Classification: What are the types of risks in the financial services industry?

Having the ability to identify where risks arise in a business is all well and good. However, knowing that the risks are there will not save a financial institution from disasters. If we imagine that the various types/classes of risks are the 'enemy' and the identification section has located where the enemy are, the next step is to classify them so that we know what we're dealing with.

Risk professionals use a whole zoo of names to describe and classify the risks they deal with. Some of them are very obvious, but others more abstract. I shall try and list the more common ones below and what the risk professionals in each area are seeking to do. Again, I don't have a full understanding on each and everyone of these areas, but I shall attempt to at least cover the basics and the essence of each of the areas of risk. If you feel that I've made some fundamental error in describing any of these topics, please feel free to contact me. The list of risks below constructed based on the degree of 'obviousness' and it is in the same order as that given in the identification section.

1) Market Risk: As the name suggests, this is the risk exposure arise out of the movement of the market and only of the market. Any financial institution that has a proprietary trading operation (as distinguished from sales and brokerage operations) will be exposed to some sort of market risk. Proprietary trading ("prop desks" as commonly know in the market, but other names have been used to disguise its true nature) is all about taking a view of the possible movements of a market over a given length of time. Most modern securities or commodities markets are considered to be efficient (from the efficient market hypothesis) and under this assumption, unless you've superior information, which is not possible in truly efficient markets, you can't beat the market as you're in turn influencing the market by your trading action. Your view of the direction of a particular stock or the market in general may prove to right or wrong, as always market can go as well as down. That, at a simplistic level, is where market risk arise. However, in fact, even the most efficient of markets are not completely efficient. Why else would people hire all these traders? A secondary form of market risk is liquidity risk. If a particular trading position becomes unprofitable, the trader may want to close out the position by buying or selling the security in the market. However, not all markets and not all securities are equally liquid and the firm faces the possibility that the position may continue to loose money as the trader tries to square his/her books.

2) Credit Risk: In certain manifestations, credit risk is the easiest type of risk to understand - it arises when someone owes you a credit - you're waiting for that someone to pay you or repay you, depending the nature of the transaction. Armed with this understanding, it means that every time you lend anyone money, you have a credit risk. However, credit risk also arises when you've given out guarantees (or equivalent) - in fact, no money has left your organization, but, if the person or entity that you're guaranteeing fails to meet his/her/its obligation, your organization is liable to make up the payment. Another area where credit risk arises is the transactions involving securities or commodities. This is a special area within credit risk called counterparty risk which looks at the risk exposure to other market participants. Few securities market truly function in a delivery-verses-payment fashion (DVP) - the simultaneous exchange of money and securities or commodities. There is usually a period after trading but before the real settlement (completion) of the transaction, and all kinds of things can happen in this brief period. Also the settlement of the transaction can go wrong for one reason or another and the trade, in effect, fails. Not only does credit risk appears in the lending and secondary markets, the derivatives market is full of credit risk also. Although derivatives transactions are off-balance sheet, there are elements of the transactions that will have on-balance sheet implication - the movement of markets (mark-to-market). All these aspects of credit risk has to be accounted. Two other forms of credit risk are commonly referred to as collateral risk and correlation risk. These are closely related in that they both deal with the collateral given by the client to secure the loan. Collateral risk arises as a result of miscalculation of the value of the collateral, either due to market movements or incorrect initial assessment. Correlation risk is the result of the collateral given by the client being closely related to the performance of the client itself - pledging shares of a company to secure a loan - if the company enters a default situation and the business environment is bleak, both the loan and the collateral become worthless.

3) Operational risk: The risk exposure that appears as the result of failure of a financial institution's internal operation is called operational risk. The operation side of financial institutions are gigantic processing machines and any machine is only as strong or efficient as its weakest link. In modern day securities markets, securities are often bought and sold through intermediaries - these are usually brokerages. However, any investment bank can perform that function for their clients. All this means that it is entirely possible that for any given traded security, real buyer may be dozen trades away from the real seller. If, for one reason or another, an institution along this supply chain fail to complete the trade, it will affect the settlement of trades further down the line. In the event that a trade fails and the institution is required to deliver the security to another one, it has to go to the market to borrow the stock, bond or whatever to fulfill its obligation and eventually source to return the borrowed security. All of this costs money. Another example of operational risk is the failure to settle complex derivative-based transactions. Financial institutions often invent new tradable objects and if the operation side of the organization is not up to speed with the methods of settlement, it will lead to breakdowns.

4) Legal and Regulatory Risks: The reason financial markets are able to function is because the legal and regulatory framework within which the markets are allow to operate. Many of these legal and regulatory limits are in fact 'common sense' for the experienced operators in the market, particularly on the secondary and tertiary markets where the boundaries are fairly clearly laid out. However, whenever new products or new securities are created, marketers are often extending the legal and regulatory frameworks to cover them. Let's imagine, a bond has been structured to provide debt financing for a low credit quality borrower. Unfortunately the borrower could not keep up with the interest payment and defaulted. While I'm not suggesting that legal problems only come in in a default situation, it is in such situation that the legal work carried out by the financial institution and its lawyers comes under the most severe scrutiny. Another situation where potential legal and regulatory problem may arise is when dealing with clients. The global financial markets are the favorite tool criminals utilize for money laundering. Regulatory bodies in sophisticated financial markets have stringent rules that market participants need to follow to ensure that the chances of allowing criminals to operate are minimized and those who managed to slip through the net will be found, eventually. All these rules can be summarized into the phase "know your client". For those who deal with clients on in financial markets, it takes minimal time to find out who the client really is, but in the heat of the moment, it may be a little too much to ask for. For corporate financiers and origination teams, especially those who deal with clients from parts of the world where legal and regulatory standards are not as high as those of the 'developed markets', this may post the a bigger problem. Extensive legal and financial due diligence need to be carried out to ensure that an accurate representation of the client is made and the organization is not facilitating criminal activities.

5) Reputation and Underwriting Risks: In a cut-throat competitive market, an organization's reputation is probably the only competitive advantage it has over its rivals. Of course, if a financial institution fails to observe the rules and regulations that it operates under, it may cause significant damage to its reputation. However, reputation risk doesn't necessarily arise out of breaking of the rules. Failure to execute a well-publicized transaction or loosing a transaction to a rival may incur damages to the operators reputation in a certain market. Execution risk, a risk of failing to complete a mandated transaction for the client, is a derivative of reputation risk and usually has a tangible monetary value attached to it - the fees of transactions. Even when mandated transactions can be successfully completed, there is always an underwriting risk involved. At times of volatile market conditions or when the market willing to in return for providing financing (ie. its perception of the quality of the issuer or borrower) is significantly different from that the issuer or borrower, the lead manager may ended up launching the transaction into the market without adequate subscription. The remaining amounts will end up in the lead manager's balance sheet. Once a transaction has 'seasoned' and the residual amounts that still remain in the lead manager's books will be subjected to market and credit risks measurements.

6) Systemic Risk: This is probably one risk category that risk managers fear most. Systemic risk usually arise out of an event, hence event risk is a large sub-set of systemic risk. For those who claim that they're equipped to manage such risk, they're either very well equipped or they're fooling themselves. Being a fast moving market, the financial services sector is capable to react to changes. However, event-driven systemic risk tends to arise in a very short space of time which does not allow risk managers adequate time to react to the situation. Additionally, the majority of market transactions are carried out between financial institutions, the problem quickly accumulate, the domino effect sets in and drives the market further and further into trouble. Another form of system risk is the break down of a particular market in a relatively isolated fashion. Modern financial markets are highly interconnected, geographically as well as across different products, thanks to globalization and high level of sophistication. However, in many of today's 'emerging markets' or even 'converging markets', there are still a degree of isolation which means that if a particular market breaks down, the impact will not spread throughout the entire global market. Since the number of participants in such markets are usually limited and their exposures are relatively small by global markets standards, the overall risk tend to be relatively small even for the dominant player in a particular local market. In this type of situations, it is entirely up to the foresightedness of the risk managers to 'see' the weakness of the system/market and respond to it in a timely fashion - reducing exposure prior to a breakdown.