GSSDGS KHALSA COLLEGE PATIALA

Assignment of “MANAGEMENT OF FINANCIAL

INSTRUMENTS”

TOPIC: What are financial institutions? Give an

overview of risk faced by financial institutions. Also
explain the various types of risks.

SUBMITTED TO: SUBMITTED BY:

Prof, Puneet Kaur Gurinder Singh
MBA (LD) -2 (Sem3)
Roll no.-9904
 FINANCIAL INSTITUTIONS

Financial Institutions are referred to as a company that deals in all types of

finance-related businesses. They are different from banks and play a very
important part in broadening the financial services in the country. They
provide a very attractive rate of returns to the customers in comparison to
any government-centric banks. It deals in loans and advances and also
specializes in some specified sectors like hire purchases and leasing etc.

The financial institution deals with finance-related services. These are

gaining popularity day by day nowadays. The attractive rate of returns on
the customer’s investment is very demanding. It also provides specialized
services like hire purchase and leasing, etc. The simple and organized
procedure of the institutions is becoming very complementary. It provides a
broad range of business opportunities. There are different types of financial
institutions. The goal of all the institutions is different and they provide
different services and have different levels of risk associated with it. All the
financial institutions have unique features and it works in a specialized way.
The financial institution is gaining immense popularity in broadening the
finance-related services in the country.

ROLES:
 The financial institution provides varied kinds of financial services to
the customers.
 The financial institution provides an attractive rate of return to the
customers.
 Promotes the direct investment by the customers and making them
understand the risk associated with that as well.
 It helps in forming the liquidity of the stock in case of an emergency in
the financial markets.

FEATURES:
  It provides a high rate of return to the customers who have invested in
the financial institution.
 It reduces the cost of financial services provided.
 It is considered very important for the development of financial
services in the country.
 It also advises the customers on how to deal with the equity and the
other securities bought and sold in the market.
 It helps to improvise decision making because it follows a systematic
approach to calculate all the risks and rewards.

Financial institutions work like banks in some ways. They give loans and
advances to the customers and also set a platform for the customers to do
some investments. The customers get exciting offers and returns from them
and therefore these institutions are gaining popularity.

It also provides consultancy services to the clients on their investments

related to the financial markets where the huge amount of risk is involved.
Moreover, the customers who are handing over their hard-earned monies to
such institutions should check for the history and origin of this financial
institution.

TYPES:
 Investment Banks
 Commercial Banks
 Internet Banks
 Retail Banking
 Insurance companies
 Mortgage companies.

RISK FACED BY FINANCIAL INSTITUTIONS:

 Risk can be referred to like the chances of having an unexpected or
negative outcome. Any action or activity that leads to loss of any type
can be termed as risk. There are different types of risks that a firm
might face and needs to overcome. Widely, risks can be classified into
three types: Business Risk, Non-Business Risk, and Financial Risk.

 Business Risk: These types of risks are taken by business enterprises

themselves in order to maximize shareholder value and profits. As for
example, Companies undertake high-cost risks in marketing to launch
a new product in order to gain higher sales.

 Non- Business Risk: These types of risks are not under the control of
firms. Risks that arise out of political and economic imbalances can
be termed as non-business risk.

 Financial Risk: Financial Risk as the term suggests is the risk that
involves financial loss to firms. Financial risk generally arises due to
instability and losses in the financial market caused by movements in
stock prices, currencies, interest rates and more.

Financial institutions risk is one of the high-priority risk types for every
business. Financial risk is caused due to market movements and market
movements can include a host of factors. Based on this, financial risk can
be classified into various types such as:

 Market Risk,
 Credit Risk,
 Liquidity Risk,
 Operational Risk,
 Legal Risk.
Market Risk:
This type of risk arises due to the movement in prices of financial
instrument. Market risk can be classified as Directional Risk and Non-
Directional Risk. Directional risk is caused due to movement in stock price,
interest rates and more. Non-Directional risk, on the other hand, can be
volatility risks. Market Risk for Financial Institutions is defined as the risk
related to the uncertainty of earnings on its trading portfolio. Value of the
investing portfolio is affected as well, because of its exposure to the same
market conditions. Market risk is the risk of losses in positions arising from
movements in market variables like prices and volatility. There is no unique
classification as each classification may refer to different aspects of market
risk.

The term market risk, also known as systematic risk, refers to the
uncertainty associated with any investment decision. Price volatility often
arises due to unanticipated fluctuations in factors that commonly affect the
entire financial market.

Systematic risk is not specifically associated with the company or the

industry one is invested in; instead, it is dependent on the performance of
the entire market. Thus, it is necessary for an investor to keep an eye on
various macro variables associated with the financial market, such as
inflation, interest rates, the balance of payments situation, fiscal deficits,
geopolitical factors, etc.

Credit Risk:
This type of risk arises when one fails to fulfill their obligations towards their
counterparties. Credit risk can be classified into Sovereign Risk and
Settlement Risk. Sovereign risk usually arises due to difficult foreign
exchange policies. Settlement risk, on the other hand, arises when one party
makes the payment while the other party fails to fulfill the obligations.

Credit risk analysis can be thought of as an extension of the credit

allocation process. After an individual or business applies to a bank or
financial institution for a loan, the bank or financial institution analyzes the
potential benefits and costs associated with the loan. Credit risk or credit
default risk is a type of risk faced by lenders.

A credit risk is risk of default on a debt that may arise from a borrower
failing to make required payments. In the first resort, the risk is that of the
lender and includes lost principal and interest, disruption to cash flows, and
increased collection costs.

The loss may be complete or partial. In an efficient market, higher levels of

credit risk will be associated with higher borrowing costs. Because of this,
measures of borrowing costs such as yield spreads can be used to infer
credit risk levels based on assessments by market participants.
Liquidity Risk:
This type of risk arises out of an inability to execute transactions. Liquidity
risk can be classified into Asset Liquidity Risk and Funding Liquidity Risk.
Asset Liquidity risk arises either due to insufficient buyers or insufficient
sellers against sell orders and buys orders respectively.

Liquidity risk occurs when an individual investor, business, or financial

institution cannot meet its short-term debt obligations. The investor or
entity might be unable to convert an asset into cash without giving up
capital and income due to a lack of buyers or an inefficient market. Liquidity
Risk in Financial Institutions.

Liquidity risk is a financial risk that for a certain period of time a given
financial asset, security or commodity cannot be traded quickly enough in
the market without impacting the market price.

Liquidity is the ability of a firm, company, or even an individual to pay its

debts without suffering catastrophic losses. Conversely, liquidity risk stems
from the lack of marketability of an investment that can't be bought or sold
quickly enough to prevent or minimize a loss.

Operational Risk:
This type of risk arises out of operational failures such as mismanagement
or technical failures. Operational risk can be classified into Fraud Risk and
Model Risk. Fraud risk arises due to the lack of controls and Model risk
arises due to incorrect model application.

Operational risk is "the risk of a change in value caused by the fact that
actual losses, incurred for inadequate or failed internal processes, people
and systems, or from external events (including legal risk), differ from the
expected losses".
It can also include other classes of risks, such as fraud, security, privacy
protection, legal risks, physical (example infrastructure shutdown) or
environmental risks. The study of operational risk is a broad discipline,
close to good management and quality management. In similar fashion,
operational risks affect client satisfaction, reputation and shareholder value,
all while increasing business volatility.

Legal Risk:
This type of financial risk arises out of legal constraints such as lawsuits.
Whenever a company needs to face financial losses out of legal proceedings,
it is a legal risk. Any risk coming out from legal proceedings are known as
the legal risk. These are the risks which are faced by financial institutions.

Controlling the loss resulting from legal risk will involve, at the legal level, a
review of impact on documentation, establishing resources to defend (or
prosecute) claims and an analysis of the likely financial impact. Decisions as
to how to react to the financial impact will ultimately be for management.