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Financial regulations, risk management and value creation in financial institutions: evidence from Europe and USA

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par Agborya-Echi Agbor-Ndakaw
University of Sussex - Master of Science 2010

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2.6 Definition and Meaning of Risk Management

Risk management has today become a virtual issue for financial institutions because some schools of thought claim that lack of proper risk management practices has been a key factor in the present financial crisis. Generally speaking, risk management is referred to the process of measuring, analysing, controlling and assessing risks as well as developing strategies to manage these risks. Some of the strategies used in managing these risks include transferring the risks to other parties, avoiding the risks, diversifying the risks, etc. Note that financial risk management focuses on just risks that can be managed using financial instruments. All businesses whether big or small do have risk management teams. Sometimes these risk management teams need to use a combination of the risk management strategies to be able to manage their risks.

There are certain principles that must be identified with risk management. As a matter of principle, risk management should result in value creation in any business, be part of any decision making process, be systematic and well-structured and be very transparent. The processes of risk management include the identification of the risk, planning what risk management strategy/strategies to use, mapping out the basis upon which the risks will be evaluated, a definition of a framework within which the `job/task' will be carried out, a development of the analysis of the risks involved in the process and finally implementing the risk management strategy/strategies to be used.

Once the risk management process has been completed, that is to say after the risks have been identified and assessed, all risks management techniques fall into one or more of these categories-avoiding, transferring (for example insurance companies), reducing and retaining (accepting and budgeting). These risk management teams are always faced with a number of

risk options including that of designing a new business process from the start with adequate built-in risk control measures.

In essence, we will like to define the role played by risks within financial institutions, identify when these risks should be managed and when they should be transformed (if possible), as well as the procedures that must be followed for any successful risk management activity of any financial institution. So far so good, it has been argued that risk is an essential factor within the financial sector. It therefore implies that active risk management has a major place in most financial institutions. In the light of this, what techniques/procedures can be used / implemented in limiting and managing these risks?

The answers to these questions are straight forward. It is obvious that if management is to control risk, it has to establish a set of procedures in order to achieve this goal. Note that for each risk type, a four-step procedure is established and implemented to define, measure and manage risk. This will go a long way to assist decision makers to manage risk in a manner that is consistent with management's goals and objectives. These steps include:

· Standards and reports-that is, the creation of a standard setting and financial reporting method. These two activities are the back bone of any risk management system. Therefore consistent evaluation and rating is essential for management to understand the true embedded risks in the portfolio and the extent to which these risks can be reduced if not totally eliminated.

· Position rules-imposed to cover exposures to counterparties and credits. This applies to traders, lenders and portfolio managers. This is so because, in large organizations with thousands of positions maintained and transactions done (on a daily bases), accurate and timely reporting is quite difficult though it is perhaps the most essential.

· Investment guidelines (strategies)-these guidelines and strategies for risk taking in the immediate future are outlined in terms of commitments to particular areas of the market and the need to hedge against systematic risk at a particular time. Guidelines offer advice to the appropriate level of active risk management.

· Incentive contracts and compensation-this explains the extent to which management can enter into incentive compatible contracts with line managers and make compensation related to the risks borne by these individuals, as such, the need for elaborate and costly controls is lessened. These incentive contracts require accurate cost accounting analysis together with risk weighting. Notwithstanding this difficulty, well designed contracts align the goals of managers with other stakeholders.

Risk management need to be an integral part of any institution's business plan. Decisions to either enter or leave or concentrate on an existing business activity require careful assessment of both risks and returns. These risk management procedures must be established so that risk management begins at the point nearest to the assumption of risk. By implication, any trade entry procedures, customer documentation as well as client engagement methods of normal business activities must be adapted to maintain management control and eliminate needless exposure to risk. As if this is not enough, data bases and measurement systems must be developed in accordance with the way the business is conducted. Moreover, for any accurate daily business reports, trades must be recorded, entered and checked in a timely fashion. This helps during an overall effective risk management system put in place by senior management.

There exists three successive levels within any organization corresponding to the levels at
which risk is considered to have been typically managed. The senior management system

used in checking and evaluating business as well as individual performances, need to be sure that these three levels of risks are attained.

Level I aggregates the standalone risks within a single risk factor such as credit risk in a commercial loan portfolio.

Level II aggregates risks across different risk factors within a single business line for instance the combination of assets, liabilities and operating risks in a life insurance.

Level III aggregates risks across different business lines such as banking and insurance. The diagram below summarises the risk management process within financial institutions. Figure 4: Risk Management Procedure.

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