Risk management involves having in place a plan that ensures that risks that face an organization are continuously identified and efforts are made to deal with the risks. The financial institutions face similar risks depending on the products that they offer in the market, and they have a predetermined approach in dealing with the risks that they face. The aim of this paper is to discuss the major approaches that the financial institutions use to deal with the risks that they face. The major risk management approaches are risk transfer and risk avoidance. The paper will compare the risk management approaches in the sector, as well as look at globalization and innovation process in the sector.
The first approach is the transfer of risks, where the banks and financial institutions are able to transfer risks to the customers or other institutions. The financial institutions may require the people requesting for loans to provide guarantors who are to repay the loans in case they fail to repay the loans. The institutions may also require that the borrowers provide security for the loans. In other instances, the financial institutions insure the loans such that they are compensated in case there are some loan defaulters.
The other approach as stated already is risk avoidance. The financial institutions engage in activities that are of different risk levels. The financial institutions evaluated the risks and determined the investments that are highly risky, and avoid engaging in such activities. This means that they are not likely to incur losses that are associated with such investments. The financial institutions also consult with credit bureaus to ensure that the individuals they give loans to are creditworthy. In such a situation, the financial institutions avoid giving risky loans to risky people, and this reduces the loans that are not being paid.
The difference between the two is that in risk transfer, the financial institutions are motivated to engage in risky activities, as compared to risk avoidance where the banks reduce some of the products that they sell to their customers. This means that the financial institutions make some revenue from risky activities with the confidence that if the event insured occurs, they are not to bear the loss alone.
Having looked at the approaches of risk management, it is important to evaluate the implications to the policy makers. First, the relevant regulatory authorities have a duty to continuously review the risks that exist in the financial market, to ensure that if certain risks are dangerous to the economy and not the banks alone, there are limits to which the banks can venture into such risky activities. Technology and innovation can be used to identify all the risky activities banks engage in so as to ensure that they do not put the country in a risk. This means that proper regulation at the national level is very important. In the international level, proper regulation has to be designed. Banks in a particular country, especially in large economies like US and China can affect the world economy, like it happened in the 2008 financial crisis. This is why there should be a platform to regulate the financial activities in the globalized world where banks in a certain country serve foreigners and the locals.
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