certain governments defaulting on their bonds is very unlikely, so they pay out less. Conversely,
some companies risk going bust and need to pay investors more to convince them to part with
their money.
3) Equities: When people talk about equities, they are usually speaking about owning shares in a
company. For companies to expand and meet their objectives, they often resort to selling slices
of ownership in exchange for cash to the general public, or initial public offering (IPO). Buying
these shares represents a great way to profit from the success of a company.
There are two ways to make money from investing in companies:
 If the company pays a dividend,
 If you sell the shares for more than you paid for them.
The market can be volatile, though. Share prices are known to fluctuate, and some companies
may even go bust.
4) Commodities: Commodities are basic goods that can be transformed into other goods and
services. Examples include metals, energy resources, and agricultural goods.
Commodities are crucial to the economy and, in some cases, are viewed as a good hedge against
inflation. Their return is based on supply and demand dynamics rather than profitability. Many
investors invest indirectly in commodities by buying shares in companies that produce them.
However, there is also a huge market for investing directly, whether that is actually buying a
physical commodity with the view of eventually selling it for a profit or investing in futures.
Each asset class carries a different level of risk and return and tends to perform differently in a
given environment.
There are also alternative asset classes, such as real estate, and valuable inventory, such as artwork,
stamps, and other tradable collectibles. Some analysts also refer to an investment in hedge funds, venture
capital, crowdsourcing, or crypto-currencies as examples of alternative investments. They said: an
asset’s illiquidity does not speak to its return potential; it only means that it may take more time to find a
buyer to convert the asset to cash.
2.2.1 Asset Class and Investing Strategy
Investors looking for alpha employ investment strategies focused on achieving alpha returns. Investment
strategies can be tied to growth, value, income, or a variety of other factors that help to identify and
categorize investment options according to a specific set of criteria. Alpha (α) is a term used in investing
to describe an investment strategy's ability to beat the market, or its "edge." Alpha is thus also often
referred to as “excess return” or the “abnormal rate of return” in relation to a benchmark, when adjusted
for risk. Alpha is often used in conjunction with beta (the Greek letter β), which measures the broad
market's overall volatility or risk, known as systematic market risk.22
Some analysts link criteria to performance and/or valuation metrics such as earnings-per-share
(EPS) growth or the price-to-earnings (P/E) ratio. Other analysts are less concerned with performance
and more concerned with the asset type or class.
Investors are often advised not to put all their eggs into one basket and invest in different asset classes to
spread their bets and reduce risk.
Historically, the three main asset classes have been equities (stocks), fixed income (bonds), and cash
equivalent or money market instruments. Currently, most investment professionals include real estate,
commodities, futures, other financial derivatives, and even cryptocurrencies in the asset class mix.
2.2.2 Which asset class has the best historical returns?
The stock market asset class has the best historical returns. It has proven to produce the highest returns
over extended periods of time. Since the late 1920s, the compound annual growth rate (CAGR) for the
S&P 500 is about 6.6%, assuming that all dividends were reinvested and adjusted for inflation. In other
words, $100 invested in the S&P 500 on Jan. 1, 1928, would have been worth about $42,500 (in 1928
dollars) by Dec. 31, 2022, without adjusting for inflation. The total would have grown to $727,560 in
2022 dollars. By comparison, the same $100 invested in five-year Treasuries would have been worth
only a little more than $7,000 in today’s dollars.23
Financial advisors focus on asset class as a way to help investors diversify their portfolios to maximize
returns. Investing in several different asset classes ensures a certain amount of diversity in investment
selections. Each asset class is expected to reflect different risk and return investment characteristics and
perform differently in any given market environment.

2.3 APPROACHES TO RISK MANAGEMENT24

There is a common misconception about risk management that the goal of risk management is to
completely eliminate the risk from a business. This is not really true because the elimination of risk is
practically impossible. Instead, the goal of risk management is to first ensure that the organization has a

22
James Chen (2023). “Alpha: What It Means in Investing, With Examples”. https://www.investopedia.com.
23
Akhilesh Ganti (2023). “What Are Asset Classes? More Than Just Stocks and Bonds’. https://www.investopedia.com.
24
Approaches to Risk Management. https://www.managementstudyguide.com.
clear picture of the level of risk that they are willing to undertake and then ensuring that the risk remains
within those limits.
There are different approaches to risk management which result in different types of outcomes for the
organization involved. Hence, the organization has to choose which approach it wants to follow. The
types of approaches commonly followed are provided below.
The approaches to risk management commonly followed in the risk management process are detailed
below.
1) Risk Avoidance
The most basic strategy is called risk avoidance. Under this approach, the company avoids taking on risks
as much as possible. However, this strategy is not viable for many companies. This is because most
activities have a certain amount of risk attached. Hence, if a company simply tries to avoid taking risks, it
would have to drastically reduce the scope of its activities. The end result of this approach is that there is
very little incentive for any activity to take place.
2) Diversification
Diversification is one of the oldest and most basic strategies in risk management. Under this approach, the
company deliberately tries to engage in business activities that are very different from one another. Since
the activities are very different from one another, they generally do not experience adverse business
events at the same time. The end result is that if some activities are facing a negative outcome, the others
automatically face a positive outcome and the overall results are stabilized. The problem with this policy
is that there it cannot be applied everywhere. It can only be applied in conglomerates that operate in
diverse businesses.
3) Risk Transfer
Another way to manage risks is to transfer risk to an external party. There are many external parties such
as insurance companies who are willing to assume risks in return for a fee. However, insurance policies
cannot be found for every risk. This is also where derivatives come into play.
Derivatives are financial instruments where the underlying cash flow changes based on the occurrence of
certain risky events. Derivatives help companies to contractually transfer their risk to outside parties. It is
important to realize that in these cases, the risk is not completely eliminated. The company still faces
counterparty risk i.e. the risk that the counterparty will not pay up in case an adverse event takes place.
4) Risk Retention
Risk retention is a strategy under which, the company decides to retain the risk on its books. This policy
may be the result of the high cost of the transfer. Alternatively, it could also be because the company is
very confident of its internal controls.
Companies that have a good operational risk control process in place tend to retain risks. This is because
they are confident that they will be able to manage the impact of the risk on their own. However, it is
important for a company to have a strong cash flow in place so that it can wither any shocks which may
arise as a result of not transferring risks.
5) Risk Sharing
There are hybrid approaches to risk management as well. Under these approaches, the company faces the
consequences of risk up to a certain threshold level. Once the threshold level is breached, the risk gets
transferred to an external party. The idea here is to make risk management cost-effective. The company
may be able to bear the smaller losses. However, it will get help in the event of catastrophic losses.
Since catastrophic losses are less likely, the premium to be paid for transferring these risks is less. Risk-
sharing can be used as an effective strategy to obtain wider coverage at a lower cost.
6) Loss Control
This strategy is used by organizations that have a certain amount of liquid assets on hand. They tend to
hold on to the assets till a certain predefined threshold is reached. This threshold is often called the “stop-
loss” point.
Once the threshold is reached, there are automatic orders in place to sell the assets and minimize the loss.
The idea behind this strategy is to ensure that assets are not sold at minor valuation differences. However,
when a significant drop in valuation is detected, assets must be sold in order to minimize the losses.
2.3.1 Risk and Returns
If you ask the management of an organization whether they want to reduce the risk in their company, the
answer, most probably, will be an emphatic yes! However, it needs to be understood that risk
management does not work in a silo. There is a clear and direct relationship between risk and reward.
Hence, if a company wants to minimize risks, there is a high chance that they will end up minimizing the
rewards as well. This is where things get tricky!
There are certain organizations that want to grow at a fast pace. Hence, by definition, they should be
taking more risks so as to allow the organization to achieve faster growth. Companies need to be aware of
this relationship between risk and reward. Having a policy of risk minimization and reward maximization
can be inconsistent and can create negative outcomes. The bottom line is that the same risk can be
handled in different ways based on the underlying policy of the firm. It is important to create a policy
based on the different approaches mentioned above.

2.4 FINANCIAL RISK MANAGEMENT FOR FINANCIAL INSTITUTIONS

Financial institutions often match savers' or investors' funds with those seeking funds, such as borrowers
or businesses seeking to trade shares of ownership for funds. Typically, this leads to future payments
from the borrower or business to the saver or investor. The tools for matching all of these parties up
include products such as loans, and markets, such as a stock exchange.25

2.4.1 Financial Institution (FI)

A financial institution (FI) is a company engaged in the business of dealing with financial and monetary
transactions such as deposits, loans, investments, and currency exchange. Financial institutions include a
broad range of business operations within the financial services sector, including banks, insurance
companies, brokerage firms, and investment dealers.26

25
CRS. "Introduction to Financial Services: The Regulatory Framework. https://crs.reports.congress.gov.
26
Adam Hayes. May 25, 2023. What is a Financial Institution? https://www.investopedia.com
Virtually everyone living in a developed economy has an ongoing or at least periodic need for a
financial institution's services.
At the most basic level, financial institutions allow people to access the money they need. For example,
although banks do many things, their primary role is to take in funds—called deposits—from those with
money, pool the deposits, and lend the money to others who need funds. Banks are intermediaries
between depositors (who lend money to the bank) and borrowers (who the bank lends money to). This
works well because while some depositors need their money at any given moment, most do not. So
banks can use deposits to make long-term loans. This applies to almost every entity and individual in a
capitalist system: individuals and households, financial and nonfinancial firms, and national and local
governments.27
Without financial institutions, businesses could not grow. And households could only buy goods,
education, and housing that the families have cash for today. Financial institutions serve most people in
some way as a critical part of any economy—whether in banking, insurance, or securities markets.
Individuals and companies rely on financial institutions for transactions and investing. For example, the
health of a nation's banking system is a linchpin of economic stability. Loss of confidence in a financial
institution can easily lead to a bank run.

2.4 FINANCIAL RISK MANAGEMENT AT INSTITUTIONAL LEVEL28

Financial risk management is a function within organizations that aims to detect, manage, and hedge
exposure to various risks stemming from the use of financial services. The complexity here is far higher
than for individuals because institutions must match various kinds of future income streams and payment
obligations, for example, raising funds for investment or working capital requirements, paying wages and
invoices, provisioning for future payment obligations like pensions, and so on. Therefore, financial risk
management involves an assessment of various assets and liabilities in the present as well as in the future.
Financial and nonfinancial institutions must be distinguished regarding their approach to risk
management. Nonfinancial institutions use financial products either to hedge nonfinancial risks or to
enable their operations. Financial institutions rather actively assume risk to make a profit either for their
own account (like banks or insurance companies) or as trustees for third parties (like asset managers).
Managing risk at financial institutions therefore must be seen in the context of a trade-off with profit
targets: loose risk management practices may increase short-term profitability at the expense of long-term
solvency; misjudgment of risk or carelessness may lead to dangerous risk concentration at financial
institutions.
Interesting research has been done in recent years analyzing the rise of risk management as an
organizational techno-social practice, as a set of proactive risk cultures that vary from institution to
institution and ameliorate risks, but that in doing so also create new ones. Since the 1990s, the tightening
of legislative and regulatory requirements as well as technological advancements has gradually increased
the influence of risk managers and chief financial officers, especially within financial companies. At the
same time, it is important to recognize that risk managers in the finance sector face a virtually impossible
task. On the one hand, they and their clients need to earn money, and they can only do so by taking risks.
On the other hand, it is the task of the risk manager to confine these risks. Restrictions on risk taking

27
US Department of Treasury. “About FIO”. https://home.treasury.gov.
28
Ekaterina Svetlova, Karl-Heinz Thielmann, in International Encyclopedia of Human Geography (Second Edition), 2020
might cause costs or even impede attractive business activities. While coping with the difficult and
sometimes contradictory requirements and mitigating risks, risk managers can contribute to emergence of
new risks and dangers.
Compared with other sectors, these conflicts of interest are much more distinct in the financial sector
since the risks there are often more abstract and can lie in the distant future. In particular, risk
management is tricky when it comes to complex financial products. After 2008, we could see that risk
assessment of many complex financial innovations in the run-up to the crisis failed. In addition,
complexity offers an opportunity to hide risks or to pass them to clueless financial market participants.
Nowadays, the ubiquitous combination of performance incentives with quantitative targets rewards short-
term success and induces financial providers to obtain market products with nontransparent risks.
Furthermore, experience has also shown that the pressure on risk managers to give up a cautious stance
increases when competitors take more risks and behave aggressively. There is therefore a basic tendency
toward the pro-cyclical behavior in risk management. The analyses of the multiple failure of risk
management before and during the last financial crisis showed that some banks had eased their risk rules
and continued investments in toxic products between 2004 and 2007. For example, risk managers
working for the failed mortgage giant Fannie Mae ignored the warnings that their sophisticated risk-
control system produced. The managers observed the market development and decided to continue
assuming more risk. This example illustrates that risk managers are as prone as lay investors to the
influence of emotions, moods, and biases.
At the same time, there was a trend to increase formalization of risk management. To protect themselves
in the strict regulatory environment, risk managers neglected traditional heuristic rules (“never put all
eggs in one basket,” “margin of safety,” and so on) and increasingly relied on mathematical tools and
slavish compliance. Although limiting their own discretionary scope, they justified their actions and
decisions by resorting to “objectifiable” numbers or regulations. For example, a parliamentary
commission in the United Kingdom examined the collapse of HBOS Bank in 2008 and criticized that risk
management in this bank was very much focused on formal procedures but too little on substantive
review and assessment of risks. However, exactly this style of formalization persists as regulation
tightens, and ever-widening reporting requirements are imposed on risk managers by the supervisory
authorities.
The tendency to formalize risk management can lead to blindness and ignorance of new, previously
unknown problems. Unforeseen, radically uncertain events, for which no probability of occurrence can
meaningfully be determined, are pressed back into a mathematical framework and then falsely appear as
measurable and thus controllable. Furthermore, liquidity risk remains one of the most underestimated
risks in risk management as it cannot be assessed with the usual quantitative concepts. In the field of
open-ended real estate funds, for example, it has become a veritable fund-killer because such funds often
had to carry out compulsory sales on bad terms due to cash outflows, which ruined their performance and
triggered further withdrawal of money. The hitherto most spectacular fund failure of the hedge fund
LTCM in 1998 is ultimately due to the sudden illiquidity of many assets. Also, reputational risk as one of
the most severe risks to which modern companies are exposed cannot be caught by formal models.

2.5 FINANCIAL RISK MANAGEMENT STRATEGIES29

29
Financial Risk Management Strategies. https://corporatefinanceinstitute.com › Resources
Financial risk management strategies are a plan of action or policies that are designed to deal with various
forms of financial risk. Financial risks are events or occurrences that have an undesirable financial
outcome or impact. These risks are faced by both individuals and corporations alike. The main financial
risk management strategies include risk avoidance, risk reduction, risk transfer, and risk retention.
The strategies are important for any firm or individual to manage the inherent financial risks that come
with operating within the economy and financial system.
2.5.1 Examples of Financial Risks
Before we can propose financial risk management strategies, we need to first understand the nature of the
financial risks faced by individuals, corporations, and financial institutions. In general, financial risks are
events or occurrences which have undesirable or unpredictable financial outcomes or impacts.
Individuals face financial risks in many aspects of their lives. These risks come in the form of:
 Risk of unemployment or loss of income: this includes unemployment, underemployment, health
issues, disability, and premature death.
 Risk of higher or unexpected expenses: this includes incurring higher expenses than budgeted or
having to deal with unforeseen emergency expenses.
 Risk related to assets/investments: this includes potential declines in the value of
assets/investments, as well as potential damage and theft of assets.
 Risks related to debt or credit financing: this includes being unable to service credit card debt,
asset loans, mortgages, and so on.
For corporations and financial institutions, there are additional types of risks faced, such as:
 Market Risk: the risk that losses may occur to financial assets based on the dynamics of the
overall financial markets, for example, an equity security losing a substantial portion of its value.
 Credit Risk: the risk that counterparty may default on their contractual obligations, for example,
an individual defaulting on their personal loan.
 Liquidity Risk: the risk that funding obligations may not be met due to cash constraints, for
example, a bank not having enough cash on hand to meet deposit withdrawal demand.
 Operational Risk: the risk that losses occur as a result of failed internal processes, people, and
systems. For example, an employee making a mistake on a transaction that results in a monetary
loss.

2.6 FINANCIAL RISK MANAGEMENT STRATEGIES

Managing financial risk for both individuals and corporations starts by working through a four-stage
process that includes the following steps:
a) Identifying potential financial risks
b) Analyzing and quantifying the severity of these risks
c) Deciding on a strategy to manage these risks
d) Monitoring the success of the strategy
There are various risk management strategies available to individuals, corporations, and financial
institutions.
At the individual level, some risk management strategies include:
a) Risk avoidance: elimination of activities that can expose the individual to risk; for example, an
individual can avoid credit/debt financing risk by avoiding the usage of credit to make purchases.
b) Risk reduction: mitigating potential losses or the severity of potential losses; for example, an
individual can diversify their investment portfolio to reduce the risk that their investment
portfolio experiences a severe negative drawdown.
c) Risk transfer: the process of transferring risk to a third party; for example, an individual may
purchase a life insurance policy to offload the risk of premature death to the insurer.
d) Risk retention: the process of accepting responsibility for a particular risk, for example, an
individual deliberately not insuring their property.

At the corporate level, the same risk management strategies may be applied, but in slightly different
contexts:
a) Risk avoidance: elimination of activities that can expose the corporation to risk; for example, the
corporation can avoid expanding operations to a geographical area that has high political and
regulatory uncertainty.
b) Risk reduction: mitigating potential losses or the severity of potential losses; for example, a
corporation may use hedging on foreign currency transactions to reduce their exposure to
currency fluctuations.
c) Risk transfer: the process of transferring risk to a third party; for example, a corporation may
purchase insurance on their property, plant, and equipment to transfer the risk of damage and
theft to the insurer.
d) Risk retention: the process of accepting responsibility for a particular risk; for example, a
corporation may accept risks of volatile input costs without using any hedging or insurance.

Difficulty arises in deciding which strategy to utilize for a particular risk. It comes down to the nature of
the risk and the individual’s or corporation’s current risk appetite. Risks should be fully understood
before deciding on the appropriate strategy to remedy them.
Example 1 – Risk Transfer: many individuals with spouses and children purchase life insurance to protect
against the risk of premature death. They want to insure against the loss of income and ensure there is an
income safety net for surviving family members.
Example 2 – Risk Retention: lumber producers are able to hedge their exposure to lumber prices with the
use of futures contracts. However, many choose to retain this risk and accept commodity price
fluctuations. It is, in fact, the industry standard. If a lumber producer were to hedge their risk, they could
place themselves at a disadvantage if the commodity price begins to move in a favorable direction.

2.7 DIFFERENT TYPES OF FINANCIAL INSTITUTIONS

In today’s financial services marketplace, a financial institution exists to provide a wide variety of
deposit, lending, and investment products to individuals, businesses, or both. While some financial
institutions focus on providing services and accounts for the general public, others are more likely to
serve only certain consumers with more specialized offerings.
The types of financial institutions range from banks and credit unions to investment banks and brokerage
firms, to mortgage lenders. To know which financial institution is most appropriate for serving a specific
need, learn about the different types of institutions and their purposes.
Within a capitalistic economic system, financial institutions help regulate the economy, ensure fair
financial practices, and facilitate prosperity. There is no hard and fast list of types of financial institutions.
Title 31 of the U.S. Code lists 31 types, while industry sources list a lot fewer. But for most consumers
and investors, these are the most important financial institutions to know about.
1) Central Banks: Central banks are the financial institutions responsible for overseeing and
managing all other banks. In the United States, the central bank is the Federal Reserve Bank
(Fed), which is responsible for conducting monetary policy and supervising and regulating
financial institutions.301
Individual consumers do not have direct contact with a central bank. Instead, large financial
institutions work directly with the Fed to provide products and services to the general public.
2) Retail and Commercial Banks: Traditionally, retail banks offered products to individual
consumers, while commercial banks worked directly with businesses. Today, most large banks
offer deposit accounts, loans, and limited financial advice to both consumers and businesses.
Products offered at retail and commercial banks include checking and savings accounts,
certificates of deposit (CDs), personal and mortgage loans, credit cards, and business banking
accounts.
Internet banks offer the same products and services as conventional banks, but they do so through
online platforms instead of brick-and-mortar locations. Internet banks may allow consumers to
carry out banking services via computer, mobile device, Automated Teller Machine (ATM), or by
calling a customer service line. Using your phone and the bank's app, you can deposit checks into
your account by taking a picture of your check.31
3) Credit Unions: A credit union is a type of nonprofit financial institution providing traditional
banking services and is created, owned, and operated by its members.
Historically, credit unions used to serve a specific and shared demographic group, also known as
the field of membership. The commonality might be based on employer, a geographic area, or
membership in another type of group. Today, many have loosened membership restrictions and
are open to the general public with minimal requirements, such as joining a nonprofit
organization for a small fee.32
Credit unions are not publicly traded and only need to make enough money to continue daily
operations, so they often can afford to provide reduced fees and better interest rates than banks.33
4) Savings and Loan (S&L) Associations: Savings and loan associations provide individual
consumers with checking accounts, personal loans, and home mortgages. Financial institutions

30
Federal Reserve System. “Overview of the Federal Reserve System. https://www.federalreserve.com
31
FDIC. "Banking at the Speed of Technology. https://www.fdic.gov
32
Mycreditunion.gov. "About Credit Unions. https://www.mycreditunion.gov
33
New York State Department of Financial Services. "Institution Definitions and Descriptions. https://www.dfs.ny.gov
 are owned by their customers or community. A savings and loan is a type of thrift that is required
by law to produce a certain number of loans secured by residential real estate, but the aim of most
savings and loans is to lend for residential mortgages.34
5) Investment Banks: Investment banks are financial institutions that provide services and act as an
intermediary in complex transactions—for instance, when a startup is preparing for an initial
public offering (IPO), or when one company is merging with another. They can also act as a
broker or financial advisor for large institutional clients such as pension funds.
Investment banks help individuals, businesses, and governments raise capital through the
issuance of securities.35
6) Brokerage Firms: Brokerage firms assist individuals and institutions in buying and selling
securities among available investors. Customers of brokerage firms can place trades of stocks,
bonds, mutual funds, exchange-traded funds (ETFs), and some alternative investments.36
7) Insurance Companies: Financial institutions that help individuals transfer the risk of loss are
known as insurance companies. Individuals and businesses use insurance companies to protect
against financial loss due to death, disability, accidents, property damage, and other misfortunes.
These companies can also include the self-insurance programs of other financial institutions such
as a savings and loan holding company.37
8) Mortgage Companies: Financial institutions that specialize in originating or funding mortgage
loans are mortgage companies. While most mortgage companies serve the individual consumer
market, some specialize in lending options for commercial real estate only.
Mortgage companies focus exclusively on originating loans and seek funding from financial institutions
that provide the capital for the mortgages. Many mortgage companies today operate online or have
limited branch locations, which allows for lower mortgage costs and fees.

34
National Information Center. "Institution Categories. https://www.ffiec.gov
35
FDIC. "Investments." https://fdic.gov
36
Investor.gov. "Brokers. https://investor.gov
37
National Information Center. "Institution Categories. https://www.ffiec.gov