During the last 40 years, risk management has evolved tremendously. The technologies and methodologies to measure risks have reached impressive levels of sophistication and complexity. However, the financial crisis of 2007 and 2008 clearly demonstrates that substantial improvements in the way financial institutions measure and manage risks are still urgently needed. This chapter provides an analysis and discussion of risk management as well as several proposals on how the financial industry should evolve. In particular, financial institutions need to improve their capital allocation strategies defining a clear risk-appetite framework by taking the following actions: (1) implementing true Enterprise Risk Management programs, which measure and aggregate all risk types; and (2) redefining the role of the risk function within the governance of financial organizations. Improving methods used to measure risks and implementing the proposed changes in risk management would allow financial institutions to restore the trust of markets and customers and to move forward into a new risk management era.
Financial markets play an essential function in the economy allowing funds to move from people who lack productive investment opportunities to those who have such opportunities. These markets are critical for producing an efficient allocation of capital, which contributes to higher production and efficiency for the overall economy. Well-functioning financial markets also directly improve the well-being of consumers by allowing them to time their purchases, which leads to improving the economic welfare of everyone in the society.
In direct finance, borrowers obtain funds directly from lenders in financial markets by selling them securities (also called financial instruments), which are claims on the borrower’s future income or assets. However, funds can move from lenders to borrowers by a second route, called indirect finance, which involves a financial intermediary that stands between the lender-savers and the borrower-spenders and helps transfer funds from one to the other.
Thus, a financial intermediary borrows funds from the lender-savers and then uses these funds to make loans to borrower-spenders. The process of indirect finance using financial intermediaries, called financial intermediation, is the primary and often the only available route for moving funds from lenders to borrowers. In fact, due to the opaqueness of the information available on the market, the time and expertise that lenders would need to assess and monitor borrowers, and the high costs that lenders would need to face, households generating excess savings do not often find investing directly in the securities issued by companies very attractive.
Financial institutions (FIs) play an important role in the economy because they provide liquidity services, promote risk sharing, and solve information problems. The success of financial intermediaries in performing this role is evidenced by the fact that most households invest their savings with them and obtain loans from them. A well-functioning set of financial intermediaries is a necessary condition to allow an economy to reach its full potential.
Several different types of FIs operate in the markets such as depository institutions, insurance companies, pension funds, mutual funds, and securities firms. Each sells different products and faces different risks. Entering the 21st century, regulatory barriers, technology, and financial innovation changes enabled single financial services firms to offer a full set of financial services weakening the boundaries between traditional industry sectors. Products and risks faced by modern FIs were becoming increasingly similar. However in 2009, after the most recent financial crisis, discussions resurfaced in several countries regarding whether financial services holding companies should still be allowed to offer a full range of financial services. Increased level of disclosure and separation between investment and commercial banking activities seem to be the common themes of the current FI’s review (Institute of International Finance, 2007; Basel Committee on Banking Supervision, 2008: Financial Services Authority, 2008; Walker, 2009).
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