RISK MANAGEMENT IN FINANCIAL
INSTITUTIONS
Notes
,CHAPTER 1: INTRODUCTION TO RISK MANAGEMENT
1. What is risk?
Risk: all personal
It is a personal feeling (risk appetite), depending on the type of risk at hand, the
impact it could have, the likelihood it could occur.
The concept of risk is hard to grasp and intuition also deviates from the widely
used formal concepts in economics/finance.
Knight: risk versus uncertainty
Uncertainty implies that we observe multiple possible outcomes.
Risk implies uncertainty where probabilities can be assigned to the possible outcomes.
BUT Uncertainty that can be quantified by probabilities does not necessarily translate into a risk.
Risk implies that you can be harmed.
Risk as a dual concept
An intuitive definition of risk is the likelihood of harmful consequence.
It incorporates the concept of uncertainty/probabilities,
but it also stresses the potential negative consequences deviating from expectations.
In addition, this approach also allows us to define opportunity as the related likelihood of favorable outcome.
Such dual focus is necessary for successful risk management strategy:
1. by limiting risk, you also limit opportunities;
2. by exploiting opportunities, you also exploit risk.
Categorising risk in likelihood and severity
Non-event: Low likelihood - low severity
Non-events not to worry about.
Included in pricing or processes: High likelihood - low severity
Events well known, that are included in pricing of products or mitigated by controls
in processes.
E.g. granting loans: mortgage on the house, interest rate accounts for credit risk
(depends on your probability to ‘not pay’).
Black swan: Low likelihood - high severity
Events one could never assume to occur until it occurs with potential high impact.
Difficult to approach with normal statistics, Extreme Value Theory is better suited.
E.g. COVID-19 (grey swan: has happened before, but no one thought it would happen again), liquidity issues, high interest rates (grey swan).
Grey Rhino: High likelihood - high severity
Well known events, with a potential high impact.
Important point of attention of Risk Management (in normal times). Normal statistics work well here.
Focus on upper right part first, but do not forget about black swans!
,How does volatility fit within this definition of risk?
To have a complete description of risk, we should also account for the utility of each of the
outcomes: not each outcome is perceived equally harmful.
Most people are risk averse!
The problem with accounting for risk aversion is that, in general, it will not give us a unique ranking: it
depends on individual preferences.
For that reason, we ignore individual preferences in risk measurement.
However, we do account for it in risk management by setting a risk appetite defined on company level.
risk one is willing to accept.
2. Risk management, risk measurement and regulation
Different kinds of financial institutions
Banks: retail, corporate (for companies), investment, private banking
Insurance companies: life, health, property and casualty; direct insurance, reinsurance
Investment funds
Financial institutions and capital
The goal of risk management is to keep a firm solvent, and to this end, a company has capital that covers for unexpected losses.
What about expected losses?
Included in pricing, mitigated by processes (high frequency / low severity)!
Risk management is particularly important for financial institutions due to their unique characteristics:
1. Their business model is all about taking risks.
2. The failure of a financial institution (mainly banks) has high costs because of contagion effects (externalities). E.g. financial crisis.
For this reason, regulation aims at financial stability.
Banking business model
Risk is central to banking: a bank is in the business of taking risks and the bank balance sheet
reflects these risks.
Assets Liabilities Financial instruments at liability side can be
Loans Own Funds bonds issued, subordinated loans, etc to increase their leverage.
Investments Banking Book Deposits Low on the list if the company defaults
Investments Trading Book Financial Instruments
Loans can be to retail, corporates, governments.
Investment in banking book are usually to keep until maturity (hold to maturity): corporate,
government bonds.
Investment in trading book are to generate trading income: bonds, equity, etc to hedge certain risk.
The production of loans creates credit risk.
The investment portfolio has credit risk and market risk.
The transformation of deposits into loans creates liquidity risk (maturity transformation) and market risk (interest rate risk).
Running the business entails operational risk (e.g. fraud).
The production of deposits creates leverage: this reinforces the above risks!
Monitoring risk is thus essential for financial institutions.
, The leverage that follows from the deposit production, further intensifies all the risks a bank is exposed to and
makes them extremely vulnerable to shocks. Typical balance sheet of bank is much bigger than capital available.
Regulation: sufficient safety cushion.
Failure of a bank: contagion effects
A well functioning financial system is key to economic growth and welfare.
Yet, the failure of a single bank can be costly to society because of contagion effects: the failure of a single institution
can bring down many more institutions. (Banking crisis 2008.)
Thus: risk management and regulation aim at financial stability in order to internalise the externalities of a bank failure.
Risk Management Regulation
1. Micro-prudential regulation is concerned with the stability of each individual
institution: it evaluates the response of an individual institution to exogenous shocks.
2. Macro-prudential regulation is concerned with the stability of the financial system as a
whole: it monitors the response of the system to endogenous risk.
Insurance business model
Also in insurance, risk is central as the business it to take over a risk from a policy holder and manage it via
mutualisation of similar risks.
I
Assets Liabilities Policy holder liabilities are the payments to be done to policyholders (claims,
Investments Own Funds reserves of life investment insurance, aging reserves, etc).
Reinsurance recoverables Policy holder liabilities
Investments can be bonds (government / corporate), equity, real
estate, loans, infrastructure investments, etc.
Reinsurance recoverables are payments received from a reinsurance company that is
taking over the risks that are not sufficiently mutualised in the portfolio.
for big catastrophes, e.g. in Turkey.
The production of insurance policies loans creates underwriting risk: the risk that expectations deviate from reality. E.g. people live longer.
The investment portfolio has credit risk and market risk.
The investment of insurance premiums in investments creates market risk (interest rate risk) (for some life insurance policies: like a deposit but
in an insurance way).
Running the business entails operational risk (e.g. fraud).
The risk management process and cycle
To ensure solvency, a financial institution sets internal boundaries in its risk management process, the so-called
company’s risk appetite to avoid conflicting individual preferences of employees/management.
These boundaries are in line with external regulatory restrictions: capital adequacy requirements, disclosure
requirements, governance requirements,... certain minimum criteria.
Importantly, managing risk is distinct from measuring risk:
1. Managing risk is about the strategic and tactical decisions to develop a business: to this end one needs to
control people, IT, infrastructure, processes, measure risk. Knowing the risk exposure, what will you do with this?
1. Measuring risk is about quantifying risk (both the nature and size). We know the risk, it has been identified.
