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Why Do Banks Manage These Risks At All?

Category: Risk Management in Banking

It seems appropriate for any discussion of risk management procedures to begin with why these firms manage risk. According to standard economic theory, managers of value maximizing firms ought to maximize expected profit without regard to the variability around its expected value. However, there is now a growing literature on the reasons for active risk management including the work of Stulz (1984), Smith, Smithson and Wolford (1990), and Froot, Sharfstein and Stein (1993) to name but a few of the more notable contributions.

In fact, the recent review of risk management reported in Santomero (1995) lists dozens of contributions to the area and at least four distinct rationales offered for active risk management. These include managerial selfinterest, the non-linearity of the tax structure, the costs of financial distress and the existence of capital market imperfections. Any one of these justify the firms’ concern over return variability, as the above-cited authors demonstrate.

How Are These Risks Managed ?

In light of the above, what are the necessary procedures that must be in place to carry out adequate risk management? In essence, what techniques are employed to both limit and manage the different types of risk, and how are they implemented in each area of risk control? It is to these questions that we now turn.

After reviewing the procedures employed by leading firms, an approach emerges from an examination of large-scale risk management systems. The management of the banking firm relies on a sequence of steps to implement a risk management system. These can be seen as containing the following four parts:

(i) standards and reports,

(ii) position limits or rules,

(iii) investment guidelines or strategies,

(iv) incentive contracts and compensation.

In general, these tools are established to measure exposure, define procedures to manage these exposures, limit individual positions to acceptable levels, and encourage decision makers to manage risk in a manner that is consistent with the firm’s goals and objectives. To see how each of these four parts of basic risk management techniques achieves these ends, we elaborate on each part of the process below. In Section IV we illustrate how these techniques are applied to manage each of the specific risks facing the banking community.

(i) Standards and Reports

The first of these risk management techniques involves two different conceptual activities, i.e., standard setting and financial reporting. They are listed together because they are the sine qua non of any risk system. Underwriting standards, risk categorizations, and standards of review are all traditional tools of risk management and control. Consistent evaluation and rating of exposures of various types are essential to understand the risks in the portfolio, and the extent to which these risks must be mitigated or absorbed.

The standardization of financial reporting is the next ingredient. Obviously outside audits, regulatory reports, and rating agency evaluations are essential for investors to gauge asset quality and firm level risk. These reports have long been standardized, for better or worse. However, the need here goes beyond public reports and audited statements to the need for management information on asset quality and risk posture. Such internal reports need similar standardization and much more frequent reporting intervals, with daily or weekly reports substituting for the quarterly GAAP periodicity.

(ii) Position Limits and Rules

A second technique for internal control of active management is the use of position limits, and/or minimum standards for participation. In terms of the latter, the domain of risk taking is restricted to only those assets or counterparties that pass some prespecified quality standard. Then, even for those investments that are eligible, limits are imposed to cover exposures to counterparties, credits, and overall position concentrations relative to various types of risks. While such limits are costly to establish and administer, their imposition restricts the risk that can be assumed by any one individual, and therefore by the organization as a whole. In general, each person who can commit capital will have a well-defined limit. This applies to traders, lenders, and portfolio managers. Summary reports show limits as well as current exposure by business unit on a periodic basis. In large organizations with thousands of positions maintained, accurate and timely reporting is difficult, but even more essential.

(iii) Investment Guidelines and Strategies

Investment guidelines and recommended positions for the immediate future are the third technique commonly in use. Here, strategies are outlined in terms of concentrations and commitments to particular areas of the market, the extent of desired asset-liability mismatching or exposure, and the need to hedge against systematic risk of a particular type. The limits described above lead to passive risk avoidance and/or diversification, because managers generally operate within position limits and prescribed rules. Beyond this, guidelines offer firm level advice as to the appropriate level of active management, given the state of the market and the willingness of senior management to absorb the risks implied by the aggregate portfolio. Such guidelines lead to firm level hedging and asset-liability matching. In addition, securitization and even derivative activity are rapidly growing techniques of position management open to participants looking to reduce their exposure to be in line with management’s guidelines.

(iv) Incentive Schemes

To the extent that management can enter incentive compatible contracts with line managers and make compensation related to the risks borne by these individuals, then the need for elaborate and costly controls is lessened. However, such incentive contracts require accurate position valuation and proper internal control systems.5 Such tools which include position posting, risk analysis, the allocation of costs, and setting of required returns to various parts of the organization are not trivial. Notwithstanding the difficulty, welldesigned systems align the goals of managers with other stakeholders in a most desirable way. In fact, most financial debacles can be traced to the absence of incentive compatibility, as the cases of the deposit insurance and maverick traders so clearly illustrate.

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