Financial Risk Management Applications in market, credit, asset and liability management, and firmwide risk by Jimmy Skoglund and Wei Chen

Financial Risk Management Applications in market, credit, asset and liability management, and firmwide risk by Jimmy Skoglund and Wei Chen

Chapter 1
Introduction
Banks and Risk Management
Risk management has gone through a long journey in the history of corporate development.
Modigliani and Miller (1958) proposed that in an environment without contracting cost,
information asymmetry, and taxes, risk management among other financial policies is irrelevant
to firm value creation. Sometimes it even lowers the value of the firm because it is seldom
free. In the last decades the topic on the role of risk management in a value creation–oriented
corporate world—especially in banks—has driven the evolution of the risk management
practice. With the development of the computational technology and the witness of several
major financial distresses, a sound infrastructure of the risk management systems becomes not
only a regulatory concern but also corporate competitive advantage reality. However, the
debate of the value and role of risk management in a financial institution still goes on. Some
institutions retain the thought that risk management is just an answer to regulatory compliance
or a defense system. The modern financial theory based on the capital asset pricing model and
other related models is fundamental to the no-arbitrage principle. That is, excess returns can
only be achieved by taking risks. This principle makes it necessary to recognize that risk
management is not just a preference but is accompanied by the profit-chasing mandate of
corporations.
The discussion on bank-specific risk management topics has to be picked up from the existence
of banks as intermediary between borrowers and investors. The development of banks and the
reliance on banks in the economic activities show that banks are a special corporate that
provide unique services for parties from both sides. Banks in general provide special value to
the corporate world by playing the role of three major intermediations: information, risk, and
liquidity. As the intermediary between borrowers and investors, banks have more information
about the type of resource available and wanted as well as the preferences of the two sides.
This information asymmetry gives banks dominant roles in the resource allocation of the
economy. Banks get their rewards by creating efficiency in the allocation process. In addition,
banks are viewed as delegated monitors or evaluators of their borrowers. Because of the scale
of economy and specialty, banks can provide monitoring services at a lower cost than the nonbank

lenders. A bank must be responsible for the safety of the money from their lenders. Banks
also offer insurance against shocks to a consumer's consumption by smoothing the resource
allocation along a multihorizon path for the consumer. When the consumer has excess money,
themoney can be lent through banks to earn returns for the future. In case the consumer runs into
a money crunch, emergency funds can be borrowed from the bank, which will have to be paid
back from future income. Hence, banks' payment systems effectively connect the spatially and
temporally separated trades.
The primary obligation of corporate entities, including banks, is to create value for their
shareholders. However, through the intermediation service a bank provides to its customers,
risk management in banks also brings social benefits as well. This is because banks not only
create value for their shareholders but also have strong impact on the value of their customers.
It is obvious that a bank's insolvency can bring the loss of its creditors. Risk management is in
the core of the banking value creation and also a public benefit. Risk management is not just a
certain methodology in a bank. It is about a culture and an end-to-end process that spirally
moves a bank up into a value chain that demonstrates its core competitive advantage against its
peers. A sound risk management process spans from identification, to measurement, to
monitoring, to control, to optimal decision making, and back to identification.
As an information, risk, and liquidity intermediary, banks possess unique information on the
general macroeconomic condition and customer and market status. Hence, banks have a unique
position in risk identification. A well-known fact in any social science study is that past
experience is not a guaranteed prediction to the future—although history does tend to repeat
itself in disguised fashion. One of the prominent difficulties is the discovery of so-called
“black swan” risks. In his famous book on the topic, Taleb (2007) borrows the term “black
swan” for the situation where seemingly impossible or nonexistent events actually occur.
Sometime overreliance on past experience will lead to loss of sight of a forthcoming crisis.
One of the lessons learned from the 2007 financial crisis is to engage a forward-looking risk
discovery practice that can identify risks that may not have existed in the past.
Traditionally financial risk measurement has been categorized into market, credit, liquidity,
and other risks. Market risk represents the risks that are primarily driven by market variables
including interest rates, foreign exchange rates, equities, and commodity prices. Credit risk is
the risk underlying the default risk of counterparties ranging from retail customers to trading
counterparties. Market risk and credit risk have traditionally been separately managed in most
banking institutions. In traditional asset and liability management, market risk and credit risk
have been separated in the way that the asset and liability committee manages interest rate risk
impacts on profitability, and liquidity risks while the business units are concerned with the
credit risk. It is an increasing trend to look at comprehensive risks in a more holistic way. All
the potential risks in a particular business line or book are analyzed together without an
artificial separation into driving risk types. For some risks this is also a prerequisite, for
example, liquidity risk, which is usually a consequential risk from other risks.
Risk assessment includes both qualitative and quantitative measurement of the risk exposures
of a bank. Such assessments require a joint effort of expert knowledge and scientific discovery
techniques. Diebold et al. (2010) provide a knowledge theory that classifies risks into known,
unknown, and unknowable. From a measurement point of view, a known risk is both identified
and completely modeled. Note that a known risk is not deterministic but can be well measured.
Diebold et al. (2010) specifically refer the models to fully specified probability distributions
of potential profit and losses. An unknown risk is known to exist but cannot be modeled
properly. A consumer behavioral risk such as prepayment risk serves as a simple illustration of
the difference between these two risk types. The prepayment risk is certainly a well-identified
risk. For consumer portfolios the well-specified statistical prepayment models can only be

Financial Risk Management Applications in market, credit, asset and liability management, and firmwide risk by Jimmy Skoglund and Wei Chen