The world of business is expanding each day especially with the emerging technological advances, thus making the world like a global village. In their running of daily businesses, financial institutions face various risks and thus must derive ways on how to counter them (Schroeck, 2002). The following paper covers the various risks common to financial institutions, reasons as to why financial institutions are the mostly regulated sectors in the world and forms of regulations imposed such institutions to ensure safety and soundness.
The most common risks encountered by financial institutions include; credit risks, market risks and operational risks (Carey et al., 2006). Credit risks are risks associated with the reliability of a client in relation to issuance of services on credit terms. For instance, when a bank wants to issue a loan to a customer, it must first access that customer’s credit worthiness so as to determine whether he/she is qualified for it. There are however defaulters who fail to repay such loans hence the need for such institutions to find ways of managing such risk. Market risks on the other hand are risks associated with insecurity in regard to earnings received from the institution’s operations. The extent of trading is determined by the interest rates in the market, currency and liquidity rates. Market risks also affects issues related to the amount of investment since financial institutions are open to the same elements in the market. Operational risks are risks associated with losses incurred due to errors arising internally such as system malfunctions and mistakes made by employees, as well as those arising from external factors such as theft, floods or destruction of assets (Carey et al., 2006).
Money is an important medium that is generally accepted in exchange for goods and services. There are other things that have been used in the past as money such as gold, silver and shells. Financial institutions generally deals with issues related to a finance which is a very sensitive parameter that affects any economy in the world. Financial institutions should therefore be regulated for several reasons. According to Benston (1999), if a financial institution fails, it might impose unnecessary costs on a third party who was not originally in the agreement, and therefore was not in a capacity to contract with the institution so as to lessen the harm. For instance, an insurance company that is unable to compensate an accident victim despite the fact that the person who caused the accident had taken a policy in that insurance company. This brings about negative externality since the person who bears the cost was not in a position to take a step in order to counterbalance the costs.
Similarly a distraught financial institution can bring about negative externalities for the whole economy. This means that shareholders and other private investors are not the only ones who suffer in case a financial institution. A market in that area as well could also suffer and the same would happen to other financial institutions. This means that any failure by a financial institution would affect the whole society hence the need for the government to get involved in their running so as to guard the society at large.
Benston (1999) argues that customers may not be adequately served in a situation where three is no or little competition amongst the financial service providers as this would bring about monopoly. In a monopolistic situation, a firm may charge very high prices and may also be biased in offering their services where they may look down on some minority groups. This means that some people may not be able to get loans to start and run businesses thus affecting their livelihood in that particular area. To curb this, laws are enacted so as to regulate their operation.
The economy of any country is very essential for its prosperity. Financial institutions are expected to ensure that economy is up and running as required. Proper liaison with financial institutions will ensure that they are provided with adequate resources to back up the growth of the economy. In addition, this liaison will provide business deals that assist in trade and growth of wealth. Both of these generally help to improve the economy and hence the need for them to be regulated to ensure that they do not fail in their tasks.
Taxes imposed on these institutions, either directly or indirectly profit the government and other personalities in power. When a financial institution is regulated, it is more competent in its job and clients are more confident when using their services. Regulation also protects an institution from unfair competition from substitute financial services which could otherwise impose extra costs on the consumer.
Quintyn and Taylor (2004) explain that the government regulates the financial institutions to ensure financial stability. In this case, regulation does not only mean looking into their performance but also involves more scrutiny and sometimes they may mediate when these institutions do not meet the required expectations.
In many countries, the central bank is delegated with the task of regulating banks. However, there are other agencies that are also involved in this task especially in monitoring the non-bank financial institutions like the insurance companies and pension schemes (Carmichael et al. 2002). As a form of regulation, the central bank requires institutions to have a certain minimum amount of money as capital in comparison to their liabilities. This is to ensure that they are in a position to bear the losses incurred from bad debts that are written off.
Regulators also require these institutions to issue reports regularly to the public so that those who have invested in them can have an overview of the performance and whether their investments are safe. Banks also have limitations on the amount of assets they posses (Symons & Jackson, 1999). They are expected to diversify their investments. For instance, that cannot have a bond that is of less value than the value of their investment. Similarly, cannot invest more than 25% of their capital in one institution. The Banking Act of 1933 in the U.S outlaws ownership of stocks by banks in that country. Instead, they are supposed to own derivatives, which are securities in form of mortgages and are considered more uncertain than stocks. They are actually believed to have caused the 2007- 2009 credit crisis (Symons & Jackson, 1999).
Kumar et al. (1997) argues that regulators also do monitoring and on-site supervision on financial institutions. In this case, they are required to give a report of their income, assets and liabilities. These reports are then statistically put into comparison with others from other financial institutions to find whether there are any crises that may be impending. For instance, in a bank, a sign that there could be a problem somewhere prompts the monitor to make an impromptu visit to the bank to inspect whatever is going on. At times, they go to the extent of conversing with customer to prove whether the loans were given and in what amounts.
In conclusion, the financial institutions in many parts of the world are more or less similar to each other, facing risks that are common such as credit, market and operational risks. Being very important for economic growth and wealth accumulation of a country, these sectors must be well regulated to ensure financial stability, protect the consumer interests and protect them from unfair competition (Carmichael et al. 2002). Various authorities, central bank included have enacted laws to govern these institutions so as to bring back the confidence in the system.
Benston G., (1999). Regulating financial markets: a critique and some proposals. American Enterprise Institute
Carey S.M., Carey Mark, Stutz M. & Natonal Bureau of Economic Research. (2006). The risks of financial institutions. University of Chicago Press
Carmichael J., Pomerleano M. & World Bank (2002). The development and regulation of non bank financial institutions. World Bank Publication
Jackson E. H., & Symons E. L., Jnr. (1999). Regulation of Financial Institutions. West Publishing Company.
Kumar A., Chuppe M. T., & Perttumen Paula.(1997). The regulation of non-bank financial institutions: the United States, the European Union, and other countries. World Bank Publications
Quintyn M. & Taylor W. M., (2004). Economic Issues: Rationale for Regulation, 32. Web.
Schroeck G. (2002). Risk management and value creation in financial institutions John Wiley and Sons