Risk Management For Banks and Financial Institutions

Risk management is the analysis of risk coupled with the implementation of quality risk controls. Risk management is needed for banks and financial institutions, mainly because it insures a margin of safety that guarantees a levered financial firm's solvency.

The unpredictability and inherent risks associated with the financial markets makes it vital for financial institutions and banks to implement risk management controls. The level of quality risk management policy and controls can make or break (literally) banks or financial institutions.

The term "risk management" has evolved over the past twenty years from the term "insurance management". This evolved term covers a wider variety of responsibilities than insurance management ever did.

Financial risk management products, derivatives and other such contracts that help hedge and protect the downside, include interest rate swaps, foreign exchange swaps and contracts, as well as a plethora of derivative securities. There are dozens of types of risk management related derivative products, the most popular of them Credit Default Swaps.

The most important part of risk management is the transferring of risk. A bank or a financial institution can protect itself from the potential risks and pitfalls of its asset portfolio by purchasing some Credit Default Swaps.

Credit Default Swaps, the most popular kind of derivative, are derivative swaps that transfer exposure to fixed income assets (bonds, mortgages, loans) from the purchaser to the seller of said derivative.

Credit Default Swaps are more or less an insurance policy taken out by a creditor that pays out if the borrower defaults. The underwriter of the swap, in return for agreeing to assume the risk of the underlying asset, receives a stream of premium payments (premiums like the ones received by insurance companies).

Credit Default Swaps are the most popular form of Credit Derivative, derivative products that protect creditors against systemic risks in both the market and in the borrower.

Risk management related credit derivative products such as Credit Default Swaps, albeit good hedges for risk, are truly double edged swords, if coupled with wanton speculation and overleveraging.

In recent years risk management products such as credit derivatives have evolved into vehicles of speculation, instruments used by financial firms and institutions to make speculative and sometimes irresponsible bets on market movements.

Lack of regulation, coupled with poor understanding of complex and Byzantine instruments, led to the credit derivative market degenerate into, to put it bluntly, a Wall Street casino.

The downturn in the housing markets has led this derivative house of cards (no pun intended) to collapse upon itself, leading to insolvency and systemic failure. Credit default swaps, however are a zero sum game. Some financial institutions have profited from correct bearish housing market bets.

If risk management products were used responsibly by banks and financial institutions, instead of used to make levered bets, the whole financial calamity could have been minimized. It is quite ironic that systems put into place to reduce risks ending up being the root of exacerbated risk.

Once the damages of the financial crash are cleaned up and settled, proper risk management can again be put into place. The need for regulation, however, is an issue up for debate.

There are too many arguments for and against regulation of credit derivative markets for there to be a concrete solution to the credit derivative problem.

There is simply too much nuance in the moral, social and financial ramifications of credit derivative rules, regulation and policy; in no way is the credit default swap debate a black or white issue.

As long as banks and financial institutions use credit derivative products such as credit default swaps for hedging purposes only, the integrity of the risk management instruments will stay in place.

The whole concept of risk management for banks and financial institutions is nullified by improper and risky speculative activities. Risk management, if done in a proper and responsible way, can effectively mitigate systemic and market risks, risks that are both inherent in today's global financial marketplace.

For risk management to truly be risk management there should be zero tolerance for rampant, irresponsible speculation. The last thing a bank or a financial institution needs to do is exacerbate its risks by mixing gambling (speculation) with risk management.