Financial risk management

From CEOpedia | Management online

Financial risk management is the practice of protecting the economic value of a company by using financial instruments to manage financial risk. Primarily operational risk, credit risk and market risk, with more specific variants listed alongside. As for risk management in general, financial risk management involves identifying their sources, measuring them, and planning to address them[1]. Risks are divided into

Risk Governance

Risk governance is central to risk management. It Manages the whole risk management process. At the same time, it ties risk management across the bank's operations. Transparency is also an important factor. Key stakeholders need to understand the assumptions and business logic of the risk methodology, but don't need to know the details of the mathematical model. The risk model development, validation, and deployment team is responsible for ensuring that models are properly developed, implemented, and validated. Moreever, they also have important responsibilities such as communication.

Quantitative and Qualitative Risk Management

Risk assessment includes both qualitative and quantitative measures of a bank's risk position. Such assessments require a concerted effort of expertise and scientific discovery skills[2]. Quantitative financial risk management comprises economics, accounting, statistics, econometrics, mathematics, stochastic processes, and computer science and technology. Financial management tools are increasingly being used to manage, monitor and measure risks, especially those associated with globalization, market volatility and economic crises[3].

Financial Risk Systems

A financial risk management system is undoubtedly a platform on which quantitative risk management techniques are practiced. Generally refers to computer systems that can be used to manage risk models and risk data, develop risk scenarios, evaluate a bank's portfolio against risk scenarios, report risk measures and, in some cases, support risk-based decision-making. Traditionally, banks have used siled risk systems to calculate different types of risk, including market, credit, asset and liability management risk.

Risk aggregation to enterprise-wide capital levels is a post-processing process of risk distribution or risk measurement in silo systems. Risk calculation itself is central to any financial risk management system, but the system's functionality also depends on the risk infrastructure and the risk technologies available to the system. The risk infrastructure should support the use of the system through appropriate workflows, configuration options, etc.

Risk techniques should be tailored to the requirements of risk calculations. In many cases, the development of the risk calculation algorithms and methods themselves must also take into account the risk technology in order to maximize the use of computational resources such as processors and memory. System functionality is categorized into three components:

  1. Risk analysis or risk calculator
  2. Risk infrastructure function
  3. Risk technology function

Risk Analytics

A risk system can be designed to calculate only market risk (for example) or can be scaled up to calculate risk across many risk types. Financial risk systems generally implement a risk calculation process, and at each step in the process, risk analysts can assign or create new methods or models to be used in risk analysis. Examples are price functions, market simulation models, and credit risk assessment models. Many modern risk systems are designed to comprehensively analyze financial risks. This means covering all financial risks of a position, which may arise from market, credit and liquidity risks.

Risk Infrastructure

Apart from the risk analysis and risk calculation process, a financial risk system requires a risk infrastructure. The risk infrastructure must support the current usage of the system and be able to adapt to future requirements. The risk infrastructure requirements of financial risk management systems will be approached through several core principles that the system should support. These basic principles include:

  • Comprehensiveness and relevance
  • Accuracy
  • Timeliness
  • Governance
  • Transparency
  • Extensibility

Risk Technology

Proper use of technology is key to the financial risk system and practical implementation of the quantitative techniques described in this paper. It is also important to adhere to the timeliness principle discussed in relation to the risk infrastructure. Like any computer system, the Risk system is subject to four major computing resource limits[4]:

  • Processor performance
  • Storage capacity
  • Memory capacity
  • Network bandwidth with distributed computation and storage over a grid of multiple compute nodes

Footnotes

  1. Christofferson, P. F. (2011)
  2. Skoglund, J., Chen, W. (2015), p. 30
  3. Zopounidis, C., Galariotis, E. (2015), p. xvii
  4. Skoglund, J., Chen, W. (2015), pp. 39-45


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References

Author: Sven Korten