In any event of a recession, financial institutions find themselves to be in one of the most affected industries. This together with the fact that they are always facing several risks at all times exposes their operations to many possible and dangerous outcomes. These risks include Credit risks, liquidity risks, interest rate risk, asset management risks, operational risks and liability risks among others which if not properly managed and countered may leave these institutions in a situation where the collapsing of their businesses would be the ultimate end. This paper covers the risks that the financial institutions have been exposed to during the past incidences of recessions and how these financial institutions faced them. Credit risk
This is a risk of loss of principal resulting from the failure of a borrower to repay a loan in accordance with the agreed terms. Credit risks are usually faced by a lot of banks during recessions since the financial strength of most borrowers is always in jeopardy. Credit risks mostly affects loans and bonds and can be categorized into three forms. These categories include; Downgrade risks, credit spread risk and the default risk. * Downgrade risk deal with rating agencies such as S & P. These agencies give an issuer a rating that gives the possibility of default. The ratings range from the best, that is, AAA, to AA, A, BBB and CCC. If a company’s rating is downgraded by one of these rating agencies, it then becomes harder for a payment to be done by the corporation. * Credit spread risks on the other hand deals with the reaction of spread of an issue over the treasury curve. * Default risk is the risk that the issuer will go out of business and not be able to pay its obligations of interest and principal. Investors use default rates to help in measuring this risk. An investor could also look at the recovery rate. A default rate is the percentage of a population of bonds that are expected to default while the recovery rate shows how much of an investor will be ploughed back in the case of a default occurring. In previous instances of recessions, banks and other financial institutions that were faced with credit risks had to take certain measures to predict, estimate and overcome them. These measures include: * Knowing the probability of default (PD) - This is the likelihood that the borrower will not make the full repayment in time as stipulated in the contract. * Loss Given Default (LGD) - This is the amount of loss in the case of a default that is expressed as a percentage of the exposure at default. * Exposure at default (EAD)-This refer to the expected value of a loan at the time it is defaulted. * Recovery rate (RR) - This refers to the proportion of the exposure at default that the bank recovers. Most banks that have survived this risk during recessions held reserves against the expected level of credit losses which are classified under costs of doing business. Liquidity risk
Liquidity is the ability to pay on demand. In relation to banks and other financial institutions, most banks if not all usually expect to provide any amount of funds on demand when a depositor withdraws money from a savings account. Financial institutions also have the need to be liquid so as to enable them pay all their bills as they come due. The main risk involved with liquidity in financial institutions is the unpredictability of customer demands. This type of risk is also concerned with investors having to sell bonds below their listed value, which is usually from a recently done transaction. When the liquidity of a market is high, then investors can either sell or purchase securities at their current prices while in the opposite case when the market is not liquid, is becomes harder to buy and sell securities at their current market price. Liquidity risk is important since it shows you how easily you can abandon a...
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