What is Risk Management?
Risk management is a very important function of every bank, as checks and balances must be put in place to ensure that an organization is a going concern (has the resources or means to continue operating). There are various forms of risk that must be identified and monitored – although controls must be weighed against their potential impacts on profitability. Finding the appropriate balance is therefore key in running a successful financial institution (or any for-profit corporate).
Types of Risks
See our counterparty credit risk section – Credit risk usually is a concern for banks when they 1) lend money 2) right-way risk for trading. Banks generally deal with credit risk whenever they lend as all loans will come with some sort of default risk. When banks are on the right side of a trade (for example, enters into a fixed-to-float swap on the pay-fixed side while interest rates rise), they are contracted to receive net positive cash flows. This is when counterparty credit risk arises.
Wrong-way risk for a trade. When a bank is obligated to pay a counterparty as a result of a trade going in an unfavorable direction (a bank enters into a pay-fixed swap and interest rates fall). Generally market risk is evaluated using Value at Risk (VaR) models that outline probabilities of losing a certain value.
The trading desk is subject to risk limits and exposures are marked-to-market – senior traders must explain excesses above limits. At some banks, a certain magic number of making trades that push the bank above assigned risk allowances is grounds for termination. Often, risk will require netting agreements (popularly, ISDAs) before they will approve limits.
Traders are trying to capture the spread between buyers and sellers, and traders will seek to hedge out flat price risk so that they can ensure that the margin is locked in. However, market price risk can be difficult to hedge when the product traded is illiquid – an example being natural gas liquids (NGLs). WTI exchanges hands in large volumes daily, but NGLs do not – some companies may use WTI as a proxy hedge. NGLs will not move in lockstep with WTI, so there is risk that if a petrochemical plant (a consumer of NGLs) is hedging with WTI call options and WTI prices are flat but NGL prices go up, they have failed to hedge their NGL price risk while paying a premium on their derivatives.
Illiquidity is the inability to meet short-term liabilities – this is markedly different from insolvency, which is the inability to meet long-term liabilities. Generally, most good organizations are solvent, but the problem with liquidity is that it tends to dry up very quickly when there is a crisis (in terms of available credit), and solvent but illiquid companies do go bankrupt (famously, Lehman Brothers). Liquidity sources that cannot be withdrawn include cash-on-hand and committed lines of credit.
Loss potential from systematic or procedural failure, including rogue traders and flawed security. For corporates, this can be a refinery going down or a pipeline spill, which inevitably leads to other risks (e.g. legal). Operational risk is broad, and accordingly demands a large risk management team. Operational risk can also involve fraud and terrorism (airlines). This risk is not diversifiable.
Legal and Reputational Risk
Litigation over topics that may garner unfavorable media attention can have consequences beyond the settlement provisions paid out to legal adversaries. For instance, a sexual harassment lawsuit may result in a reduced recruiting talent pool and possible consumer backlash that does not present itself as an obvious impact on the top or bottom line.
Large enough as is for heavily regulated industries such as banking, the current political landscape can cause headaches for project approvals and taxation certainty, especially if a corporate operates in a sensitive industry (oil and gas, pipelines). For corporates that operate in countries with less established legal frameworks, this risk may be amplified and there may be government actions that are more severe than that of a jurisdiction such as Canada – including expropriation of mines and arbitrary taxes that are poorly thought out and excessively punitive.