2.7 Reasons for Risk-taking in Financial
Institutions
In spite of the dangers associated with risk-taking and the
procedures involved in measuring and managing these risks, some if not all
financial institutions still take on to these risks. The question now wondering
in our minds is why these institutions need to take on those risks. In order to
answer this question, it will be good for us to look into the reasons for
financial institutions taking risks. Because this will help us to better
understand the need for taking such risks.
It will be ideal to begin by discussing the place of risks
and risk management within financial institutions. This can be done by
stressing on why `risk' matters and what approaches can be taken to eliminate
or reduce these risks. Understanding these, will very much help managers and
investors who are faced by these challenges within the financial sector.
The prime goal of every manager is that of profit
maximisation. This implies managers ought to maximize their expected profits
regardless to the variability of the reported earnings. However, today, there
is a growing literature on the reasons for managerial concern over the
volatility of financial performance within financial institutions. This is
justifiable with the following reasons because any one of these reasons is
sufficient enough to motivate management to concern itself with risk and embark
upon careful assessment of both the level of risk associated with any financial
product as well as any potential risk mitigation. Managerial self-interest, tax
effects, the cost of financial distress and capital market imperfections are
all potential risk mitigation techniques.
Note that managers have limited ability when it comes to
diversifying their investment. This fosters risk aversion as well as a
preference for stability. The progressive tax system takes care of the tax
effects. This is because, with this system of taxation, the expected tax burden
is reduced by reduced volatility in reported taxable income. Financial distress
on its own is
costly and the cost of external financing increase rapidly
when the financial institution viability is in question. Accepting the fact
that the volatility of performance has some negative impact on the value of
these financial institutions, leads managers in considering some risks
mitigation strategies. Some of these include:
· Risks being eliminated by simple business
practices- here the practice of risk avoidance involves actions to reduce
the chances of idiosyncratic losses by eliminating such risks that are
superfluous to the institution's business purpose.
· Risks being transferred to other
participants-there are some risks that can be eliminated or reduced
through the technique of risk transfer.
· Risks being actively managed-here there must
be good reasons existing for using further resources to manage risks. This is
because risk management is central to its business purpose.
In each of the above cases, the goal of the institution is to
get rid of the institutions' risks that are not essential to the financial
services provided. Financial institutions take such risks because they know how
to deal with them either through eliminating, transferring or actively managing
the risks. Remember, risks and returns are directly proportionate, the higher
the risk the higher the expected return. All in all, precaution is taken that
the risk is absorbed and the risk management activity monitors the business
activity efficiently as far as risk and return are concerned.
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