By definition, financial risk management is a process, where corporations, both financial and non-financial, create guidelines that determine their ability to accept the financial risk. Simply put, it entails procedures and practices that companies use to optimize the risks that they handle considering their financial interests. The most common risks that corporations guard against are market and credit risks. However, there are other risks that could befall an organization, for instance, foreign exchange, volatility, inflation as well as liquidity risks.
Like many other risks, the sources of financial risk should be identified, measured and strategies should be put in place to address them. However, it is important to note that financial risk management can be quantitative or qualitative. As such, a number of financial instruments (hedges), including insurance, stocks, funds traded in the exchange market, options, and forward contracts, can be used to guard against financial losses. Furthermore, they can also help benefit from the prevailing market conditions.
According to Froot, Scharfstein, and Stein (1993), finance theory did well to instruct to create an avenue for informing corporations on how to implement hedges. Unfortunately, its notable shortcoming is the inability to clearly guide or provide logical answers to pertinent issues before undertaking a hedging strategy. For instance, it does not give answers to what should be hedged, whether or not hedging should be full, and what kind of instruments could be used to achieve a given hedging strategy. This paper focuses on the development of a general framework to analyze corporate financial risk management using the various instruments. Furthermore, the paper examines the arguments for and against financial risk management using different instruments. The analysis provides a chance to determine whether financial risk management is an important strategy that individuals charged with the responsibility of administering public finances should continue implementing or discard altogether.
Evidence Supporting Financial Risk Management
The role of financial risk management has evolved tremendously over the years, particularly in financial organizations. In fact, financial risk management has advanced from simply identifying risks to determine econometric complexes and create financial models that can predict uncertainties. Firstly, the proponents of financial risk management cite deregulation as one of the measures that have been important in the administration of public entities. As an aspect of financial risk management, deregulation of capital flows gained prominence in the 1970s and, since that time, has contributed to increased globalization. When firms deregulate financial flows, they expand rapidly to new ones and begin to offer services that they could not offer before. For instance, a financial institution such as a bank may begin providing insurance services while insurance firms may begin to offer credit derivatives (Alexander, 2005).
Secondly, financial risk management has resulted in supervision or regulation of banks as well as other financial institutions. Apparently, regulation has been instituted to make sure that financial institutions meet capital requirements. Capital adequacy ensures that financial institutions can meet the extended needs that may result in increased risks. For instance, Alexander (2005) records that initially, the Basel Accord in 1988 considered only credit risks that banks faced. However, when the accord was amended in 1996, the risks were extended to include market risks. The third amendment that was conducted in 2007 ensured that the calculation of risk assessment included operational risks (Alexander, 2005). Moreover, Basel II stated that brokerage subsidiaries, banking operations, as well as asset management included solvency ratios (Alexander, 2005). Because of deregulation, there are certain financial services that only a few firms can provide now, thereby enhancing competition.
Regulation of banking activities has also been seen as a source of competition. For example, when the Basel Accord was first implemented, services that included custody as well as agencies were required to incur charges on regulatory capital. It meant that the best option for the financial providers in such situations was to outsource the services. Besides, financial services such as asset management, insurance as well as banking were to be merged to create a large and more complex banking institution (Alexander, 2005). Undoubtedly, such kind of bringing together of different types of services underscores the need for financial risk management in firms. Such a regulatory outcome regarding the supervision of financial organizations represents a shift of strategy that could as well be applied elsewhere in the financial sector based on a comparable basis.
Thirdly, the traditional banking industry has contributed to the changing roles witnessed in various structures of financial organizations. The disintermediation has occasioned the change. Notably, large companies no longer rely on banks for loans or bonds; on the contrary, they now prefer debts issued by bonds. At other times, the firms go for private equity offered in the capital markets (Oldfield & Santomero, 1997). The new approach has seen the banks relying mostly on commissions or fees charged on the corporate services that they offer. However, banks have come up with other mitigation strategies such as pension and mutual funds, as well as non-bank financial options. Indeed, currently, there are several layers of intermediation and interlinkages between various operators in the financial segment. In the end, there are advanced technologies used in financial risk management offered through the internet or intranet. Thus, communication, order management, database management and security management are enhanced.
Evidence Opposing Financial Risk Management
The opponents of financial risk management argue that deregulation of capital flows in the emerging world has catalyzed globalizations in the developing world, particularly in Asia, South America, and Eastern Europe. In some of these regions, particularly Asia and Eastern Europe, the exponential growth of capitalism, backward accounting standards, as well as unproductive financial intermediation that led to credit crises in the 1980s followed this process (Alexander, 2005). According to the Federal Reserve (2013), the Baa credit in the United States started in the 1980s when Russia faced a debt crisis. Another contributor was numerous defaults that occurred in the United States' communication sector. Notably, technology catalyzed the extraordinary price increments witnessed in the stocks during the late 1990s. As the prices of technology stocks rose, the communications companies involved paid ludicrous sums. It prompted many governments to demand their licensure because of the huge debts accrued (Alexander, 2005). Therefore, financial institutions can use communication and technological developments deregulation for exploitative purposes.
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Recent trends in the global financial markets have led to operational risks. For instance, there are new companies, which have adopted fake accountancy as well as management practices for rapid growth and deregulation (Grody, Hughes, & Toms, 2011). Such practices can be termed as the fraud. An example of a company that fraudulently deregulated in the United States is Enron. In the 1990s, the company was formed after the deregulation of the United States' energy sector. Besides, there have been increased systems risks due to the enhanced use of technology while the concentration of financial activities in one locality has resulted in increased operational risks.
There has also been a business risk or the risk of bankruptcy because of wrong management decisions as financial organizations continue to make changes (Marin, n.d). Apparently, there is a decline in the demand for banking loans while the opposite occurs for corporate finances. Bank credit risks and markets reduce, but business risks continue to increase. Alexander (2005) cites the case of Abbey National, one of the largest banks in the United Kingdom that started as a building society. Thereafter, when it received a license to offer retail-banking services, it expanded its services to offer corporate finance and treasury operations. Though the bank may have opted to offer additional services as a way to mitigate financial risks, it did not last after it made huge losses. It is a case point of poor risk management decision overextended.
Business risks have become common because of mergers or acquisitions that have been witnessed in the financial industry over the recent past (Grody, Hughes, & Toms, 2011). From history, banks, asset management, and insurance companies have had irreconcilable risk management principles that cannot be merged. In addition, there are differences between commercial and investment banking, which do not support the mergers or acquisitions that could be used for financial risk mitigations.
Systemic risks have led to insolvencies not only in banking but also in other sectors. Evidently, similar risk management practices may result in systemic risks. For instance, the prices of risky assets may fall, causing the funds that have performed dismally to retain their solvency ratio. In such a case, if the assets were from an insurance company, then, the risky assets could be sold. In fact, if the assets were performing below their market prices, then their prices would fall further. It could lead to selling more assets, and, as this downward trend continues, more products would be sold below their correct value.
The trend of regulating the financial industry to manage risks may be counterproductive. The regulations create a homogenous risk assessment or control. As the financial industry continues to embrace integration, chances are high that more integration will occur in the future, thereby creating a systemic risk. Besides, the effects of illiquidity spillover may also enhance systemic risk. In such cases, financial problems in one market could potentially be witnessed in other markets, especially where financial services are left in the hands of a few market players only. In the event of a problem, the effects could be disastrous.
Critique of the Arguments
Various financial risk management tools examined here are critical for the success of financial organizations. However, from the analysis, it became apparent that there are those financial risk management tools that financial service providers could abuse. For instance, systems can be compromised to defraud customers or the financial institutions themselves. Therefore, it is important to develop systems fraud-proof systems. The systems could be tested several times before putting them into practice. Besides, individuals operating the systems should have high integrity so that they are not compromised to leak systems' weaknesses. Furthermore, financial institutions should have their security systems without relying on others. If financial organizations relied on their systems that meet the set standards, then it could be possible to avoid cases of tampering. However, it is notable that the system risks in financial institutions have reduced considerably due to advancements in technology.
Finally, financial organizations concentrating their operations in one geographical area pose significant risks. For instance, in the case of a terror attack, chances are high that the financial organizations found in that particular geographical location will lose. Instead, financial organizations should consider diversifying their operations to areas with greater potential. Globalizing operations can enhance survival and security of important information. For example, a financial organization could consider decentralizing risk management functions to different branches. The strategy could also enhance specialization of such branches.
Conclusion and Recommendation
In conclusion, financial risk management has played an important role in enhancing the success of the operation of various financial organizations. However, challenges abound when the instruments of risk management are not applied correctly. Proponents of financial risk management note that it promotes deregulation and enhances globalization. The argument is that since it promotes supervision of banks, only banks that meet set capital thresholds are registered to offer certain services. In addition, banks need to note that the roles have changed as well. Therefore, they can now offer services characteristic of insurance institutions and vice versa. Those who do not support the postulations put forward for financial risk management argue that it has led to work crises and increased both operational and business risks. Nevertheless, the positive contributions of financial risk management cannot be underestimated because they have been helpful to financial organizations. Therefore, financial service providers should continue to apply them.
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