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spikegifted - Risk Management


I have briefly explained on the Investment Banking page about Credit/Counterparty Risk Management, but financial risk management on the whole has grown up to almost an entire sub-sector within the financial services industry. Therefore, I believe that in order to fully understand the role of risk management in the financial services industry, I need to explore and explain how and why certain risks arise and how the industry react to these and measures taken to mitigate these risks. I mentioned that the process of risk management can be broken down to: identification, classification, assessment & monitoring and mitigation. In the following paragraphs, I shall attempt to provide answers and approaches to each of these areas, bases on my personal experience and knowledge. Of course, this is not the be-all and end-all explanation, but I hope it will give the readers a good understanding why risk professionals are here and what they do for a living.

Understanding: What is risk?

Since we're talking about risk management, it is a perfectly legitimate question to ask. If we don't know what risk is, how do we, as professionals, manage it?

Risk is everywhere! Everywhere you go, everything you do, has a certain risk attached to it. When you leave your home in the morning to go to school or work, you can twist your ankle when you go down some steps or find out that one of the tires of your car is flat or miss the bus/train/ferry or whatever transport you need or there are delays on route or in the craziest of situation, the whole train network ceases to function due to industrial action by striking unions. All of these are risks! And that's just the beginning of the day, you haven't even arrive at your destination. Of course, we learn to deal with risks like these - we allow some extra time in the morning to make sure that you get to your destination without hurrying too much, we take extra care when we're running or jumping down steps and we have spare types in the trunk of our cars  and we adapt to delays by leaving earlier or take alternative routes to avoid the delays or industrial actions. We can deal with these thing. Additionally, we take our cars to regular check ups to make sure the vehicle is operational or even pay of a recovery service and we learn to leave for work/school at a certain time to arrive on time, but not too early, and we learn to give out excuses so that our bosses, teachers, colleagues and classmates don't get the impression that we're slow in the morning...

The above selection of examples are chosen for a reason. They deal with different levels of risk - risk to our own well being (twisting the ankle, missing the train), risk on our vehicle or particular form of transport being delayed and a system wide failure (industrial action). And for each of these different levels of risk, we learn to employ different levels of diligence to mitigate the risk - we take good care when we go down each step of the stairs, we become familiar with the train time-table for the morning rush hour and learn to use alternatives when the system breaks down.

Risks in the financial services industry, that is the risks to financial capital, are no different to the above scenario of getting to work/school. It may be argued that the risks in financial services are more complicated and they have larger (often substantially) financial implications than the risk of arriving late in the morning, but they still affect the participants at different levels - the individual transaction, the organization and the whole financial system itself.

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Version history:
July 2003: First version.