The financial services industry is the backbone of economic activity within the U.S. and globally. It comprises of several industries, including banking, insurance, accounting and tax services, and investment management. All in all, it accounts for almost 20% of the U.S. GDP.
Its importance can be summed up by a quote from Warren Buffet, CEO of Berkshire Hathaway:
“The financial system is like the circulatory system of the economy. If it fails, everything else fails, too.”
Though it is a vital part of the global economy, the financial services industry is still prone to certain risks. Businesses in this industry must regularly take steps to identify, monitor, and mitigate these risks in order to protect their clients and for their own survival.
In this article, we will discuss five risks faced by the financial services industry and how you can mitigate them for your business.
Market Risks
The global market is volatile, which means it is inherently risky. Major fluctuations in market prices – including interest rates, exchange rates, etc. – can lead to financial instability which can adversely affect a business’s profitability and even its solvency.
Some recommended practices that your firm can put in place to mitigate the impact of market risks include diversifying your investments, employing hedging strategies, and maintaining robust risk management frameworks. Tax and financial services firms should also regularly monitor economic indicators and stress-test their portfolios so they can be prepared for whatever the market throws at them.
Credit Risks
The likelihood that borrowers or counterparties may fail to pay off their debts – or meet their debt obligations – is referred to as credit risk. This type of risk is especially high during tough economic times or when interest rates increase.
Credit risk is critical in the tax and financial services industry because defaults can lead to major losses and can even threaten the stability of the lending institution.
To efficiently manage credit risks and minimize their impact, you should consider implementing some of the following practices at your financial services firm:
- Thoroughly conducting credit evaluations of borrowers
- Setting appropriate lending limits
- Diversifying their credit portfolios
- Employing credit derivatives and securitization to manage and transfer credit risk
These practices help to safeguard a lending institution’s financial stability and also prevent adverse impacts on the entire financial system.
Operational Risks
This type of risk can be attributed to failures of internal processes, systems, or people that lead to disruptions in business operations. Operational risks are especially damaging for businesses in the tax and financial services industry because they can result in financial loss, damage to a firm’s reputation, as well as regulatory penalties. Unfortunately, unlike credit or market risks, operational risks are very hard to predict, which makes tackling them a real challenge.
To mitigate the impact of operational risks, you need to follow a comprehensive approach, which includes:
- Implementing strong internal controls
- Investing in cyber security
- Implementing business continuity plans
- Regularly training employees in sound business practices
- Strong oversight and auditing practices
The above measures can help your financial services firm maintain client trust, remain compliant with regulations, and ensure operational continuity.
Liquidity Risks
The likelihood that a financial services firm is unable to meet its short-term commitments due to insufficient cash-flow, or is unable to sell off its assets without incurring major losses, is referred to as liquidity risk.
This type of risk usually results from major market disruptions, unexpected withdrawals, or a sudden lack of confidence in an institution. Liquidity risk is especially a cause for concern because if it is not kept in check, it can cause a solvency crisis and even lead to the failure of a business itself.
To mitigate liquidity risk at your firm, the following are some recommended practices:
- Maintain high levels of liquid assets which can quickly be converted into cash.
- Carry out regular stress tests to make sure your firm is prepared for severe financial shocks.
- Use a variety of funding sources and borrow from several channels.
Keeping a close eye on and properly managing your firm’s liquidity can help you meet your financial obligations and maintain financial stability during difficult circumstances. If yours is a small to mid-sized company, then reach out to a reliable provider of business accounting for small businesses to assist you.
Cyber Risks
This is a relatively new risk faced by the tax and financial services industry, but it is no less severe than the others. Cyber risks arise when a cyberattack, data breach, or failure in the IT security systems of a financial services firm has the potential to cause financial loss, disrupted operations, or reputation damage.
Cyber risks are especially deadly because of the sensitive nature of financial data and the financial industry’s heavy reliance on IT infrastructure. A successfully carried out cyberattack can lead to major financial losses, loss of customer trust, and legal repercussions. It can take years for an institution to recover from the damage caused by such an event.
The good news is that there are ways to protect your firm from cyber risks. These include:
- Investing in cybersecurity measures, including advanced encryption, multi-factor authentication, intrusion detection systems, and periodic security audits.
- Conducting regular employee training to prevent phishing and other social engineering attacks.
- Developing and implementing comprehensive incident response plans in case of security breaches to minimize the damage caused.
Safeguard Your Business: Partner with the Risk Management Experts
This article discusses only a few of the risks financial services firms are exposed to and their potential impacts. To learn about other risks your business may be vulnerable to and how to mitigate them, you need to get in touch with trusted risk management experts.
Nazaire & Co. are very experienced in helping firms in Long Island and New York identify and mitigate financial risks. They also provide accounting and tax services and specialize in business accounting for small businesses. Reach out to us today for all your financial needs.
