Financial institutions face risks including lack of transparency, overlap within the company, and potential for bad transactions or unexpected losses. Increased regulation and communication between executives and risk professionals can mitigate these risks.
A possible lack of transparency is a risk in financial institutions. Much of the world’s capital markets at some point move through the channel of financial institutions, including investment banks and money management firms such as hedge funds and mutual funds. Increased regulation in certain financial services sectors reduces the level of risk to which banks and markets are exposed. If a bank is so large and influential that its disappearance would have a domino effect on the economy, the risk in this type of financial institution is great. The potential sharing of sensitive information in the wrong way is another risk factor surrounding financial companies.
Financial institutions create many of the sophisticated instruments that are bought and sold in the markets every day. Securities, like credit derivatives, are often traded in an attempt to protect other exposures and to make money for the bank as well as customers. Since a bank can invest money from its own balance sheet to increase the profits generated in the company, the risk in financial institutions increases due to the possibility of bad transactions or unexpected losses. Those shortcomings can trigger declining revenue, which becomes apparent on the balance sheet—a reflection of an institution’s financial health.
Another risk in financial institutions surrounds the potential for overlap within a company. Some banks in particular are so large that there are various functions taking place, from financial analysis to investment banking activities. Ethical lines could easily become blurred when a company benefits from a client based on how public investors treat a stock, for example. Regulation and industry practices, such as a Chinese wall, have evolved to cause a separation between these roles so that wrongdoing is less likely or likely to occur.
Financial institutions can mitigate risks to the company and the economy in general. For example, some financial institutions are so large and conduct such a high volume of financial transactions that any bankruptcy or other failure could pose a systemic risk to the economy. The regional regulation that requires transparency in the types of transactions carried out by banks and other financial companies and the strategies used promote a lower degree of risk. Furthermore, the more senior executives, such as the CFO, and risk professionals, such as the chief compliance officer, communicate and coordinate objectives, the more likely risk at financial institutions will decrease.
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