spikegifted.net - Risk Management

Identification: Where are the risks?

Within the financial services industry, just like any business sector, risks are everywhere. Just like in real life, nearly everything a financial institution does carries some kinds of risk. At this stage I'm not going to attach the commonly used names employed by risk managers because they may cause some confusion. Let's first identify where the risks arise in the day-to-day operation of a financial institution.

1) Let's look at the most simple of situation: a bank bought some stocks and bonds last week and the prices for these stocks and bonds are now lower than the prices they were paid for, the bank incurs an unrealized loss. Unrealized because it still holds the stocks and bonds and the loss hasn't been 'crystallized', yet. Financial institutions buy lots of stocks, bonds, convertible bonds, warrants, currencies, options, swaps, etc, on a daily basis. They can incur massive losses due to small market movements - ask any insurance company or asset/pension/fund manager.

2) Here is another simple example - a bank lend to a firm and as soon as the money is lent, the bank is exposed to the business of the firm. Now, I'm taking the assumption that since the bank is willing to lend money to the firm, the bank is comfortable with being exposed to the business fortunes of the firm. Imagine the firm fails to make an interest payment due to a change in business circumstances. What do you do? Write the loan off? Lend the firm more money to get over the difficult times and hope (or pretend) that the firm will be able to repay you somewhere down the line? By writing off part or all of the loan, you immediately 'crystallize' an estimated amount that you've considered unrecoverable and it will reflect on you profit for the year. By lending more money to the firm, the bank is increasing its exposure.

If we move our focus away from banks, we can see forms of risk that banks as well as business of all sectors are exposed to.

3) Imagine a firm signs a help desk contract with a computer service company and the software used by the firm has been customized and resultant applications are not like anything the service company has seen before and hence it fails to perform as outline in the contract. This is a risk every company which contracts out certain parts of its operation. Similarly financial institutions are exposed the same kinds of 'performance' risk as the result of introduction of new products or complicated forms of existing products without the ability to complete the transaction on the operational level.

4) Again, the following is another non-banking sector example which can be applied to financial institutions. In the UK, most utilities are regulated in order to ensure that the operators are providing high levels of services at affordable prices. Let's imagine that the water regulator has decided that the UK drinking water standard is currently too low and want to raise the standard to a higher level. To give the operators time to respond and invest, this standard has to be achieved in 5 years without raising the cost to the customers. By the change of this standard or other regulations, the operators are suddenly facing an unforeseen problem which has dramatic impact on where investment should go and/or on their ability to generate profits. Obviously, a similar situation will arise if a piece of legislation that directly affect the operation of the firm or its supplier or customer is changed. Similarly, the domestic regulator of a financial institution or international standards may change and the financial institution has to adopt to these regulations and standards in order to compete. Additionally, these may mean that certain operations that were previously considered appropriate will now be considered otherwise.

5) Say you own and run a second-hand car dealership for a number of years and you've built up a good reputation by being honest and never cheated your customers or the sellers. Then one day one of the employees accepted a car which turned out to be a stolen car which have been used in an armed robbery and a hit-and-run incident. Thanks to this careless employee, your dealership is under police investigation for collaborating with criminals and the police is looking into your firm's transaction history. Local newspapers picked up on this development and your reputation that you've so carefully built up over a number of years has vanished. Your sales dropped and customers who recently bought used cars from you want to have refunds. You may argue that this employee should have done his/her 'homework' prior to taking on the vehicle, however, in the financial services sector - money is money and most of the money (or wealth) appear in electronic form rather than physical form and the owner of this wealth doesn't have their name stamped on the money. As we're well aware, financial institutions are favorite tools for criminals to launder funds obtained via illegal means. So how do they avoid these complications?

6) Imagine the cheese industry... Imagine there is a healthy and competitive cheese-selling sector - firms that specialize in just selling cheeses. Cheeses are made from milk of one animal or another: cows, goats, sheep, etc. Let's say there has been a huge industrial accident somewhere near a farming center (we're talking about continental size here, not some small corner of a local region) and the resultant pollution from the accident has contaminated a wide area of grazing pasture. The animals that have fed on this pasture in turn produced contaminated milk which cannot be used for cheese production. (I'm sure that the dairy and chess industries would be the last thing people really worry about, but we have to put ourselves in the affected people's positions.) Due to the size of the affected area, it is not as simple as 'bring the milk in form somewhere else'. So the entire cheese industry has come to a standstill - the people who sell the milk to make cheese, the cheese producers, the cheese sellers and, of course the cheese buyers. The whole 'cheese system' has broken down! All this due to an industrial accident that is not related to cheese production at all. The financial services sector is exposed to this kind of system breakdown as well and because the financial institutions tend to trade amongst themselves, the implication of this domino effect is even more devastating.

The choices of the above examples are no accident - they represent the categories of risk that risk professionals in financial services industry worry about, on a day-to-day basis as well as on a longer term. Many of the risks are closely related and for any given transaction there is a number of these risks involved. What the technical names for these risks are actually not that important, since a name is just a name, no more, no less. What is important is the individual's awareness of these risks and his/her training and intuition to identify them in a given situation.

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