Risks & Rewards of Financial Sector in India

What is Financial Sector?

Financial Sector is a category of stocks containing firms that provide financial services to commercial and retails customers. This sector includes Banks, Investment Fund, insurance companies and real estate. Financial services perform best in low-interest rate environment. A large portion of this sector generates revenues from mortgages and Loans.

Risks faced by Financial Sector in India:

1. Credit Risk:

Credit Risk can be defined as the potential that a Bank Borrower or a counterparty will fail to meet its obligation in accordance with the agreed terms. In simple words, it can be explained as if a person who has borrowed money from Bank fails to repay the loan due to inadequate income, loss in business, unwillingness to pay or any other reason the bank will face credit risk.

To minimise this credit risk the bank will keep the high-interest rate for the loan is associated with high credit risk.

2. Market Risk:

Market Risk is the risk in the Bank’s trading books due to change in equity prices, interest rates, foreign exchange rates, commodity prices and other indicators. Market risk can be further classified into 4 types:

1. Interest Rate Risk: Potential loss due to fluctuation in the interest rate.
2. Equity Risk: Potential loss due to fluctuation in the stock price.
3. Currency Risk: Potential losses due to fluctuation in international currency exchange rate.
4. Commodity Risk: Potential losses due to fluctuation in prices of agricultural, industrial and energy commodities.

 

3. Operational Risk:

Operational Risk can be defined as the risk of loss resulting from inadequate or failed internal process, people or system or external events. Operational risk can be categorized into following types:

1. Human Risk: Potential loss due to human error done willingly or unconsciously.
2. IT/System Risk: Potential loss due to system failure and programming error.
3. Process Risk: Potential loss due to improper information, leaking or hacking of information.

4. Liquidity Risk:

Liquidity Risk is the risk arising from the lack of marketability of the investment that cannot be bought or sold quickly. It is a type of risk which disable the bank from carrying out the day to day cash transaction.

5. Reputational Risk:

Reputational Risk is the potential loss of the reputational capital based on either real or perceived loss of reputational capital. This risk may be triggered by bank’s activities, rumors about the bank, willingly or unconsciously non- compliance with the regulatory compliances.

6. Business Risk:

Business Risk is the risk that the bank will have lower than anticipated profit, or that it may incur a loss rather than profit. Business Risk is the risk associated with the failure of bank’s long-term strategy, the estimated forecast of revenue and number of other things related to profitability.

The entire financial sector is unpredictable, the long-term strategy must have the backup plan.

Rewards of Financial Sector:

1. Availability of adequate and transparent credit from formal banking channels will foster the entrepreneurial spirit to increase output and prosperity in the country.
2. Reduction in the cash economy.
3. To inculcate the habit of saving, thus increase the capital formation in the country.
4. Credit Provision: Because of Financial Sector the business persons are allowed to invest beyond their cash in hand. The financial market is the ultimate provider of credit.
5. Liquidity Provision: Business and household need to have protection against the unexpected need for cash. Banks are the direct provider of liquidity and by offering lines of credit.
6. Risks management services: Finance allows business and household to pool their financial risks from exposure to the financial market.

Risks of Financial Sector:

1. Backward Financial System:

One of the most important drawbacks of industrial finance system is that it is not yet developed fully, the extent of capital market which is a source of long-term finance including equity and debt is quite small. It also fails to provide risk capital in adequate quantity. The development of non-banking financial intermediaries is also poor.

2. The paucity of Funds:

Another shortcoming of the financial sector is that it is grossly inadequate for the continuously growing and large requirements, especially to meet the need of large industries. Moreover, the small industries are also facing the shortage of finance in an acute manner. As a result of the paucity of funds finance the expansion of industries are becoming very difficult.

3. Unsatisfactory Interest Structure:

The interest rate of different types of loan is more or less unsatisfactory. These rates are not properly aligned with other. Indigenous money lenders also provide high-interest rate from small industries distorting the existing market rates.

4. Lack of adequate capital formation:

Industrial finance usually suffers from lack of adequate capital formation. There are inherent difficulties of mobilizing the quantum of incremental rural income which could have been utilized for financing rural industries.