Financial Risk Management | RBI Grade B Phase 2 Preparation - Bank Exams PDF Download

 Page 1


56
Financial System,
Markets and Services UNIT 4 MANAGEMENT OF RISK IN
FINANCIAL SERVICES
Objectives
The main objectives of this unit are to:
• provide an overall understanding on the nature of risk associated with financial
service companies;
• identify the sources of risk; and
• explain the process and products available in managing the risk.
Structure
4.1 Introduction
4.2 Trade in Risk
4.3 External and Internal Risk
4.4 Types of Risk
4.5 Management of Risk
4.6 Summary
4.7 Key Words
4.8 Self Assessment Questions
4.9 Further Readings
4.1 INTRODUCTION
The term financial services is broadly understood to include banking, insurance,
housing finance, stock broking and investment services. The services include fund-
based as well as fee-based services. In fund-based services, the firm raises equity,
debt and deposits and invests in securities or lends to those who are in need of
capital. In fee-based services, the financial service firms enable others to raise capital
from the market or exchange financial assets and risk with other participants of the
market.  In the US and other developed western economies, the financial services
sector has grown rapidly over the post-war period and now represents a significant
portion of total economic activity. In India too, during the last few years especially
after the liberalisation process was initiated, the financial services sector has grown
rapidly. Institutions and markets within the financial services sector play a major role
in the operation of the economic system. Today, it is difficult to run the economy
without this sector. You could have seen the impact of bank strikes and default of
stock brokers on the economy and financial markets.
The financial sector is also known for its dynamic characteristic and within a short
period, it has introduced several new products and services.  Though the sector is
growing rapidly all over the world, the financial markets have seen a number of bank
and insurance companies failure, securities scams and market crashes.  The industry
is operating in an environment where the risk is very high. Thus, the success of a firm
in the financial service industry to a large extent depends on the way in which it
manages the risk.
Content Digitized by eGyanKosh, IGNOU
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56
Financial System,
Markets and Services UNIT 4 MANAGEMENT OF RISK IN
FINANCIAL SERVICES
Objectives
The main objectives of this unit are to:
• provide an overall understanding on the nature of risk associated with financial
service companies;
• identify the sources of risk; and
• explain the process and products available in managing the risk.
Structure
4.1 Introduction
4.2 Trade in Risk
4.3 External and Internal Risk
4.4 Types of Risk
4.5 Management of Risk
4.6 Summary
4.7 Key Words
4.8 Self Assessment Questions
4.9 Further Readings
4.1 INTRODUCTION
The term financial services is broadly understood to include banking, insurance,
housing finance, stock broking and investment services. The services include fund-
based as well as fee-based services. In fund-based services, the firm raises equity,
debt and deposits and invests in securities or lends to those who are in need of
capital. In fee-based services, the financial service firms enable others to raise capital
from the market or exchange financial assets and risk with other participants of the
market.  In the US and other developed western economies, the financial services
sector has grown rapidly over the post-war period and now represents a significant
portion of total economic activity. In India too, during the last few years especially
after the liberalisation process was initiated, the financial services sector has grown
rapidly. Institutions and markets within the financial services sector play a major role
in the operation of the economic system. Today, it is difficult to run the economy
without this sector. You could have seen the impact of bank strikes and default of
stock brokers on the economy and financial markets.
The financial sector is also known for its dynamic characteristic and within a short
period, it has introduced several new products and services.  Though the sector is
growing rapidly all over the world, the financial markets have seen a number of bank
and insurance companies failure, securities scams and market crashes.  The industry
is operating in an environment where the risk is very high. Thus, the success of a firm
in the financial service industry to a large extent depends on the way in which it
manages the risk.
Content Digitized by eGyanKosh, IGNOU
57
Management of Risk
in Financial Services
4.2 TRADE IN RISK
The financial service sector offers several products and services to its customers.
There are two ways in which you could look at these products and services. For
example, if a bank collects money towards a fixed deposit, you may view this
transaction as the bank selling a product called fixed deposit to you. If you consider
the entire activity of the bank, you will realise the bank is giving you a ‘financial
claim’ in exchange of money and acquire another ‘financial claim’ when it lends
money to a firm. Financial claim is nothing but a promise to give a fixed amount under
certain predetermined terms. Thus the main activity of the bank is buying financial
claims from the borrowers and selling financial claims to the deposit holders. All
financial claims in general are risky and thus bank trade in risk. Similarly, stock
brokers buy and sell shares and bonds which are nothing but financial claims issued
by the corporate sector and they also trade in risk. If you have an asset say building
which is exposed to some amount of risk like fire, you can pass on the risk to the
insurance companies. The insurance companies take risk from you and some time sell
the risk to another insurance companies. They also issue financial claims to those
who invest money in their equity and bonds. The case of investment companies are
not much different from that of others. For example, venture capital companies take
business risk when they invest money in new technologies. Mutual funds offer the
benefit of eliminating or reducing the risk (unsystematic) of investment. Merchant
Bankers facilitate the companies to sell financial claims to the public.  In other words,
risk is an integral part of the financial services industry and also the main product of
the industry.
4.3 EXTERNAL AND INTERNAL RISK
 The financial services industry primarily deals with financial claims. When a
company deals with financial claims, there is always a chance for default which in
turn affects the performance of the company. The risk in financial services industry is
very high as the chances of default by those who sold financial claims are very high.
The default could arise due to several reasons. We can broadly classify them into two
categories for easy understanding. The default could be due to failure of the person
from whom financial service company has taken the financial claim.  It could also be
due to changes in interest rate in the market that reduces the value of existing
financial claims. As these events arise outside the company, they can be grouped
under external sources. There are internal reasons that cause default in meeting the
financial liability.  For example, the financial services company which is in different
activities may take higher risk in some activities that affect the company as a whole.
There could also be mismatching in the assets and liabilities of the bank. These
reasons could be grouped under internal sources. In the next section, we will list
down various sources of risks for different financial services.
External Risk
As described earlier, this type of risk arises mainly on certain developments that take
place outside the financial services company.  As the industry offers different
services, the external sources of risk also vary for different services. The following
are few external sources of risk applicable to different services.
a) Institutions Providing Direct Finance
There are different types of institutions available in the financial market providing
finance for various requirements. Commercial banks normally provide finance for
short term needs of the firms. Term-lending institutions meet the long term funding
Content Digitized by eGyanKosh, IGNOU
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56
Financial System,
Markets and Services UNIT 4 MANAGEMENT OF RISK IN
FINANCIAL SERVICES
Objectives
The main objectives of this unit are to:
• provide an overall understanding on the nature of risk associated with financial
service companies;
• identify the sources of risk; and
• explain the process and products available in managing the risk.
Structure
4.1 Introduction
4.2 Trade in Risk
4.3 External and Internal Risk
4.4 Types of Risk
4.5 Management of Risk
4.6 Summary
4.7 Key Words
4.8 Self Assessment Questions
4.9 Further Readings
4.1 INTRODUCTION
The term financial services is broadly understood to include banking, insurance,
housing finance, stock broking and investment services. The services include fund-
based as well as fee-based services. In fund-based services, the firm raises equity,
debt and deposits and invests in securities or lends to those who are in need of
capital. In fee-based services, the financial service firms enable others to raise capital
from the market or exchange financial assets and risk with other participants of the
market.  In the US and other developed western economies, the financial services
sector has grown rapidly over the post-war period and now represents a significant
portion of total economic activity. In India too, during the last few years especially
after the liberalisation process was initiated, the financial services sector has grown
rapidly. Institutions and markets within the financial services sector play a major role
in the operation of the economic system. Today, it is difficult to run the economy
without this sector. You could have seen the impact of bank strikes and default of
stock brokers on the economy and financial markets.
The financial sector is also known for its dynamic characteristic and within a short
period, it has introduced several new products and services.  Though the sector is
growing rapidly all over the world, the financial markets have seen a number of bank
and insurance companies failure, securities scams and market crashes.  The industry
is operating in an environment where the risk is very high. Thus, the success of a firm
in the financial service industry to a large extent depends on the way in which it
manages the risk.
Content Digitized by eGyanKosh, IGNOU
57
Management of Risk
in Financial Services
4.2 TRADE IN RISK
The financial service sector offers several products and services to its customers.
There are two ways in which you could look at these products and services. For
example, if a bank collects money towards a fixed deposit, you may view this
transaction as the bank selling a product called fixed deposit to you. If you consider
the entire activity of the bank, you will realise the bank is giving you a ‘financial
claim’ in exchange of money and acquire another ‘financial claim’ when it lends
money to a firm. Financial claim is nothing but a promise to give a fixed amount under
certain predetermined terms. Thus the main activity of the bank is buying financial
claims from the borrowers and selling financial claims to the deposit holders. All
financial claims in general are risky and thus bank trade in risk. Similarly, stock
brokers buy and sell shares and bonds which are nothing but financial claims issued
by the corporate sector and they also trade in risk. If you have an asset say building
which is exposed to some amount of risk like fire, you can pass on the risk to the
insurance companies. The insurance companies take risk from you and some time sell
the risk to another insurance companies. They also issue financial claims to those
who invest money in their equity and bonds. The case of investment companies are
not much different from that of others. For example, venture capital companies take
business risk when they invest money in new technologies. Mutual funds offer the
benefit of eliminating or reducing the risk (unsystematic) of investment. Merchant
Bankers facilitate the companies to sell financial claims to the public.  In other words,
risk is an integral part of the financial services industry and also the main product of
the industry.
4.3 EXTERNAL AND INTERNAL RISK
 The financial services industry primarily deals with financial claims. When a
company deals with financial claims, there is always a chance for default which in
turn affects the performance of the company. The risk in financial services industry is
very high as the chances of default by those who sold financial claims are very high.
The default could arise due to several reasons. We can broadly classify them into two
categories for easy understanding. The default could be due to failure of the person
from whom financial service company has taken the financial claim.  It could also be
due to changes in interest rate in the market that reduces the value of existing
financial claims. As these events arise outside the company, they can be grouped
under external sources. There are internal reasons that cause default in meeting the
financial liability.  For example, the financial services company which is in different
activities may take higher risk in some activities that affect the company as a whole.
There could also be mismatching in the assets and liabilities of the bank. These
reasons could be grouped under internal sources. In the next section, we will list
down various sources of risks for different financial services.
External Risk
As described earlier, this type of risk arises mainly on certain developments that take
place outside the financial services company.  As the industry offers different
services, the external sources of risk also vary for different services. The following
are few external sources of risk applicable to different services.
a) Institutions Providing Direct Finance
There are different types of institutions available in the financial market providing
finance for various requirements. Commercial banks normally provide finance for
short term needs of the firms. Term-lending institutions meet the long term funding
Content Digitized by eGyanKosh, IGNOU
58
Financial System,
Markets and Services
needs of industries which are commonly known as project financing.  Housing
finance companies provide funds to individuals and some times house-construction
companies for acquisition of house property.  V enture capital provides funds in the
form of equity to new projects which involve some innovative ideas. Credit cards,
factoring, forfeiting and bill discounting are other services which involve partly a
service and partly a financing method. Though there are companies in the market
specialising in these services, the commercial banks are also offering these services.
As the nature of business is primarily lending and they borrow money from the
market to offer these services, the nature of risk associated with these different
ventures is common. For the purpose of convenience, all these services could be
brought under the common head of banking services.
A bank may fail to honour the deposit claims of the deposit holders if the non-
performing assets of the bank increased above its net worth. Though this situation is
unlikely in the present Indian conditions since most of the major banks and financial
institutions are owned by the government, the failure of the banks is common in the
west and other countries which follow open economy and banks are not owned by
the government. Even in India, there were few cases of bank failures like Bank of
Karad and Bank of Thanjavore though they were subsequently merged with other
banks and investors were protected. As the privatisation is order of the day in every
sector of the economy and already a number of private sector banks have been
established in India, the sector will be exposed to more failures if the quality of the
credit is poor.
Another important external reason for the failure of these institutions in the business
of lending is the quality of other assets in their total assets. These institutions often
invest a part of the funds in securities either to fulfil the regulatory requirements or
for investment purpose. If the investment is made in high-risk debt or equity
securities, and any adverse development in the capital market or the issuing company
or agency will reduce the value of the investments and in this process it may affect
the bank’s ability to meet the liability. Thus evaluation of credit and investment
assume importance in dealing with the external sources of risk.
b) Insurance Services
Insurance companies take the risk associated with the assets of their clients. The
premium collected for this service is in turn invested either in securities or lent to
outsiders who are in need of money. Thus the insurance companies deal with the
external environment in two ways. An insurance company may fail to honour its
obligation if the investments they have made turned poor. Similarly, the quality of
assets they have insured may also turn bad such that there may be a large number of
claims which exceed the expectation of the company. It should be noted that
insurance companies are exposed to two common problems namely moral hazard
and adverse selection. Moral hazard is the tendency of an insured to take greater risk
because she/he is insured. For example, a machine owner may run the machine
continuously ignoring the normal shut-down requirement, to complete an order in short
time. Without insurance, the owner may not run the unit ignoring the normal shut-
down requirement. Another simple example that will help you to understand this moral
hazard is the customers behaviour during the warranty period.  You might have noticed
the tendency of the people to use the product maximum during the period of warranty.
The adverse selection is the tendency of insuring the low quality asset and not
insuring high quality assets. For example, suppose the price of insurance is same for
all the ships.  Then owners of ships that are in poor shape will find insurance more
attractive and are more likely to insure the ships than owners of sound ships. Thus,
the assessment of quality of assets has become important for the insurance company
to meet these sources of risk.
Content Digitized by eGyanKosh, IGNOU
Page 4


56
Financial System,
Markets and Services UNIT 4 MANAGEMENT OF RISK IN
FINANCIAL SERVICES
Objectives
The main objectives of this unit are to:
• provide an overall understanding on the nature of risk associated with financial
service companies;
• identify the sources of risk; and
• explain the process and products available in managing the risk.
Structure
4.1 Introduction
4.2 Trade in Risk
4.3 External and Internal Risk
4.4 Types of Risk
4.5 Management of Risk
4.6 Summary
4.7 Key Words
4.8 Self Assessment Questions
4.9 Further Readings
4.1 INTRODUCTION
The term financial services is broadly understood to include banking, insurance,
housing finance, stock broking and investment services. The services include fund-
based as well as fee-based services. In fund-based services, the firm raises equity,
debt and deposits and invests in securities or lends to those who are in need of
capital. In fee-based services, the financial service firms enable others to raise capital
from the market or exchange financial assets and risk with other participants of the
market.  In the US and other developed western economies, the financial services
sector has grown rapidly over the post-war period and now represents a significant
portion of total economic activity. In India too, during the last few years especially
after the liberalisation process was initiated, the financial services sector has grown
rapidly. Institutions and markets within the financial services sector play a major role
in the operation of the economic system. Today, it is difficult to run the economy
without this sector. You could have seen the impact of bank strikes and default of
stock brokers on the economy and financial markets.
The financial sector is also known for its dynamic characteristic and within a short
period, it has introduced several new products and services.  Though the sector is
growing rapidly all over the world, the financial markets have seen a number of bank
and insurance companies failure, securities scams and market crashes.  The industry
is operating in an environment where the risk is very high. Thus, the success of a firm
in the financial service industry to a large extent depends on the way in which it
manages the risk.
Content Digitized by eGyanKosh, IGNOU
57
Management of Risk
in Financial Services
4.2 TRADE IN RISK
The financial service sector offers several products and services to its customers.
There are two ways in which you could look at these products and services. For
example, if a bank collects money towards a fixed deposit, you may view this
transaction as the bank selling a product called fixed deposit to you. If you consider
the entire activity of the bank, you will realise the bank is giving you a ‘financial
claim’ in exchange of money and acquire another ‘financial claim’ when it lends
money to a firm. Financial claim is nothing but a promise to give a fixed amount under
certain predetermined terms. Thus the main activity of the bank is buying financial
claims from the borrowers and selling financial claims to the deposit holders. All
financial claims in general are risky and thus bank trade in risk. Similarly, stock
brokers buy and sell shares and bonds which are nothing but financial claims issued
by the corporate sector and they also trade in risk. If you have an asset say building
which is exposed to some amount of risk like fire, you can pass on the risk to the
insurance companies. The insurance companies take risk from you and some time sell
the risk to another insurance companies. They also issue financial claims to those
who invest money in their equity and bonds. The case of investment companies are
not much different from that of others. For example, venture capital companies take
business risk when they invest money in new technologies. Mutual funds offer the
benefit of eliminating or reducing the risk (unsystematic) of investment. Merchant
Bankers facilitate the companies to sell financial claims to the public.  In other words,
risk is an integral part of the financial services industry and also the main product of
the industry.
4.3 EXTERNAL AND INTERNAL RISK
 The financial services industry primarily deals with financial claims. When a
company deals with financial claims, there is always a chance for default which in
turn affects the performance of the company. The risk in financial services industry is
very high as the chances of default by those who sold financial claims are very high.
The default could arise due to several reasons. We can broadly classify them into two
categories for easy understanding. The default could be due to failure of the person
from whom financial service company has taken the financial claim.  It could also be
due to changes in interest rate in the market that reduces the value of existing
financial claims. As these events arise outside the company, they can be grouped
under external sources. There are internal reasons that cause default in meeting the
financial liability.  For example, the financial services company which is in different
activities may take higher risk in some activities that affect the company as a whole.
There could also be mismatching in the assets and liabilities of the bank. These
reasons could be grouped under internal sources. In the next section, we will list
down various sources of risks for different financial services.
External Risk
As described earlier, this type of risk arises mainly on certain developments that take
place outside the financial services company.  As the industry offers different
services, the external sources of risk also vary for different services. The following
are few external sources of risk applicable to different services.
a) Institutions Providing Direct Finance
There are different types of institutions available in the financial market providing
finance for various requirements. Commercial banks normally provide finance for
short term needs of the firms. Term-lending institutions meet the long term funding
Content Digitized by eGyanKosh, IGNOU
58
Financial System,
Markets and Services
needs of industries which are commonly known as project financing.  Housing
finance companies provide funds to individuals and some times house-construction
companies for acquisition of house property.  V enture capital provides funds in the
form of equity to new projects which involve some innovative ideas. Credit cards,
factoring, forfeiting and bill discounting are other services which involve partly a
service and partly a financing method. Though there are companies in the market
specialising in these services, the commercial banks are also offering these services.
As the nature of business is primarily lending and they borrow money from the
market to offer these services, the nature of risk associated with these different
ventures is common. For the purpose of convenience, all these services could be
brought under the common head of banking services.
A bank may fail to honour the deposit claims of the deposit holders if the non-
performing assets of the bank increased above its net worth. Though this situation is
unlikely in the present Indian conditions since most of the major banks and financial
institutions are owned by the government, the failure of the banks is common in the
west and other countries which follow open economy and banks are not owned by
the government. Even in India, there were few cases of bank failures like Bank of
Karad and Bank of Thanjavore though they were subsequently merged with other
banks and investors were protected. As the privatisation is order of the day in every
sector of the economy and already a number of private sector banks have been
established in India, the sector will be exposed to more failures if the quality of the
credit is poor.
Another important external reason for the failure of these institutions in the business
of lending is the quality of other assets in their total assets. These institutions often
invest a part of the funds in securities either to fulfil the regulatory requirements or
for investment purpose. If the investment is made in high-risk debt or equity
securities, and any adverse development in the capital market or the issuing company
or agency will reduce the value of the investments and in this process it may affect
the bank’s ability to meet the liability. Thus evaluation of credit and investment
assume importance in dealing with the external sources of risk.
b) Insurance Services
Insurance companies take the risk associated with the assets of their clients. The
premium collected for this service is in turn invested either in securities or lent to
outsiders who are in need of money. Thus the insurance companies deal with the
external environment in two ways. An insurance company may fail to honour its
obligation if the investments they have made turned poor. Similarly, the quality of
assets they have insured may also turn bad such that there may be a large number of
claims which exceed the expectation of the company. It should be noted that
insurance companies are exposed to two common problems namely moral hazard
and adverse selection. Moral hazard is the tendency of an insured to take greater risk
because she/he is insured. For example, a machine owner may run the machine
continuously ignoring the normal shut-down requirement, to complete an order in short
time. Without insurance, the owner may not run the unit ignoring the normal shut-
down requirement. Another simple example that will help you to understand this moral
hazard is the customers behaviour during the warranty period.  You might have noticed
the tendency of the people to use the product maximum during the period of warranty.
The adverse selection is the tendency of insuring the low quality asset and not
insuring high quality assets. For example, suppose the price of insurance is same for
all the ships.  Then owners of ships that are in poor shape will find insurance more
attractive and are more likely to insure the ships than owners of sound ships. Thus,
the assessment of quality of assets has become important for the insurance company
to meet these sources of risk.
Content Digitized by eGyanKosh, IGNOU
59
Management of Risk
in Financial Services
c) Stock Broking Services
Stock Brokers buy and sell securities on behalf of their clients. They collect the
securities from the sellers and collect money from the buyer (broker) and hand over
the funds to seller after deducting the brokerage for the service rendered. Though the
activity looks relatively simple, the risk from external sources are very high. First, in a
situation where the trades are not guaranteed by the stock exchanges or the clearing
corporation, it is always possible that the failure of one broker will have chain reaction
in the market place. There are several instances of this nature in the Indian stock
market and often exchanges are closed to sort out this problem of default by one or
group of brokers. Second, there is also a possibility that the client may fail to honour
the commitment but the broker has to make good the loss.
d)  Leasing and Hire Purchase
Leasing and hire purchase service is very close to the banking service. These
companies also raise money from the market through deposits and other means and
lend to industries. Of course, the lending is done not in the form of term loan or
working capital loan, but in the form of assets.  The quality of the portfolio of leased
assets is crucial to their survival. Though the leasing company can technically take
back the asset in the event of failure of the leasee, the resale value of the asset often
is very negligible compared to the outstanding obligation. In addition to the
performance of the firms to which the assets are leased, the leasing and hire
purchase companies were also affected by the performance of their investment in
other assets. These companies often use surplus funds, either temporarily or
permanently, in securities markets. As the securities market prices are affected by so
many factors, the performance of the investment in these securities has a bearing on
the ability of the leasing and hire purchase companies to meet their obligations. Thus
the sources of risk that affect the securities prices have become the external risk to
the lease and hire purchase companies.
Leasing and hire purchase companies are also affected by the frequent changes in
the regulations.  The recent Reserve Bank of India regulation is expected to wipe out
many of these companies from the market as RBI has put rigid norms in raising
deposits from the public.  Further, the performance of these companies also depends
on their ability to attract deposits since the operation of these companies will be viable
only when they operate with high leverage. For instance, a lease or hire-purchase
company can sustain their financial viability only when they are able to achieve a
debt-equity ratio of 4 or above.  The market for deposits has become competitive
especially when banks started offering interest rates close to the lease and hire
purchase companies and the moment the funds stop flowing the operations of the
company will be affected. This applies even to companies which are performing well
and the quality of lease portfolio is good.  The continuous flow of deposit is essential
because these companies operate with a mismatch of assets and liabilities under the
assumption that subsequent deposits will take care of this mismatch. An example will
be useful to understand this concept.
Example 1
Suppose, you have deposited Rs. 1 lakh for two years under the public deposit
scheme of lease and hire purchase company. The company in all probability will lease
an asset worth of Rs. 1 lakh to a company and following the general practice of the
industry, the lease period may be for 60 months (5 years) or 36 months (3 years).
How would the company repay your deposits at the end of second year?  The time
mismatch of the asset (lease asset) and liability (deposit raised from you) poses a
serious problem to the company. Though the company could create a lease asset only
for two year period to avoid the mismatch, the market for lease asset may not exist to
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56
Financial System,
Markets and Services UNIT 4 MANAGEMENT OF RISK IN
FINANCIAL SERVICES
Objectives
The main objectives of this unit are to:
• provide an overall understanding on the nature of risk associated with financial
service companies;
• identify the sources of risk; and
• explain the process and products available in managing the risk.
Structure
4.1 Introduction
4.2 Trade in Risk
4.3 External and Internal Risk
4.4 Types of Risk
4.5 Management of Risk
4.6 Summary
4.7 Key Words
4.8 Self Assessment Questions
4.9 Further Readings
4.1 INTRODUCTION
The term financial services is broadly understood to include banking, insurance,
housing finance, stock broking and investment services. The services include fund-
based as well as fee-based services. In fund-based services, the firm raises equity,
debt and deposits and invests in securities or lends to those who are in need of
capital. In fee-based services, the financial service firms enable others to raise capital
from the market or exchange financial assets and risk with other participants of the
market.  In the US and other developed western economies, the financial services
sector has grown rapidly over the post-war period and now represents a significant
portion of total economic activity. In India too, during the last few years especially
after the liberalisation process was initiated, the financial services sector has grown
rapidly. Institutions and markets within the financial services sector play a major role
in the operation of the economic system. Today, it is difficult to run the economy
without this sector. You could have seen the impact of bank strikes and default of
stock brokers on the economy and financial markets.
The financial sector is also known for its dynamic characteristic and within a short
period, it has introduced several new products and services.  Though the sector is
growing rapidly all over the world, the financial markets have seen a number of bank
and insurance companies failure, securities scams and market crashes.  The industry
is operating in an environment where the risk is very high. Thus, the success of a firm
in the financial service industry to a large extent depends on the way in which it
manages the risk.
Content Digitized by eGyanKosh, IGNOU
57
Management of Risk
in Financial Services
4.2 TRADE IN RISK
The financial service sector offers several products and services to its customers.
There are two ways in which you could look at these products and services. For
example, if a bank collects money towards a fixed deposit, you may view this
transaction as the bank selling a product called fixed deposit to you. If you consider
the entire activity of the bank, you will realise the bank is giving you a ‘financial
claim’ in exchange of money and acquire another ‘financial claim’ when it lends
money to a firm. Financial claim is nothing but a promise to give a fixed amount under
certain predetermined terms. Thus the main activity of the bank is buying financial
claims from the borrowers and selling financial claims to the deposit holders. All
financial claims in general are risky and thus bank trade in risk. Similarly, stock
brokers buy and sell shares and bonds which are nothing but financial claims issued
by the corporate sector and they also trade in risk. If you have an asset say building
which is exposed to some amount of risk like fire, you can pass on the risk to the
insurance companies. The insurance companies take risk from you and some time sell
the risk to another insurance companies. They also issue financial claims to those
who invest money in their equity and bonds. The case of investment companies are
not much different from that of others. For example, venture capital companies take
business risk when they invest money in new technologies. Mutual funds offer the
benefit of eliminating or reducing the risk (unsystematic) of investment. Merchant
Bankers facilitate the companies to sell financial claims to the public.  In other words,
risk is an integral part of the financial services industry and also the main product of
the industry.
4.3 EXTERNAL AND INTERNAL RISK
 The financial services industry primarily deals with financial claims. When a
company deals with financial claims, there is always a chance for default which in
turn affects the performance of the company. The risk in financial services industry is
very high as the chances of default by those who sold financial claims are very high.
The default could arise due to several reasons. We can broadly classify them into two
categories for easy understanding. The default could be due to failure of the person
from whom financial service company has taken the financial claim.  It could also be
due to changes in interest rate in the market that reduces the value of existing
financial claims. As these events arise outside the company, they can be grouped
under external sources. There are internal reasons that cause default in meeting the
financial liability.  For example, the financial services company which is in different
activities may take higher risk in some activities that affect the company as a whole.
There could also be mismatching in the assets and liabilities of the bank. These
reasons could be grouped under internal sources. In the next section, we will list
down various sources of risks for different financial services.
External Risk
As described earlier, this type of risk arises mainly on certain developments that take
place outside the financial services company.  As the industry offers different
services, the external sources of risk also vary for different services. The following
are few external sources of risk applicable to different services.
a) Institutions Providing Direct Finance
There are different types of institutions available in the financial market providing
finance for various requirements. Commercial banks normally provide finance for
short term needs of the firms. Term-lending institutions meet the long term funding
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needs of industries which are commonly known as project financing.  Housing
finance companies provide funds to individuals and some times house-construction
companies for acquisition of house property.  V enture capital provides funds in the
form of equity to new projects which involve some innovative ideas. Credit cards,
factoring, forfeiting and bill discounting are other services which involve partly a
service and partly a financing method. Though there are companies in the market
specialising in these services, the commercial banks are also offering these services.
As the nature of business is primarily lending and they borrow money from the
market to offer these services, the nature of risk associated with these different
ventures is common. For the purpose of convenience, all these services could be
brought under the common head of banking services.
A bank may fail to honour the deposit claims of the deposit holders if the non-
performing assets of the bank increased above its net worth. Though this situation is
unlikely in the present Indian conditions since most of the major banks and financial
institutions are owned by the government, the failure of the banks is common in the
west and other countries which follow open economy and banks are not owned by
the government. Even in India, there were few cases of bank failures like Bank of
Karad and Bank of Thanjavore though they were subsequently merged with other
banks and investors were protected. As the privatisation is order of the day in every
sector of the economy and already a number of private sector banks have been
established in India, the sector will be exposed to more failures if the quality of the
credit is poor.
Another important external reason for the failure of these institutions in the business
of lending is the quality of other assets in their total assets. These institutions often
invest a part of the funds in securities either to fulfil the regulatory requirements or
for investment purpose. If the investment is made in high-risk debt or equity
securities, and any adverse development in the capital market or the issuing company
or agency will reduce the value of the investments and in this process it may affect
the bank’s ability to meet the liability. Thus evaluation of credit and investment
assume importance in dealing with the external sources of risk.
b) Insurance Services
Insurance companies take the risk associated with the assets of their clients. The
premium collected for this service is in turn invested either in securities or lent to
outsiders who are in need of money. Thus the insurance companies deal with the
external environment in two ways. An insurance company may fail to honour its
obligation if the investments they have made turned poor. Similarly, the quality of
assets they have insured may also turn bad such that there may be a large number of
claims which exceed the expectation of the company. It should be noted that
insurance companies are exposed to two common problems namely moral hazard
and adverse selection. Moral hazard is the tendency of an insured to take greater risk
because she/he is insured. For example, a machine owner may run the machine
continuously ignoring the normal shut-down requirement, to complete an order in short
time. Without insurance, the owner may not run the unit ignoring the normal shut-
down requirement. Another simple example that will help you to understand this moral
hazard is the customers behaviour during the warranty period.  You might have noticed
the tendency of the people to use the product maximum during the period of warranty.
The adverse selection is the tendency of insuring the low quality asset and not
insuring high quality assets. For example, suppose the price of insurance is same for
all the ships.  Then owners of ships that are in poor shape will find insurance more
attractive and are more likely to insure the ships than owners of sound ships. Thus,
the assessment of quality of assets has become important for the insurance company
to meet these sources of risk.
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c) Stock Broking Services
Stock Brokers buy and sell securities on behalf of their clients. They collect the
securities from the sellers and collect money from the buyer (broker) and hand over
the funds to seller after deducting the brokerage for the service rendered. Though the
activity looks relatively simple, the risk from external sources are very high. First, in a
situation where the trades are not guaranteed by the stock exchanges or the clearing
corporation, it is always possible that the failure of one broker will have chain reaction
in the market place. There are several instances of this nature in the Indian stock
market and often exchanges are closed to sort out this problem of default by one or
group of brokers. Second, there is also a possibility that the client may fail to honour
the commitment but the broker has to make good the loss.
d)  Leasing and Hire Purchase
Leasing and hire purchase service is very close to the banking service. These
companies also raise money from the market through deposits and other means and
lend to industries. Of course, the lending is done not in the form of term loan or
working capital loan, but in the form of assets.  The quality of the portfolio of leased
assets is crucial to their survival. Though the leasing company can technically take
back the asset in the event of failure of the leasee, the resale value of the asset often
is very negligible compared to the outstanding obligation. In addition to the
performance of the firms to which the assets are leased, the leasing and hire
purchase companies were also affected by the performance of their investment in
other assets. These companies often use surplus funds, either temporarily or
permanently, in securities markets. As the securities market prices are affected by so
many factors, the performance of the investment in these securities has a bearing on
the ability of the leasing and hire purchase companies to meet their obligations. Thus
the sources of risk that affect the securities prices have become the external risk to
the lease and hire purchase companies.
Leasing and hire purchase companies are also affected by the frequent changes in
the regulations.  The recent Reserve Bank of India regulation is expected to wipe out
many of these companies from the market as RBI has put rigid norms in raising
deposits from the public.  Further, the performance of these companies also depends
on their ability to attract deposits since the operation of these companies will be viable
only when they operate with high leverage. For instance, a lease or hire-purchase
company can sustain their financial viability only when they are able to achieve a
debt-equity ratio of 4 or above.  The market for deposits has become competitive
especially when banks started offering interest rates close to the lease and hire
purchase companies and the moment the funds stop flowing the operations of the
company will be affected. This applies even to companies which are performing well
and the quality of lease portfolio is good.  The continuous flow of deposit is essential
because these companies operate with a mismatch of assets and liabilities under the
assumption that subsequent deposits will take care of this mismatch. An example will
be useful to understand this concept.
Example 1
Suppose, you have deposited Rs. 1 lakh for two years under the public deposit
scheme of lease and hire purchase company. The company in all probability will lease
an asset worth of Rs. 1 lakh to a company and following the general practice of the
industry, the lease period may be for 60 months (5 years) or 36 months (3 years).
How would the company repay your deposits at the end of second year?  The time
mismatch of the asset (lease asset) and liability (deposit raised from you) poses a
serious problem to the company. Though the company could create a lease asset only
for two year period to avoid the mismatch, the market for lease asset may not exist to
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match the period of liability. The company still carry on the business with the
mismatch, expecting some one will come at the end of second year with a deposit of
Rs. 1 lakh so that it could repay your debt. Though this example is made very simple
and in the real world so many other factors are taken into account in the asset-liability
management, you could have appreciated the need for continuous flow of deposits for
the existence of the lease and hire purchase companies.
e) Institutions Offering Fee Based Services
Merchant banking, mutual funds, credit rating, debt securitization, merger and
acquisition and corporate restructuring are few examples of fee based services
offered by the financial services companies. The absence of direct involvement in
funding considerably reduces their risk of operations. The performance of these
companies depends on the quality of the services offered by them and as such
internal factors play more role. As far as external sources of risk is concerned, the
regulatory changes is a common source of risk to all these services. For example,
there were major changes in the regulation of merchant banking and mutual funds
which will effectively reduce the number of players in their respective industry.  The
quality of credit rating service is heavily questioned during the period of East-Asian
crisis as the credit rating companies have failed to forewarn the users of credit rating.
In India too, the credit rating services were criticised when the CRB Capital had
failed to honour the commitments to its deposit holders. There were number of
factors external to the firms in East-Asia and CRB Capital causing their failure which
in turn cast doubt on the credit rating services.  Debt securitization service is yet to
develop as a major service in India. The performance of debt-obligations being
securitized and different laws relating to stamp duty in force in different states are
potential source of external risk to the operations of a company offering debt
securitization service.
Activity 1
a) How do you describe the business of credit card services ?
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b) Name a few financial services firms that provide funds to various requirements
of the corporate sector.
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c) In the context of ‘moral hazard’ and ‘adverse selection’ that affect insurance
companies, how will you evaluate the insurance proposals?
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d) Why does the Reserve Bank of India made the rules governing acceptance of
public deposits by NBFC strict?
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