Risk Management Fundamentals: An introduction to risk management in the financial services industry in the 21st century by Justin McCarthy

Chapter 1: Risk and Risk
 Management
 1.1 Introduction
 An initial concept to understand is that risk is not a bad thing – some
 element of risk taking is required to gain rewards, both in finance and in life.
 It is the management of this risk that is key. Understanding the probability
 and impact of risks is the first step in managing risk. Working through the
 risk process and getting to the point where a risk is being properly mitigated
 is part of the journey in becoming a risk manager.
 This chapter provides an understanding of risk throughout the financial
 services industry and an understanding that its management is a topic outside
 of financial services.
 1.2 Risk and Risk Management
 Before learning about risk management, it is best to understand the concept
 of risk. Once a person understands that not all risk is dangerous, then a more
 thoughtful approach to risk management and its mitigation can be
 considered.
 Risk
 Risk combines the uncertainty of some event occurring and the additional
 uncertainty of the effect of that event. Most importantly, we need to
 understand that risk may have positive or negative outcomes.
 For some, the focus of risk in financial services has been on the negative:

Excessive risk was taken by banks in concentrating their loans on sub
prime loans. The outcome was huge losses for these banks and knock
on effects to the global economy and society during the Great
 Recession of the late 2000s.
 Continental Illinois was once one of the largest commercial banks in
 the United States with approximately $40 billion in assets. During the
 1980s it was bailed out due to a liquidity crisis prompted by a flight of
 wholesale investors and creditors alarmed by the bank’s excessive
 exposure to energy and less developed countries.
 Nick Leeson, an employee in Barings Bank, was able to circumvent
 internal controls and took on unauthorised market positions. The
 outcome was losses greater than Barings Bank could absorb resulting in
 the collapse of the bank.
 Royal Bank of Scotland was involved in the largest bank acquisition
 ever through a deal to purchase ABN Amro bank. The outcome was a
 bank overstretched for capital when other parts of its business were
 stressed by a financial crisis. While the bank survived, its CEO was
 forced to resign and a multi-billion pound bailout had to be provided by
 the UK government.
 Risk can also be a positive force and result in a reward in financial services.
 Some examples:
 Extending credit to a customer is rewarded with a series of payments
 that cover the original loan and reward the credit institution with
 interest for the use of the funds extended.
 Investing in a bond from an EU Government is rewarded with interest
 payments for providing funds to allow government services to be
 financed.
 A firm decides to go into business in a new area – for example selling
 insurance to car owners as well as providing loans for their cars.
 All three scenarios may have adverse outcomes – the loan may end up
 unpaid, the bond may default, and the insurance business may not make a
 profit due to premiums not covering claims – but these risks are taken in an
 attempt to improve a business.

Risk Management Fundamentals: An introduction to risk management in the financial services industry in the 21st century by Justin McCarthy