Use of Risk Management in Investment Banking

July 3, 2017

They way most institutions view risk management is changing. There is a fundamental shift in thought, it is not only viewed as a control mechanism but as an advisor or as a critical viewpoint, which could help in an event of a probable risk factor. Now for any banking sector risk management becomes a vital part, which will help the bank to grow, all the while keeping an eye on any potential risk factors, internal or external, for example, external like, recession, or stock market breakdown and internal like IT failure.

Currently, risk management takes two things into deliberation in the banking sector, (I) possibility of a negative impact and (II) cost of the negative impact. So basically, risk management has a very controlling role in the functioning of a bank. The bank wants to make sure that they can repay the debt in a negative scenario, so it ensures, that too much money is not taken from the client, or push the client into a liability.

Risk management becomes the nucleus of internal control of investment banks, especially in mature international markets. Investment banks buy and sell bonds, prices of these securities vary regularly if the prices go up there is a profit made and if they go down, the loss is incurred.

The trading is done on multiple types of securities across countries and markets and hence there are various risks an investment bank has to manage, one can categorise them as Macro Level, Industrial Level, Exterior Level and the Corporate Level.

Macro-level risks, known as market risks, are the most important risks in the financial market and they are unavoidable. They are generally defined as the risks of losses on and off balance sheets, primarily due to changes in the market variables. Interest rate risks, Exchange rate risks, Inflation and Fluctuation risks, all come under this umbrella. It affects the uncertainty of the profitability of securities. To manage this risk, investment banks put forward, control measures, such as making a team in market risk management, who assess the risk assessment standards and set risk limits.

System Risk Management is an industrial level risk factor, which can be explained as a chain, reaction that follows within an investment bank or within the industry. They can fuel circulation difficulty as triggered by the collapse of a single subsidiary or the business unit of the bank, an example of the menacing result of system risk was the collapse of Lehman Brothers. For the regulators and financial institution, this risk could be the single biggest threat. Banks thus need to build a secure set of flexible risk management controlled framework, combined with capital funds to mitigate the impact of this threat.

Exterior risk factors like the credit risks are generally seen when the investment bank acts as an intermediary in OTC transactions when the counterparty defaults its payment. Or if the client fails to pay the interest, or principal amount after being financed by the bank. To control this risk, investment banks, have put some control measures like scrutinising the screening process of the client and using standard exchange trading as much as possible.

There are a few Corporate level risk factors as well. Operational risks, caused by human error, program malfunction, these could have a huge impact, to control this, banks have strengthened their training and written detailed job descriptions, with cause and effect.

Liquidity Risks are also corporate level risks, caused by the investment banks fail, to not acquire a reasonable price in selling, or while assigning financial mechanisms at a lower price, due to low liquidity ratio. Usually, investment banks set low liquidity risks through hedging.

It can be concluded by saying, risk management should be applied consistently across the banking sector, where ‘Risk Experts’ who have the knowledge of banking and compliance, create policies and procedures to mitigate the risk factors.

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