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Managing Risks in Investment Banking

Mar 05, 2021| Article

The primary component of the investment bank’s risk management strategy is the risk appetite based on the current and future risk profile, as determined by the Investment Bank’s Council.

Risk management involves the identification, analysis, and response to risk factors that are part of a business life cycle. A good risk management structure involves the calculation of the uncertainties and prediction of their influence on the business.

A perfect risk management structure supports proactive risk management and other risk mitigation systems too, such as planning, budgeting, and cost control. As a result, the business will not face many surprises.

At investment banks, the risk management strategy is approved by the Council, revised, and evaluated on an annual basis.

Risk classification

Investment banks engage in different types of businesses and as such, each type is associated with a specific set of risks. Depending on their sources and impact, they are grouped as follows.

Simple tips to managing risks at investment banks

This is how investment banks can manage risks at different levels.

Market risk management:

  • Monitor, measure, and manage - liquidity, interest rate, foreign exchange, and commodity price risks through an all-inclusive dynamic framework.
  • Assess potential problems through stress testing.

Credit risk management:

  • Maintain credit exposure within the acceptable parameters.
  • Make lending decisions based on the credit score.
  • Gauge how much a bank stands to lose on credit portfolio.

Operational risk management:

  • Establish internal audit systems.
  • Assess and eliminate weak control procedures.
  • Train the staff at all levels

Legal risk management:

  • Conduct all activities within the regulatory frameworks

Liquidity risk:

  • Diversify
  • Secure back-up funding
  • Limit cash flow gaps

Reputational risk:

  • Demonstrate business integrity
  • Manage social media, feedbacks, and reviews
  • Secure data and data integrity
  • Foster a productive workplace

Key takeaways

Though the above principles and information are helpful, they may not fully address an investor’s concerns. The risk equation is dependent on how people view gains and losses.

Tversky and Kahneman documents that, “investors would put twice the weight on the pain associated with a loss than the good feeling associated with a profit”.

Risk occurs everywhere!

While we think of risk in negative terms, the investment world has a different note as risks are inseparable from the desirable performance.

If the investors believe they can tolerate the risk, both at an emotional and financial level, they invest!

Another behavioral tendency is the ‘drawdown’. The magnitude, duration, and frequency of a negative period are considered while measuring drawdown. Drawdown is the period during which the asset’s return is negative in relation to the previous high mark.

Risk management is closely associated with psychology too!

What is your risk equation? Share with us.

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