Risk Management in Financial Institutions

If savers and investors and buyers and sellers could locate each other efficiently, purchase any and all assets at no cost, and make their decisions with freely available, perfect information, there would be no need for financial institutions. However, in real economies, market participants seek the services of financial institutions because they can provide market knowledge, transaction efficiency, and contract enforcement. Such firms operate in two ways: (1) they may actively discover, underwrite, and service investments using their own resources, or (2) they may merely act as agents for market participants who contract with them for some of these services. In the latter case, investors assemble their portfolios from securities that the firms bring to them.

Because of the ways in which institutions may operate in the financial sector, two issues arise. First, when and under what circumstances should the firms use their own resources to provide financial services, rather than offering them through a simple agency transaction? Second, to the extent that the institution offers such services by using its own resources, how should it manage its portfolio to achieve the highest value added for its stakeholders?

In addressing these two issues, we define the appropriate role for institutions in the financial sector and focus on the role of risk management in firms that use their own balance sheets to provide financial products. Our objective is to explain when an institution is better off transferring risks to the purchaser of the assets that the firm has issued or created, and when the firm itself should absorb the risks of these financial products. However, once the firm absorbs the risks, it must efficiently manage them. So, we have developed a framework for efficient, effective risk management for the firm that chooses to manage risks within its balance sheet and achieve the highest value added. To develop our analysis of risk and return in financial institutions, we first define the appropriate role of risk management. Next, we detail the services that financial firms provide, define several different types of risks, and discuss how they occur as an inherent part of financial institutions’ business activities.

Some institutions manage risks, while others contract to avoid them. We contrast these two methods in two different institutions — a passive institution, namely, a real estate mortgage investment conduit (REMIC), and one of the most actively managed financial firms, a commercial bank.

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References

1. For a full discussion of this issue, see:

M. Gertler, “Financial Structure and Aggregate Economic Activity: An Overview,” Journal of Money, Credit and Banking, volume 20, August 1988, pp. 559–88; and

R.J. Herring and A.M. Santomero, The Role of Financial Structure in Economic Performance (Stockholm, Sweden: SNS Publishing, 1991).

2. R. Stulz, “Optimal Hedging Policies,” Journal of Financial and Quantitative Analysis, volume 19, June 1984, pp. 127–140; and

F. Allen and A.M. Santomero, “The Theory of Financial Intermediation,”Journal of Banking and Finance, forthcoming, 1997.

3. For a detailed discussion of this literature, see:

A.M. Santomero, “Financial Risk Management: The Whys and Hows,” Financial Markets, Institutions and Instruments, volume 4, number 5, 1995, pp. 1–14.

4. In fact, a well-known textbook in the field devotes an entire chapter to motivating financial risk management as a value-enhancing strategy using the arguments outlined above. See:

C. Smithson, C. Smith, Jr., and D. Wilford, Managing Financial Risk: A Guide to Derivative Products, Financial Engineering, and Value Maximization (Burr Ridge, Illinois: Irwin, 1995).

5. This point has been made in a different context. See:

A.M. Santomero and J. Trester, “Financial Innovation and Bank Risk Taking,” Journal of Economic Behavior and Organizations, forthcoming, 1997; and

A.N. Berger and G.F. Udell, “Securitization, Risk, and the Liquidity Problem in Banking,” in M. Klausner and L.J. White, eds., Structural Change in Banking (Homewood, Illinois: Irwin, 1993, pp. 227–291.

6. Absent from this list are institutions that are pure information providers, e.g., Moody’s. These excluded firms provide important services to the financial sector, but only as third-party vendors. Their credibility is based on reputation, and their product is used by buyers to make better-informed judgments.

7. We distinguish here between the basic financial services offered by financial institutions and the six core functions outlined by Merton and by Merton and Bodie that a financial system provides. In our view, institutions providing the basic services that we define will create a financial system that provides core functions as defined by Merton. See:

R.C. Merton, “Operation and Regulation in Financial Intermediation: A Functional Perspective,” in P. Englund, ed., Operation and Regulation of Financial Markets (Stockholm, Sweden: Economic Council), pp. 17–67; and

R.C. Merton and Z. Bodie, “Financial Infrastructure and Public Policy: A Functional Perspective,” in D. Crane et al., eds., The Global Financial System: A Functional Perspective (Boston: Harvard Business School Press, 1995).

8. Commercial banks are a clear example of such institutions. Therefore, they have devoted considerable energy to interest-rate risk management. See:

B. Esty, P. Tufano, and J. Headley, “BancOne Corporation: Asset and Liability Management,” Journal of Applied Corporate Finance, volume 7, number 5, 1994, pp. 33–51; and

D. Babbel and A.M. Santomero, “Risk Management by Insurers: An Analysis of the Process,” Journal of Risk in Insurance, volume 64, June 1997, pp. 231–270.

9. To see how this is done, see:

K. Jesswein, C. Kwok, and W. Folks, “Corporate Use of Innovative Foreign Exchange Risk Management Products,” Columbia Journal of World Business, volume 30, Fall 1995, pp. 70–82.

10. Accordingly, lending institutions actively manage their credit portfolios. For a presentation of the techniques used by the banking and insurance industry, respectively, see:

E. Morsman, Commercial Loan Portfolio Management (Philadelphia: Robert Morris Associates, 1993); and Babbel and Santomero (1997).

11. For a discussion of how banks manage counterparty risk, see:

A.M. Santomero, “Commercial Bank Risk Management: An Analysis of the Process,” Journal of Financial Services Research, volume 11, September 1997.

12. For a detailed discussion of this and other mortgage-backed instruments, see:

A.M. Santomero and D. Babbel, Financial Markets, Instruments and Institutions (Burr Ridge, Illinois: Irwin, 1996).

13. While we focus on REMICs, huge amounts of credit card receivables, auto loans, and other consumer loans are also securitized in similar types of transactions.

14. An interesting characteristic of REMICs is the use of tranching of the cash flows generated by the underlying assets. The underwriter tries to create each tranche to fit one or a few specific customers’ needs. Other tranches are more or less generic.

15. Such capital constraints have become increasingly stringent lately due to the multinational Basle accord. This requires minimum risk-related capital. For a broader discussion, see:

A.M. Santomero, “The Bank Capital Issue,” in M. Fratianni, C. Wihlborg, and T.D. Willett, eds., Financial Regulation and Monetary Arrangements after 1992: Contributions to Economic Analysis(Amsterdam, The Netherlands: North Holland Press, 1991), pp. 61–77.

16. Some equity participation is permitted in different countries around the world. However, no U.S. chartered institutions are permitted to hold equity within the bank’s portfolio. See:

H. Langohr and A.M. Santomero, “The Extent of Equity Investment by European Banks: A Note,” Journal of Money, Credit and Banking, volume 17, May 1985, pp. 243–252.

17. This issue has received substantial attention in the academic literature. See:

H. Leland and D. Pyle, “Informational Asymmetries, Financial Structure, and Financial Intermediation,” Journal of Finance, volume 32, May 1977, pp. 371–87;

T. Campbell and W. Kracaw, “Information Production, Market Signalling, and the Theory of Financial Intermediation,” Journal of Finance, volume 35, September 1980, pp. 863–882;

A.M. Santomero, “The Intermediation Process and the Future of Thrifts,” in Expanded Competitive Markets and the Thrift Industry (San Francisco: Federal Home Loan Bank Board of San Francisco, 1988), pp. 187–199; and

Santomero and Trester (1997).

18. Exactly how this is done is the subject of entire textbooks. For a discussion of techniques employed, see, for example:

A. Saunders, Financial Institutions Management: A Modern Perspective, second edition (Burr Ridge, Illinois: Irwin, 1997).

19. The ability of fund managers to provide such services has long been debated. See:

J.L. Treynor, “How to Rate Management Investment Funds,” Harvard Business Review, volume 43, January–February 1965, pp. 63–75; and

Z. Bodie, A. Kane, and A. Marcus, Investments (Homewood, Illinois: Irwin, 1996).

20. For discussion of the shortcomings in simple linear risk-sharing incentive contracts for assuring incentive compatibility between principals and agents, see:

M. Jensen and W. Meckling, “Theory of the Firm: Managerial Behavior Agency Costs and Ownership Structure,” Journal of Financial Economics, volume 3, October 1976, pp. 305–360; and

A.M. Santomero, “Modeling the Banking Firm: A Survey,” Journal of Money, Credit and Banking, volume 16, November 1984, pp. 576–602.

21. This is an area in which institutions such as Bankers Trust have long excelled. For a review of their system of risk-adjusted return on capital, see:

Salomon Brothers, “Bankers Trust New York Corporation — Risk Management,” United States Equity Research, February 1993.

22. This is why value-at-risk has become an attractive risk management tool in proprietary trading. See:

G.P. Hopper, “Value at Risk: A New Methodology for Measuring Portfolio Risk,” Federal Reserve Bank of Philadelphia — Business Review, volume 37, July–August 1996, pp. 19–31.

23. The recent disasters at Bankers Trust, Barings, and BancOne demonstrate that risk management systems in themselves do not prevent risk taking. It takes the commitment of senior management to use such systems in order to avoid such disasters. For research that suggests that these managers did not allow their risk management systems to prevent devastating losses, see:

P. Jorion, Value at Risk (Burr Ridge, Illinois: Irwin, 1997);

J. Rawnsley, Total Risk: Nick Leeson and the Fall of Barings Bank (New York: Harper, 1995); and

Esty, Tufano, and Headly (1994).

24. For a review of current practice in risk management system implementation, see:

Babbel and Santomero (1997); and

Santomero (1997b).

Acknowledgments

The authors thank the Sloan Foundation for its generous support.