08 December 2010

Idea of Bank Risk Management

By definition, banking business is risky. Everyone in the industry knows it. There are risks like credit risk, market risk, operational risk, liquidity risk, earnings volatility risk, different risk concentrations – you name it. Risks are inherent to the banks’ business models: using high leverage and financing long term assets with short term liabilities.

Furthermore, the whole financial system as such is very fragile and contagion risks are high. If one of the systemically important banks were to fail, financial markets would melt down (as we saw right after the collapse of Lehman Brothers), and banks, without the help by central banks and governments, would fall like domino blocks. Not less importantly, this is because there is more debt than money outstanding (refers to the concept of fractional reserve banking and everything related to it).

If the true level of risks that banks and the financial industry as a whole are taking were to be measured and borne by private investors, one probably would end up with the conclusion that banking business is far too risky. It all depends on the confidence of markets and customers, and that’s why there are guarantee schemes and central banks ready to print money whenever it is deemed to be necessary. Doing too risky business and benefitting from explicit and implicit safety nets is what makes banking profitable – more profitable than so many other industries.

Knowing that, the legitimate question arises: what’s actually the point or idea of a bank’s risk management?

Keep risks low? No. This would destroy business.

Manage crises and fight fire? Guess again. Risk managers don’t have the tools.

Build complex risk models? Closer – if nothing else, complex risk models at least enable to argue that everything is precisely measured and controlled, and in that way make regulators happy. Usually they also provide a good reason for improving data quality and availability. But models are just tools.

Ensure that the risks taken are controlled and appropriately priced? Sounds good, but this is only half truth at best.

Well, actually find the subtle balance between:
  • starting taking risks too early (new customers will default) vs too late (better customers have been “reserved” by competitors),
  • being too small (no bail-outs) vs growing too big (costs may start exceeding the benefits),
  • stepping out too early (small profits) vs waiting too long (significant losses and damages),
  • asking too low vs too high price (and losing the deal),
  • etc.
In order to maximise risk-based profitability, all this must be done in an environment where the bank operates – and this environment includes government guarantees, central banks’ liquidity facilities and every kind of other assistance.

Isn’t it ironical? I thought that business and risks should be independent from each other, but it turns out that for ensuring the best combination of risk and return, they need to work closely together. I also thought that the aim of risk management is to ensure a safe bank. In fact, the aim is just to be a little safer than the riskiest peers. One more conclusion is that if all banks would manage their risks perfectly, systemic risks wouldn’t disappear or even considerably decrease.

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