FRBSF Economic Letter
2003-03; February 14, 2003
How Financial Firms Manage Risk
Financial Notes: This series supersedes Western
Banking. It appears on an occasional basis and is prepared under the
auspices of the Financial and Regional Research Section of the FRBSF's
Economic Research Department. Regional
Banking Tables will continue to be updated online quarterly.
Over the past several years, there has been a steady march toward financial
integration across product lines among larger financial firms. The trend
is in part due to the increasing globalization of financial markets, the
development of new financial instruments, and advances in information
technology. In the United States, the Gramm-Leach-Bliley Act of 1999 permits
financial firms to engage in banking, securities exchange, and insurance
under a new charter type that creates financial holding companies (FHCs).
The Federal Reserve is the primary supervisor for FHCs, and it had granted
640 FHC charters to top-tier holding companies as of January 24, 2003.
The attraction to firms of offering an array of financial services can
stem from the potential advantages of cross-selling several products to
customers or from the similarity in underlying expertise and information
systems used. However, from a supervisory perspective, it is important
to recognize that different financial activities typically give rise to
different types of underlying risks. This Economic Letter outlines
these risks and the differing risk management techniques commonly used
for banking, securities, and insurance activities.
Common risk categories
Financial firms face four common risks: market risk, credit risk, funding
risk, and operational risk. Market risk refers to the possibility of incurring
large losses from adverse changes in financial asset prices, such as stock
prices or interest rates. Standard risk management involves the use of
statistical models to forecast the probabilities and magnitudes of large
adverse price changes. These so-called "value-at-risk" models
are used to set capital against potential losses. In practice, while models
provide a convenient methodology for quantifying market risks, there are
limitations to their ability to predict the magnitude of potential losses.
To address these limitations, firms also use stress tests that examine
the impact of large hypothetical market movements on their portfolio values.
Credit risk is the risk that a firm's borrowers will not repay their
debt obligations in full when they are due. The traditional method for
managing credit risk is to establish credit limits at the level of the
individual borrower, industry sector, and geographic area. Such limits
are generally based on internal credit ratings. Quantitative models are
increasingly used to measure and manage credit risks (see
Lopez, 2001, for further discussion).
Funding (or liquidity) risk is the risk that a firm cannot obtain the
funds necessary to meet its financial obligations, for example short-term
loan commitments. Three common techniques for mitigating funding risk
are diversifying over funding sources, holding liquid assets, and establishing
contingency plans, such as backup lines of credit. Generally, firms set
funding goals as benchmarks to measure their current funding levels, and
take mitigating actions when they are below certain thresholds.
Finally, operational risk is the risk of monetary loss resulting from
inadequate or failed internal processes, people, and systems or from external
events (see
Lopez, 2002, for a more complete discussion). Although operational
risk management is a rapidly developing field, standard risk mitigation
techniques have not yet been developed.
Common risk management techniques
A key element of financial risk management is deciding which risks to
bear and to what degree. Indeed, a financial firm's value-added is often
its willingness to take on specific risks. Correspondingly, risk management
involves determining what risks a firm's financial activities generate
and avoiding unprofitable risk positions. Other important components are
deciding how best to bear the desired risks and what actions are needed
to mitigate undesired risks by shifting them to third parties.
Financial firms protect themselves from risk by setting aside funds to
cover losses. Broadly speaking, these funds are known as provisions and
capital. Provisions are funds set aside to cover expected (or average)
losses, and capital refers to funds set aside to cover unexpected (or
extraordinary) losses. Capital takes several forms on the balance sheets
of financial firms, but typically it includes such items as shareholder
equity. The reliance on provisions and capital varies among financial
firms engaging in banking, securities, and insurance activities due to
differences in their underlying risks.
Since financial firms have similar general goals regarding risk bearing,
some of their risk management techniques are similar. For example, all
firms have procedures to ensure that independent risk assessments are
conducted and that controls are in place to limit the amount of risk individual
business units take. In addition, hedging—i.e., paying third parties
to take on some of the risk exposure—is common to all types of financial
activities. Market risk is the easiest to hedge, because of the wide variety
of exchange-traded and over-the-counter derivatives available. Increasingly,
credit risk is hedged using credit derivatives, which are over-the-counter
derivatives for which payments are based on borrower credit quality. Finally,
certain risk exposures arising from insurance activities can be hedged
using the reinsurance market.
At the same time, important differences in risk management techniques
exist. As noted in the 2001 report by the Joint Forum consisting of international
bank, securities, and insurance supervisors, financial firms tend to invest
more in developing risk management techniques for the risks that are dominant
in their primary business lines. The report also found that risk management
still is conducted mainly on the basis of specific business lines. The
following sections highlight the key differences in risk management techniques
across financial activities.
Financial risks of commercial banking
A defining characteristic of commercial banking is extending credit to
borrowers of all types. Hence, commercial banks' main risks are the credit
risk arising from their lending activities and the funding risk related
to the structure of their balance sheets. Banks hold loan loss provisions
to cover expected losses, but capital to cover unexpected credit accounts
for a larger share of the balance sheet. Banks are required to hold minimum
levels of regulatory capital, and bank regulators in most countries adhere
to the 1998 Basel Capital Accord. As mentioned, credit risk management
is placing greater emphasis on producing detailed quantitative estimates
of credit risk. These measures are used to form better estimates of the
amount of provisions and capital necessary at the portfolio level and
to price and trade individual credits; in addition, they would be used
for regulatory capital purposes under proposed changes to the Basel Capital
Accord.
Commercial banks are particularly vulnerable to funding risk because
they finance illiquid longer-term lending commitments with short-term
liabilities, such as deposits. Broadly speaking, funding risk management
consists of an assessment of potential demands for liquidity during a
stressful period relative to the potential sources of liquidity. To avoid
a shortfall, banks seek to expand the size and number of available sources,
for example, the interbank market. In the United States, banks also have
access to the Federal Reserve discount window.
Financial risks of securities activities
Securities firms engage in various financial activities, but key among
these are serving as brokers between two parties in transfers of financial
securities and as dealers and underwriters of these securities. The degree
to which individual securities firms engage in these activities varies
widely. In general, a large share of securities firms' assets are fully
collateralized receivables arising from securities borrowed and reverse
repurchase transactions with other market participants. Another asset
category is securities they own, including positions related to derivative
transactions. The main risk arising from securities activities is the
market risk associated with proprietary holdings and collateral obtained
or provided for specific transactions. Securities firms generally do not
maintain significant provisions because their assets and liabilities can
be valued accurately on a mark-to-market basis. Hence, hedging techniques
and capital play dominant roles in risk management for securities firms.
With respect to credit risk, securities activities generate fewer credit
exposures than commercial bank lending. With fully secured transactions,
securities firms mitigate their credit risk exposures by monitoring them
with respect to the value of the collateral received. For partially secured
or unsecured transactions, such as funds owed by counterparties in derivative
transactions, they mitigate credit risk by increasing or imposing collateral
requirements when the creditworthiness of the counterparty deteriorates.
In addition, with frequent trading counterparties, securities firms enter
into agreements, such as master netting and collateral arrangements, that
aggregate and manage individual transactions exposures.
Securities firms have significant exposure to funding risk because a
majority of their assets are financed by short-term borrowing from wholesale
sources, such as banks. The liquidation of their asset portfolios is viewed
as a source of funding only as a last resort. Accordingly, the primary
liquidity risk facing securities firms is the risk that sources of funding
will become unavailable, thereby forcing a firm to wind down its operations.
To mitigate this risk, securities firms hold liquid securities and attempt
to diversify their funding sources.
Financial risks of insurance activities
Insurance activities are broadly divided into life and non-life insurance,
and firms specializing in either category face different risks. Specifically,
these two types of activities require firms to hold different technical
provisions, by virtue of both prudent business practices and regulatory
mandates. For life insurance companies, technical provisions typically
are the greater part of their liabilities—about 80%, according to
the Joint Forum report—and they reflect the amount set aside to pay
potential claims on the policies underwritten by the firms; capital is
a relatively small percentage. Thus, the dominant risk arising from life
insurance activities is whether their technical provisions are adequate,
as measured using actuarial techniques. While term-life insurance policies
are based solely on providing death benefits, whole-life insurance policies
typically permit their holders to invest in specific assets and even to
borrow against the value of the policies. Hence, life insurance companies
also face market and credit risks.
For a non-life insurance company, technical provisions make up about
60% of liabilities, which is less than observed for life insurance companies.
The different balance between provisions and capital for non-life insurance
companies reflects the greater uncertainty of non-life claims. The need
for an additional buffer for risk over and above provisions accounts for
the larger relative share of capital in non-life insurance companies'
balance sheets.
Regarding funding risk, insurance activities are different from other
financial activities because they are prefunded by premiums; for this
reason, insurance companies do not rely heavily on short-term market funding.
Life insurance companies have more than 90% of their assets in the investment
portfolio held to support their liabilities. Hence, whether the investment
portfolio generates sufficient returns to support the necessary provisions
is a major financial risk. Investment risks include the potential loss
in the value of investments made and therefore include both market and
credit risk. These investment risks traditionally have been managed using
standard asset-liability management techniques, such as imposing constraints
on the type and size of investments and balancing maturity mismatches
between investments and liabilities.
Conclusion
Several factors have contributed to the convergence of the financial
service sectors. Yet, significant differences in their core business activities
and risk-management techniques remain. There are also important differences
in the regulatory capital frameworks, reflecting differences in the underlying
businesses.
As firms become active participants in new markets and take on new types
of financial risks, it is important that appropriate policies and procedures
be put into place to measure and manage these risks. However, risk management
still is conducted on the basis of specific business lines. Hence, the
challenge for risk managers is to aggregate different financial risks
across the firm accurately. At present, there are significant practical
and conceptual difficulties associated with these calculations. Because
of differing time horizons and the difficulty of precisely measuring correlations
across financial risks, many firms calculate the amount of economic capital
separately for each risk type and aggregate. Clearly, simple summation
is too conservative, since it ignores any possible diversification. Much
further research is necessary to determine the best methods for firm-wide
risk management for FHCs.
Jose A. Lopez
Economist
References
[URL accessed February 2003.]
The Joint Forum. 2001. "Risk
Management Practices and Regulatory Capital: Cross-Sectoral Comparison."
Lopez, J.A. 2001. "Modeling
Credit Risk for Commercial Loans." FRBSF Economic Letter
2001-12 (April 27).
Lopez, J.A. 2002. "What
Is Operational Risk?" FRBSF Economic Letter 2002-02 (January
25).
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