The mechanism for limiting the concentration of financial risks is typically used for those types that are beyond the permissible level, i.e. for financial transactions carried out in a critical or catastrophic risk zone.
This limitation is realized by establishing appropriate internal financial standards in the enterprise in the process of developing policies for the implementation of various aspects of financial activity.
A system of financial regulations to limit the concentration of financial risks may include:
- Limit (share) of debt used in business.
This limit is set separately for the operation and investment activities of the enterprise, and in some cases for individual financial transactions (financing of a real investment project;
Financing the formation of working assets, etc.).
- Minimum size (specific weight) of assets in highly liquid form.
This limit ensures the formation of the so-called "liquid cushion," which characterizes the amount of reservation of highly liquid assets for the purpose of forthcoming repayment of urgent financial liabilities of the enterprise.
The "liquid cushion" is primarily the short-term financial investments of the enterprise, as well as short-term forms of its receivables.
- The maximum size of the commercial or consumer loan granted to one buyer.
The amount of the credit limit aimed at reducing the concentration of credit risk is established in the formation of the policy of granting commodity credit to buyers of products.
- Maximum investment in single issuer securities.
This form of limitation is aimed at reducing the concentration of non-systematic (specific) financial risk when forming a portfolio of securities.
For a number of institutional investors, this limit is set in the process of state regulation of their activities in the system of mandatory norms.
- Maximum diversion period to receivables.
This financial standard limits insolvency risk, inflation risk and credit risk.
Limiting the concentration of financial risks is one of the most common internal risk management mechanisms that implement the financial ideology of the enterprise in terms of accepting these risks and do not require high costs.