Risk management has been widely used not only in finance industry but also in other industries such as process industry, insurance, environment and health. Framework for best practice on risk management requires the consolidation of the policies, methodologies and technological infrastructure. The proactive risk management needs the top-down policies on risk tolerance and authorities that help to establish business strategies. The policies have to clear and disclosed. The enterprise need to deploy risk measurement methodologies to quantify the corporate risk. The most popular and widely used measures are VaR (value-at-risk), CrVaR (credit value at risk), RaRoRaC (risk-adjusted return on risk-adjusted capital) and valuation methods or pricing models for complicated financial engineering products. The technological infrastructure is also very important to make the business operation run smoothly which enable to generate integrity data for effective risk monitors and controls.
Implementation of an effective risk management
It can be summarized as the followings.
Establish a risk-oriented organization culture.
Top executives are directly responsible to corporate risk. They have to endorse the enterprise-wide risk policy and procedures.
Deploy appropriate methodologies to quantify.
Employ risk management staffs with knowledge in advanced quantitative methods and experiencing in core business activities.
Risk managers in the independent middle office have to report directly to the ALCO or risk committee.
Able to use and x-rays through financial engineering tools in portfolio and in hedging risk.
Apply risk-adjusted performance measure, e.g. RaRoRaC.
Effective use of capital for risky business lines
Integrated IT systems that can segregate front, middle and back offices and ensure the data integrity.
Use intelligence software tools to compute risk figures and reports and spend lot of time in managing corporate risk.
Typology of Risks
As top executives, managers have to involve with financial management. Major categories of risks faced by a financial management are market risk, credit risk and operational risk.
Market risk is the possible amount of money that the value of asset would be lost by the effects of change in financial market prices and rates. There are 4 basic classes of assets, e.g. bonds, equities, foreign currencies and their derivatives, which are in the trading or investment positions in the banks, mutual funds and investment companies.
The traditional measure of market risk is duration for bonds and CAPM’s beta for equities which are deterministic and cannot explained the risk in a near future. Value-at-risk (VaR) is the most popular and widely used and standardized answer to measure how risky the portfolio is in terms of stochastic measurement. It is used to quantify the risks that originate from assets like stock portfolio, bond portfolio, foreign currency portfolio or raw material resources.
Credit risk is the risk that changes in the credit quality, possibility of default included, of a counterparty affects the value of the bank’s position of credit-risk portfolio. Today credit risk is a significant risk to the bank. Earning of bank depends on how to price the loan rate right for various rating. The component of credit risk consists of credit scoring for individual obligor, credit migration and probability of default, correlation of default, exposure at default, recovery rate and loss given default and asset valuation.
Operational risk refers to potential losses resulting from inadequate systems, management failure, faulty controls, fraud, and human errors.
Liquidity risk comprises of asset liquidity risk and funding liquidity risk. Asset liquidity risk is the risk of not being able to execute a transaction, at the current prevailing market price. Otherwise, value of asset has to be under a deep discount. Funding liquidity risk relates to the inability to raise the necessary cash to roll over debt, and to meet cash requirement for a working capital.
Risk on ALM is mainly focused on future cash inflows and outflows as well as expected net earning in the future. Similarly to the VaR concept, the cash flow at risk (CFaR) will measure the deviation between actual cash flows and the planned value is due to changes in the underlying risk factors such as exchange rates and interest rates. It in turns affects the corporate planned value in the budget. The earnings at risk (EaR) focus on uncertainty of profits and losses relevant to the many risk factors.
