The idea of managings risks in investment banking may seem pretty straightforward, but in order to cover the topic fully, let’s start with a brief overview of what it entails in the general sense. Risk management entails protecting financial assets against loss. In order to do this, risky behaviors or strategies must be identified and avoided.
In certain instances, risky behaviors are necessary, specifically when it comes to the financial world. To this end, strategies or tactics that minimize the impact of risky behaviors must be employed.
Risk Management and Investment Banking
In terms of internal control, risk management sits at the core of the investment banking industry. There are two primary factors that banks must take into consideration when it comes to risk management:
The possibility and/or probability of something negative occurring based on an investment or investment strategy
How much a negative occurrence can or will cost the bank
A proper risk management strategy or program is critical for every investment bank. It should be a major factor in how the bank functions on a daily basis. The bank wants to prevent any major loss to themselves or hedge against substantial loss. It also aims to prevent clients from losing money.
In the event that a loss is passed on to a client, a proper risk management strategy helps curb the financial blow to the client. The last thing an investment bank wants to do is drive a client into a situation of financial liability if they are unable to pay. It is bad for the client and, in turn, ends up being bad for the bank in terms of recovering payment.
Risks That Must Be Managed
Because an investment bank invests in a variety of securities at all levels of the market, there are similarly a variety of types of risks. The following are just a few:
1. Market risk
Market risk, also known as macro risk, is unavoidable and, therefore, of the utmost concern for investment banks. Market risk can be defined as the risk of loss due to variables in the market. The variables include exchange rates, inflation, and interest rate risk.
2. External risk factors
Exterior risk factors, such as credit risks, occur primarily when an investment bank fulfills the role of intermediary for over the counter (OTC) trades. The negative side of such risk comes into play if the counterparty in the transaction defaults on making its payment. It can also occur if the client – after being financed by a bank – fails to make interest payments or repay the principal amount. To manage the risk, banks must make the loan selection process fairly rigorous; only the most qualified candidates should be offered funding.
Risk management is of critical importance in finance. In the investment banking world, effective risk management strategies are crucial to a bank’s bottom line. More than that, however, if an investment bank fails to properly manage its risk, it stands not only to lose out financially but potentially to run itself out of operation.
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