Introduction to Financial Risk
Financial Risk is a term applicable to the individual, business and government, Risk means the probability of losing money in investment or in case of government and business inability to pay off its debt taken from various financial institutions.
Risk also includes various factors, which may affect desired results of operations or provide unwanted results affecting operations eventually affecting business, investor and the entire market. Financial risk for an individual is the loss of investment, the ability to pay off loans. Business financial risk may occur due to problems in operations of the business, credit risk i.e. inability to pay off debt, market risk i.e. when business losses its customers due to upgrades, innovations by competitors, change in consuming patterns. For government financial risk means the inability to control inflation, defaulting bonds and other debt instruments.
Example of Financial Risk
Examples of financial risk are given in detail:
Great Recession in 2008
- Subprime mortgage crisis.
- It started from 2007 December with a fall in GDP by 4.3% and a rise in unemployment by 10%.
- High-risk loans granted to borrowers with less credit score and poor credit history.
- From 2000-2005 due to the housing boom in the United States, many lenders want to capitalize on rising home prices.
- As a result, many financial institutions took risky mortgages in bulk from buyers with poor credit history known as mortgage-backed securities.
- In the U.S. in early 2007 New Century Financial declared Bankruptcy.
- Freddie Mac(Federal Home loan and mortgage corporation) declared inability to buy further Mortgage-backed securities.
- As a result, there is no market available for a mortgage to sell and recover the investment in such high-risk loans many firms started on a path of bankruptcy as resulted in price decline in the real estate market and no way to recover the investment.
- Because of the fall in housing prices, many borrowers realized that their home has much less value than the loan amount.
- Many homeowners started to default on their loans and since there is a lack of buyers in such market houses prices continue to fall further resulting in a rise in a number of defaults from homeowners and no way to recover such loans for financial institutions.
- Like a snowball effect on the economy even when Dow Jones crossed 14000 for the first time, it was not able to maintain that level and over next 18 months, it falls more than 6500 points, which resulted in a loss of investment for many Americans who invested a large portion of their life savings in the stock market. As a result credit market start to decline.
- To take action against a fall in economy Federal Reserve in the US reduced target for interest rates to promote borrowing and unfreeze credit market.
- In February 2008 Economic Stimulus Act signed by U.S. President to encourage a certain amount of rebates to taxpayers with the intention of an increase in spending and increasing loan limit to promote home sales and boost the economy.
- Investment banking giants like Bear Sterns and Lehman Brothers collapsed declaring bankruptcy as a result of the subprime mortgage crisis in 2008.
- Insurance giant American Insurance Group(AIG), which insured many such Mortgage-backed loans from various financial institution also faced trouble. But because of its asset qualities, the Fed agreed to lend further 85 billion dollars to AIG to manage its business.
- TARP(Troubled Asset Relief Program) allowed the US government $700 billion to buy such assets from companies, which are in trouble. Such assets can be slowly sold in a market as the economy recovers.
- Tarp Funds also used to bail out General Motors and Bank of America.
- Second stimulus package announced by the US government in 2009 to promote spending on infrastructure, health care, energy, etc.
- Great Recession also created an impact in European countries resulting in default in bonds by Greece, Portugal, and Ireland with an expectation of bailout.
- Countries were forced to take certain measures like rising in tax and cuts in social programs to avoid further defaults in debt.
- Great Recession in 2008 describes Financial Risk and its impact on Individual, Government and Global economy. If not managed properly such Risk creates a catastrophic result, which makes it hard for the economy to recover and forced the government to take certain measures through policy to avoid further dowfall.
Types of Financial Risk
Various types of financial risk are given below:
1. Market Risk
Market risk arises out of upgrades or innovation in technology, change in prices or change in consumption patterns of customers affecting business revenues.
Market risk includes systematic and unsystematic risk resulting in a loss of investment. Systematic risk includes the recession, change in interest rates, natural disasters, which cannot be avoided. Unsystematic risk is the ones, which can be avoided or managed through a change in operations, strategy, and planning.
2. Credit Risk
The inability of a borrower to repay the debt according to contractual obligations. Defaulting in repayment of debt will affect business reputation in the market, the ability to borrow funds from other financial institutions and loss of investor’s confidence. While in case of government credit risk can have vast effects on the entire economy and world, since defaulting bonds and inability to control inflation will affect countries’ reputation, business transaction, social stability and relations with other countries.
3. Operational Risk
Operational risk can be a result of decisions from management affecting business output or provide unwanted results. Generally, Operational risk does not mean complete failure but the reduction in output capacity, which can be managed by a change in decision, upgrade and maintenance of technology.
4. Liquidity Risk
The ability of an individual or business to pay out its short-term financial obligations, due to failure to sell its assets quickly in a market without loss. The inability to sell assets or investments for cash can be a result of market conditions, lack of buyers, etc. Liquidity risk can be managed by maintaining diversified investment in short term assets, maintaining adequate cash in the business to meet short-term obligations.
Difference between Financial Risk vs Business Risk
Basis of Comparison
|Definition||Financial Risk means the probability of loss in investment or an inability to pay off debt.||Business Risk means inefficiency of business in generating enough revenue to meet operational expenses.|
|Why||In the case of Business and government, financial risk is the inability to pay off its debt.||Business risk generally related to inefficiency in operations.|
|Reasons||Financial Risk can be caused due to the high burden of debt instead of equity with the intention to generate better returns.||Business Risk is inevitable as long as the business continues to operates, as business needs growth and expansion, which includes risk.|
|Risk Management||Financial Risk can be managed by maintaining a balance between equity and debt as well as using debt for growth of business for better returns.||Business risk can be managed by managing the operation process, reduction in the cost of productions, technical upgrades, and new strategies.|
|How to calculate||Debt to Asset ratio, Debt to equity ratio, the interest coverage ratio||Change in Revenue and EBIT|
Advantages and Disadvantages of Financial Risk
Following are the advantages and disadvantages below:
Following are the advantages:
- Growth: Risk is an important part of the business and for growth and expansion in a new market; businesses might need to raise finance through debt. Financial Risk although it looks burden for the company, if a company is able to perform and generate better revenues through growth and expansion such risk needs to be taken.
- Tax Planning: Many companies use losses for a tax deduction, which can be spread over multiple years. Reduction in tax liability and risk management of a company can turn financial risk in a long-term advantage.
- Alert for investors and management: Financial risk is an alarm for investors and management to take certain measures to avoid further damage.
- Valuation assessment: Financial risk includes in certain business or projects helps in evaluating income through risk-reward ratio, which tells whether such business or projects are worth or not.
- Financial Risk is can be analyzed through various ratios, which makes it easy to understand the role of risk involved in the business.
Following are the disadvantages:
- Can Create Catastrophic Result: In the case of government, Financial Risk leads to defaulting bonds and other debt from financial institutions, which can cause long-lasting damage to the country’s as well as the global economy. E.g. Greece crisis created an impact on countries in the European Union, which invested in Greece through bonds.
- Cannot be Control: Financial risk arising out of global factors, natural disasters, wars, change in interest rates, change in government policies which cannot be controlled by a business operating in a certain market.
- Long-Term Effects: Financial Risk if not managed at the right time with the right strategies can cause damage to financials and reputation affecting the entire business and loss of confidence of investors and lenders. It can be very difficult for a business to overcome such setbacks.
- Impact: Financial risk can create an impact on the entire sector, market, and economy.
Financial Risk is an important part of Individual finances, Business, and government. Such risk is not necessarily a negative sign but can be a sign of growth if utilized and managed properly. In the case of business, financial leverage ratios like interest coverage ratios, debt-asset ratio, debt-equity ratio are used to understand the level of debt the company has in the market. Financial Risk if tackled with growth in revenues and expansion of business can be useful but if not managed properly can cause the bankruptcy of business and loss for investors and lenders in the business.
In the case of Government, Financial Risk needs to be monitored continuously to avoid catastrophic effects on the country and economy in the future. Individual Financial risk can be lost in investment or increasing financial debt can be a concern for his or her future. Such risk can be reduced and diverted with proper management techniques.
This is a guide to Financial Risk. Here we discuss the introduction and types of financial risk along with the advantages and disadvantages. You may also have a look at the following articles to learn more –