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What Kinds Of Risks Are Being Absorbed?

Category: Risk Management in Banking

The risks contained in the bank’s principal activities, i.e., those involving its own balance sheet and its basic business of lending and borrowing, are not all borne by the bank itself. In many instances the institution will eliminate or mitigate the financial risk associated with a transaction by proper business practices; in others, it will shift the risk to other parties through a combination of pricing and product design.

The banking industry recognizes that an institution need not engage in business in a manner that unnecessarily imposes risk upon it; nor should it absorb risk that can be efficiently transferred to other participants. Rather, it should only manage risks at the firm level that are more efficiently managed there than by the market itself or by their owners in their own portfolios. In short, it should accept only those risks that are uniquely a part of the bank’s array of services. Elsewhere, Oldfield and Santomero (1997), it has been argued that risks facing all financial institutions can be segmented into three separable types, from a management perspective. These are:

(i) risks that can be eliminated or avoided by simple business practices,

(ii) risks that can be transferred to other participants, and,

(iii) risks that must be actively managed at the firm level.

In the first of these cases, the practice of risk avoidance involves actions to reduce the chances of idiosyncratic losses from standard banking activity by eliminating risks that are superfluous to the institution’s business purpose. Common risk avoidance practices here include at least three types of actions. The standardization of process, contracts and procedures to prevent inefficient or incorrect financial decisions is the first of these. The construction of portfolios that benefit from diversification across borrowers and that reduce the effects of any one loss experience is another. Finally, the implementation of incentive-compatible contracts with the institution’s management to require that employees be held accountable is the third. In each. This point has been made in a different context by both Santomero and Trester (1997) and Berger and Udell (1993).

There are also some risks that can be eliminated, or at least substantially reduced through the technique of risk transfer. Markets exist for many of the risks borne by the banking firm. Interest rate risk can be transferred by interest rate products such as swaps or other derivatives. Borrowing terms can be altered to effect a change in their duration. Finally, the bank can buy or sell financial claims to diversify or concentrate the risks that result in from servicing its client base. To the extent that the financial risks of the assets created by the firm are understood by the market, these assets can be sold at their fair value. Unless the institution has a comparative advantage in managing the attendant risk and/or a desire for the embedded risk they contain, there is no reason for the bank to absorb such risks, rather than transfer them.

However, there are two classes of assets or activities where the risk inherent in the activity must and should be absorbed at the bank level. In these cases, good reasons exist for using firm resources to manage bank level risk. The first of these includes financial assets or activities where the nature of the embedded risk may be complex and difficult to communicate to third parties. This is the case when the bank holds complex and proprietary assets that have thin, if not non-existent, secondary markets. Communication in such cases may be more difficult or expensive than hedging the underlying risk.4 Moreover, revealing information about the customer may give competitors an undue advantage. The second case included proprietary positions that are accepted because of their risks, and their expected return. Here, risk positions that are central to the bank’s business purpose are absorbed because they are the raison d’etre of the firm. Credit risk inherent in the lending activity is a clear case in point, as is market risk for the trading desk of banks active in certain markets. In all such circumstances, risk is absorbed and needs to be monitored and managed efficiently by the institution. Only then will the firm systematically achieve its financial performance goal.

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