risk management and financial institutions

Operational risk assessment
The Commercial Imperative of a More Forensic and Transparent Approach

Brendon Young and Rodney Coleman

“Brendon Young and Rodney Coleman’s book is extremely timely. There has never been a greater need for the financial industry to reassess the way it looks at risk. […] They are right to draw attention to the current widespread practices of risk management, which […] have allowed risk to become underpriced across the entire industry.”

Rt Hon John McFall MP, Chairman,
House of Commons Treasury Committee

Failure of the financial services sector to properly understand risk was clearly demonstrated by the recent ‘credit crunch’. In its 2008 Global Stability Report, the IMF sharply criticised banks and other financial institutions for the failure of risk management systems, resulting in excessive risk-taking. Financial sector supervision and regulation was also criticised for lagging behind shifts in business models and rapid innovation.

This book provides investors with a sound understanding of the approaches used to assess the standing of firms and determine their true potential (identifying probable losers and potential longer-term winners). It advocates a ‘more forensic’ approach towards operational risk management and promotes transparency, which is seen as a facilitator of competition and efficiency as well as being a barrier to fraud, corruption and financial crime.

Risk assessment is an integral part of informed decision making, influencing strategic positioning and direction. It is fundamental to a company’s performance and a key differentiator between competing management teams. Increasing complexity is resulting in the need for more dynamic, responsive approaches to the assessment and management of risk. Not all risks can be quantified; however, it remains incumbent upon management to determine the impact of possible risk-events on financial statements and to indicate the level of variation in projected figures.

To begin, the book looks at traditional methods of risk assessment and shows how these have developed into the approaches currently being used. It then goes on to consider the more advanced forensic techniques being developed, which will undoubtedly increase understanding. The authors identify ‘best practice’ and address issues such as the importance of corporate governance, culture and ethics. Insurance as a mitigant for operational risk is also considered. Quantitative and qualitative risk assessment methodologies covered include: Loss-data analysis; extreme value theory; causal analysis including Bayesian Belief Networks; control risk self-assessment and key indicators; scenario analysis; and dynamic financial analysis.

Views of industry insiders, from organisations such as Standard & Poors, Fitch, Hermes, USS, UN-PRI, Deutsche Bank, and Alchemy Partners, are presented together with those from experts at the FSA, the International Accounting Standards Board (IASB), and the Financial Reporting Council.

In addition to investors, this book will be of interest to actuaries, rating agencies, regulators and legislators, as well as to the directors and risk managers of financial institutions in both the private and public sectors. Students requiring a comprehensive knowledge of operational risk management will also find the book of considerable value.

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The progressive financial deregulation, following the abolishment of the Bretton Woods System in the early 1970s, changed the use and the configuration of technologies in the organizational contexts of finance. Information systems and financial engineering have led to an unprecedented reinvention of the business of banking. Written by experts from the social studies of finance, information systems specialists, and historians and sociologists of technology, this book explains why the management and the regulation of financial organizations, especially in periods of crises with systemic consequences, requires an understanding of the complex techno-organizational landscapes which emerged from this evolution. It shows the interconnection between the difficulty of overcoming the financial and operational risks we are facing, and the global webs of organizational and technological complexity.

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Very often, we associate the dawn of modern financial theory with Harry Markowitz who in the 1950s introduced the formal mathematics of probability theory to the problem of managing risk in an asset portfolio. The 1970s saw the advent of formal models for pricing options and other derivative contracts, whose primary purpose was also financial risk management and hedging. But events in the 1990s made it clear that effective risk management is a critical element for success, and indeed, for long term survival, not only for financial institutions, but also for industrial firms, and even for nonprofit organizations and governmental bodies. These recent events vividly show that the world is filled with all manner of risks, and so risk management must extend far beyond the use of standard derivative instruments in routine hedging applications. The articles in this volume cover two broad themes. One theme emphasizes methods for identifying, modeling, and hedging specific types of financial and business risks. Articles in this category consider the technology of risk measurement, such as Value at Risk and extreme value theory; new classes of risk, such as liquidity risk; new financial instruments and markets for risk management, such as derivative contracts based on weather and on catastrophic insurance risks; and finally, credit risk, which has become one of the most important areas of practical interest for risk management. The second theme stresses risk management from the perspective of the firm and the financial system as a whole. Articles in this category analyze risk management in the international arena, including payment and settlement risks and sovereign risk pricing, risk management from the regulator’s viewpoint, and risk management for financial institutions. The articles in this volume examine the “State of the Art” in risk management from the standpoint of academic researchers, market analysts and practitioners, and government observers.

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Focusing on internal business unit performance, this in-depth practitioner guide addresses both traditional and risk-adjusted performance measures in financial institutions, proving you with the tools to implement a ‘balanced scorecard’ approach to performance measurement. As performance measurement in financial institutions moves progressively away from traditional measures and towards the objective of shareholder value creation, finance professionals now need to understand many new drivers of performance which are unfamiliar to them. Risk Professional must also be aware of how measures of risk integrate with financial and operational drivers of the new measures of performance. In the spirit of enterprise risk management, you will benefit from an integral treatment of the three pillars of internal performance measurement in a financial institution: * Funds transfer pricing * Economic capital * Expense allocation You will get a look at Basel II from the perspective of improved financial and operational performance. Furthermore, you will be introduced to the concept of ‘balanced scorecards’, a new approach of balancing financial and non-financial drivers of performance. This practical new title addresses segment reporting and examines the issues and pitfalls of comparing performances across units and institutions as well as factors related to performance and compensation in financial institutions, which are rarely found in this type of literature. Focusing on internal business unit performance, this in-depth reference handbook will enable you to successfully measure and control performance. It is recommended for chief financial officers, treasurers, financial analysts, accountants, chief risk officers, risk managers, auditors and management consultants engaged in financial consulting to financial institutions.

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A comprehensive and innovative look at how to protect financial institutions from operational risks

Operational risk is the risk associated with human error, systems failures, and inadequate controls and procedures in information systems or internal controls that will result in an unexpected loss. According to a recent survey, about seventy percent of banks consider operational risk as important as market or credit risks. Nearly a quarter of the same banks admit to operation-related losses of more than $1.6 million-many cases are so embarrassing that banks will not actually admit any error on their part. Firms are just beginning to develop their own operational risk management systems and they need guidance on how to do it. This book will help them identify, measure, and manage their operational risks.

Christopher Marshall (Singapore) is Associate Director of the Center for Financial Engineering at the National University of Singapore. He has written numerous articles in Risk magazine and Harvard Business School cases.

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Recently risk management has become a standard prerequisite for all financial institutions. Value-at-Risk is the main tool of reporting to the bank regulators the risk that the financial institutions face. As it is essential to estimate it accurately, numerous methods have been proposed in order to minimise the forecast error. This book provides a selective survey of the risk management techniques that have been applied and discusses potential improvements in estimating, evaluating and adjusting Value-at-Risk and Expected Shortfall.

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