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  5. Risk Management for Financial Institutions

The core purpose of banks and finance companies is to assume manageable levels of maturity risk and credit risk, and to generate a level of return consistent with it. This is hard to do, even in relatively small financial institutions because of the fact that each risk is being assumed by the institution on a near continuous basis and not just in head offices but also in distant branches. Despite these difficulties, management of these risks is of key strategic importance for banks and financial institutions. Decisions such as the choice of data generating processes for each source of risk; implementing appropriately chosen transfer pricing methodologies; and the setting of confidence bands to assess the requirements of capital, need more of the attention of top management than do issues such as locations of new branches or making individual credit decisions.

However, most top management teams are poorly equipped to make these decisions because the language is shrouded in arcana and there is often so much material to cover that it appears impossible to grasp without a life-time of study. While it is indeed true that there are many details that need to be well understood for the practicing risk manager, the concepts underlying these ideas are very few, and, with a little bit of effort, not at all hard even for somebody with only a basic understanding of mathematics or with very little time at their disposal. The material in this book has been especially developed with this in view. It needs ideally be studied or taught in small intimate groups of two or three people and intensively reviewed, on a line by line basis, rather than skimmed through rapidly. There is indeed some usage of mathematics and statistics since the essence of risk management is the quantification and management of uncertainty, but it is all carefully developed in the text itself, without assuming any prior knowledge of the associated tools and techniques. The focus is on ensuring that there is a good grasp of the concept rather than complete mastery of every aspect of the subject matter. Wherever possible the implications of the mathematical equations are made visible by using graphs, charts, and real-life examples.

The material in this book is broken into three parts. The first part delves into some of the fundamentals and explores basic ideas such as probability, random variables, and data generating processes. From there it goes on to build metrics such as Value at Risk and Return on Equity. The second part then takes these basic ideas and seeks to apply them to actual risks faced by banks and finance companies. Because the interest risk and credit risk are the most important it focusses on them. It also provides some ideas on how each of these risks is to be separately managed. The last part is focussed on the tools used by regulators and practitioners to manage these risks at a somewhat of an aggregate level and introduces concepts such as capital, securitisation, and options.

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