It is said to be very essential because it decreases the chances of loss and enhances profit expectation.
Like any other firm, the ultimate objective of banks and financial institutions is to maximize profit and shareholder wealth. Financial management plays an important role in achieving these goals in banks. The crucial aspects of financial management such as capital budgeting, investment appraisal, capital structure and risk management are some very important considerations in banking operations. Maximization of profit and shareholder wealth is only possible if banks perform its fundamental activities i.e. advancing loans and receiving deposits in a manner that can minimize the elements of risk. For this purpose, the use of financial management is very important in banks. The preceding paragraphs elaborate the use of financial management in banks for the maximization profit and shareholder wealth and the importance of risk management techniques in this regard.
Financial management is considered to be very crucial when a bank undertakes a new project or investment. Investment and capital budgeting decisions in banks are taken on the basis of positive NPV criterion. It is because of the fact that it is consistent with the notion of shareholder wealth maximisation as a positive NPV means increase in the expected bank cash flows (Schroeck, 2002). Therefore, when decisions are taken on the basis of positive NPV, they are expected to enhance profit as well as shareholder wealth in the form of share price maximization. These new projects and investments have a great impact on bank cash flows, earnings and shareholder wealth. The use of financial management capital budgeting techniques help bank to stabilise their rate of return and minimise costs.
Risk management is one of the most essential aspects of bank activities. Managing risk is important for the purpose of profit and shareholder wealth maximization. Banks confront with lending capacity restrictions and rising cost of acquiring new funds. This makes it crucial for banks to invest their funds in a prudent manner by employing various risk management techniques (Froot and Stein, 1995). Risk management helps a bank to reduce the volatility of its expected cash flows and earnings and thus increase the chances of profit and shareholder wealth maximization. It protects a bank's stock price to fluctuate in response to market uncertainties and stabilises return on equity. Risk management can also lead to reduction of cost of capital as it enables banks to proactively acquire enough funds to meet its future investment needs. Shareholder value is also protected as risk management techniques prevent fluctuations in the market value of banks (Schroeck, 2002).
Increasing competition in banking sector due to ever increasing number of banks is also becoming the major source of risk. Banks remain ready to advance loans without extracting complete information on borrowers' capacity and credit rating. This leads to increase in bank's credit risk because most borrowers fail to pay off the loans they acquire (Marquez, 2002). The risk in the banking sector has increased a lot in the recent year. Many