Financial Institutions and Risks

The activities of financial institutions expose them to four primary types of ongoing risks: market risk, credit risk, liquidity risk, and political risk. Market (price) risk is caused by changing market conditions. Credit risk is the exposure to loss from the default or downgrade of a financial or other counterparty instrument. Liquidity risk is the risk that a financial institution will be unable to meet its short-term cash flow requirements. Political risk is exposure to non-financial variables. The entire set is called enterprise or firm-wide risk. Modern portfolio theory promotes diversification of exposure to reduce portfolio risk.