Financial risk management is one of the fundamentals of management in financial institutions. There are policies which are defined by general management which operate centrally to facilitate best practices in financial risk management.
Policies for financial risk management define the different categories of risk, specify the steps required and outline the limits of operation in financial transactions. According to these policies the Groups or financial institution implementing best practices must use derivative contracts for all financial assets, liabilities and future transactions. Financial risk management revolves around the Sector Treasuries which evaluate the risks and put up necessary controls to manage the risk. These controls must be setup in supervision and with coordination of the Treasury Team. Sector Treasuries cannot operate independently or directly due to external restrictions. However they can coordinate activities of the Local Treasury Units.
CATEGORIES OF FINANCIAL RISKS
The Operating Unit of any financial institution is responsible for providing necessary information regarding risk management. It is also expected to manage contracts and negotiate with the sector treasuries. Note that there are financial risks which are represented by invoices of purchases and sales. Therefore, the sector treasury must also identify the exchange risk points in financial transactions.
Additionally, the sector treasuries in financial institutions are also accountable for the assessment and management of the positions of the currencies involved. Best practices are required and they must be in accordance with the pre-set limits and policies. There is also the requirement of best practice in negotiating the derivative contracts in the market; however this usually involves forward contracts. It must be emphasized that forward contracts are not hedging instruments, although they are used for risk management. This is because forward contracts are not up to the criteria required for hedging instruments as set by the IAS 39.
When these policies are in place, changes in the exchange rates will not reflect as significant changes in the income statement.
Risk of Currency Translation:
There are risks associated with financial statements when different currencies are being used in the financial institution. Currencies fluctuate in exchange rates which cause changes in consolidated equities. There will be need for currency translations which require best practices in risk management. Furthermore, currency translation risks cannot be hedged.
Risk of Interest Rate
Banks and other financial institutions try to maintain a balance between the fixed rate debt and floating rate debt. The aim is usually to maintain the fixed rate debt at about 60% of the total financial debt. Therefore there will be need for best practices to ensure risk management to control the fluctuations. This is usually done using derivative contracts to manage the risk of increase in floating rate debt interest rates by compensating the floating rate receivables. Derivative contracts may be used as hedging instruments in accordance with the IAS 39. There will be need for step-by-step decisions and authorization by the management of the institution.
Therefore, best practices require policies for financial risk management to ensure transparent and loss-free financial transaction.