The idea of risk is straightforward for the most part but exists in different ways for every industry. In investment banking, risk management means protecting financial assets against loss. This is done by first identifying risky behaviours and then avoiding them if possible or deploying appropriate strategies to reduce chances of negative impact.
Often, we tend to think of risk as a bad thing. In reality, the world of investing is known to label risk as necessary in tandem with desirable performance. Another way of thinking about investment risk is just deviation from an expected outcome. Achieving higher returns often means increased risk in the higher volatility of an investment.
Teams dedicated to reducing volatility and stabilising higher chances of successful investment form strategies around numerous types of risk to not only protect the bank’s interest but the interest of their clients. Below is a list of just some of the major risk management factors that banks must continuously take into consideration:
Market risk, sometimes referred to is macro risk, is external and unavoidable. This makes it a point of focus for investment banks. Variables in the market such as fluctuations in exchange rates, inflation and interest rates all have the potential to incur losses.
Because banks fund their operations by loaning and borrowing funds across international financial institutions with different currencies and interest rate structures, exposure to these complex risk calculations is minimised with the use of derivative instruments. These instruments assist in measuring and managing risk as well as guesstimating price changes in assets.
Across the board, operational risk exists with the potential to cause financial losses or damaged reputation to any business. In banking, these could occur from business function interruptions, employee errors and product failures to external events, IT system failures and litigation.
Banks need to set operational risk management teams to focus on what proactive measures can be taken to ensure a continuous business operation and deliver accurate information both internally and externally. It is important to ensure that staff adhere to rules and procedures and maintain an established level of integrity and expertise. This is done in part by continually developing and upgrading company-wide strategy and communication systems.
Credit risk is the main type of financial risk that banking institutions face. In essence, this is the possibility of losses resulting from a borrower’s failure to repay a loan, failing to fulfil their contractual obligations while the collateral provided does not cover the Bank. Majority of credit risk comes from regular lending operations to individuals and businesses.
Strategies are employed to ensure proper risk diversification and identify any risk areas that require further attention. A core part of credit approval is the use of detailed assessments that analyse risk vs return. Part of this includes the implementation of rigorous loan selection processes that determine candidates that qualify for funding.
With the advancement in technology and what it affords banks to be able to offer their clients comes an increase in online criminal activity. For most banks, ensuring protection against cyberattacks are a strategic top priority. It is an evolving science that will surely only increase in importance over time and require greater resources. Banks store large amounts of data about their clients and need to keep them protected to ensure trust and financial security.
The takeaway from these factors is that risk management is critically important in finance. Effective risk management strategies are crucial for investment banking and its bottom line. Banks that do not deploy effective solutions to manage risk stand to face financial losses and potentially liquidate if they are not fixed over time.
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