A Risk Professional�s Survival Guide

Applied Best Practices in Risk Management

Clifford Rossi

• Publisher: Wiley
• Year: 2014
• ISBN:
  9781118953044
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Balanced, practical risk management for post – financial crisis institutions

A Risk Professional's Survival Guide fills a critical gap left by existing risk management texts. Instead of focusing only on quantitative risk analysis or only on institutional risk management, this book takes a comprehensive approach. The disasters of the recent financial crisis taught us that managing risk is both an art and a science, and it is critical for practitioners to understand how individual risks are integrated at the enterprise level.

This book is the only resource of its kind to introduce all of the key risk management concepts in a cohesive case study spanning each chapter. A hypothetical bank drawn from elements of several real world institutions serves as a backdrop for topics from credit risk and operational risk to understanding big-picture risk exposure. You will be able to see exactly how each rigorous concept is applied in actual risk management contexts.This book includes:

• Supplemental Excel-based Visual Basic (VBA) modules, so you can interact directly with risk models
• Clear explanations of the importance of risk management in preventing financial disasters
• Real world examples and lessons learned from past crises
• Risk policies, infrastructure, and activities that balance limited quantitative models

This book provides the element of hands-on application necessary to put enterprise risk management into effective practice. The very best risk managers rely on a balanced approach that leverages every aspect of financial operations for an integrative risk management strategy. With this book, you can identify and control risk at an expert level.

CHAPTER 1
Navigating Risk at SifiBank

OVERVIEW

Managing risk at a banking institution is one of the most critical activities carried out by financial firms. Banks could not expect to have much longevity if risk management were ignored or poorly executed. The subprime mortgage crisis of 2008 offers a once-in-a-lifetime case study of how many different types of financial institutions lost sight of the importance of risk management and either went out of business, were forced to merge with healthier firms or had to take a bailout from U.S. taxpayers. And this was not a U.S. phenomenon limited to only the U.S. banking industry: The global financial sector during the 2008–2009 period was in virtual free fall with many experts fearing an economic depression on an unprecedented scale. While many causes have been attributed to the crisis—a number of gaps in regulation, a financial incentive structure that rewarded short-run profitability and production, the interconnectedness of banks and other financial entities comprising the so-called shadow banking sector—nevertheless, at the heart of the crisis was a fundamental lapse in risk management across a great swath of the industry. Particularly problematic was that the largest financial institutions were among the companies where risk management deficiencies were most acute. Given the scale and scope of these global financial behemoths, these gaps in risk management at the institution level would manifest as systemic risk and contribute to one of the worst financial calamities on a global scale. These institutions became the focus of intense scrutiny by regulators after the crisis and have been designated as systemically important financial institutions, or SIFIs for short.

We begin our journey of risk management by taking one such SIFI (we will refer to it as SifiBank) and following it though its various business functions with the intention of understanding how such firms identify, measure and manage their risks. Risk management is not a separate discipline as is finance or accounting, and in practice every employee of a bank should take an active role in risk management, whether they are in sales and production, trading, operations, or other important areas of the company.

SIFIs are a unique class of financial institution. The term SIFI surfaced after the crisis as concerns arose over the size and complexity of some firms to become, in principle and reality, too-big-to-fail (TBTF). Institutions were designed as SIFIs by U.S. federal regulators and as G-SIFIs by the United Kingdom’s Financial Stability Board (FSB) based on their size, complexity of operations, degree of interconnectedness across the financial sector, global reach and substitutability of activities. The largest banking institutions worldwide have found their way onto this list and in addition, regulators have developed a set of criteria to designate other institutions as systematically important, such as insurance companies and nonbank companies.¹

SifiBank makes an excellent case study for risk management since its far-flung businesses touch on every aspect of financial risk management that most banks would encounter. In fact, one could say that banks are in the business to take prudent risk. As will be seen shortly, banks that take zero risk are not going to be profitable enterprises. Similarly, banks taking excessive risk—that is, risk not well understood and outside the firm’s capabilities to price and manage that risk and its risk appetite—will eventually be doomed. That’s why the term prudent risk is critical to understanding the process of risk management.

Thinking of risk management as a process or system in itself is helpful since managing risk effectively entails establishing a feedback loop (Figure 1.1) in which risk tolerance is communicated across the organization; expectations are set in terms of how much risk is acceptable for businesses to take (usually expressed in terms of capital allocated to each line of business); there is ongoing measurement and reporting of risks, there are processes and controls for managing risk coming into the firm in the way of transactions, loans, and services; there are techniques and controls for mitigating risk on the books of t...