What Is the Risk in Financial Institutions?

Geri Terzo

A potential lack of transparency is a risk in financial institutions. Much of the global capital markets at some point moves through the channel of financial institutions, including investment banks and money management firms, such as hedge funds and mutual funds. Greater regulation in certain pockets of financial services reduces the level of risk that banks and the markets are exposed to. If a bank is so large and so influential that its demise would have a ripple effect on the economy, the risk in financial institutions of this sort is great. The potential sharing of sensitive information in an improper way is another risk factor surrounding financial firms.

Greater regulation in certain segments of the financial industry can reduce the level of risk to which banks and global markets are exposed.
Greater regulation in certain segments of the financial industry can reduce the level of risk to which banks and global markets are exposed.

Financial institutions create many of the sophisticated instruments that are bought and sold in the markets each day. Securities, such as credit derivatives, are often traded in an attempt to protect other exposures and to earn money for the bank itself in addition to clients. Given that a bank can invest money from its own balance sheet in order to increase the profits generated at the firm, the risk in financial institutions becomes greater due to the possibility of bad trades or unexpected losses. Those shortfalls may trigger declines in revenues, which becomes evident on a balance sheet — a refection of the financial health of an institution.

Another risk in financial institutions surrounds the potential of overlap within a firm. Some banks in particular are so large that there are various functions that take place, ranging from financial analysis to investment banking activity. The lines of ethics could easily become blurred when a firm stands to benefit with a client based on the way public investors treat a stock, for instance. Regulation and industry practices, such as a Chinese wall, have evolved to cause a separation between these roles so that there is less of a tendency or likelihood of any improprieties to occur.

There are ways for financial institutions to mitigate risk for the firm and the broader economy. For instance, some financial institutions are so large and perform such a high volume of financial transactions that any bankruptcy or other failure could pose a systemic risk to the economy. Regional regulation that calls for transparency in the types of transactions that banks and other financial firms perform and strategies used promotes a lesser degree of risk. Also, the more that top executives, such as the chief financial officer, and risk professionals, such as a chief compliance officer, communicate and coordinate goals, the more likely that risk in financial institutions is to decline.

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