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Risk Assessment

In an investment bank, risk assessment refers to the work conducted to quantitatively evaluate a risk event's effects on the assets and operation of the bank and the possibility of losses before or after its occurrence (but before it ends). Risk assessment has the following five tasks:

1. Identify the risks facing the subject of the assessment.

2. Evaluate risk probability and possible negative impact.

3. Determine the risk resistance of an organization.

4. Determine the priority levels of risk mitigation and control.

5. Recommend risk mitigation measures.

After years of crisis and multiple waves of mergers and acquisitions, investment banks in mature international markets have established rather scientific and sensible risk assessment systems (see the next section, "Risk Management of Investment Banks"). Despite that, real-life operation and management of investment banks may still make mistakes by failing to sufficiently identify a risk or by overestimating risk resistance.

Again, using Lehman Brothers as an example, in the five years from 2003 to 2007 Lehman Brothers' profit averaged USD 1.6 billion. Its share price rose by 29 percent every year. But an overly optimistic view on the prospects of the company directly led the board of directors and the management of the company to overlook the importance of internal risk assessment. Of the USD 800 billion shown on its balance sheet, net assets only accounted for USD 25 billion. Securitized products, which were difficult to evaluate, accounted for 2.5 times the amount of its net assets. The leverage ratio more than doubled the maximum number allowed by U.S. regulators.

Even investment banks in mature international markets have to consider the internal risk-assessment system as the lynchpin of the internal control of the company as a whole. In practice, management and operation should be conducted with a cool head and sufficient objectivity. In addition, due to its special nature, an investment bank usually faces much greater risks than a regular enterprise. To some extent, investment banks are institutions that operate risks. Therefore, provided that sound risk-assessment techniques are adopted, the decision makers are well-advised to be relatively pessimistic. A risk should be considered as real until proven otherwise. The risk resistance of the bank itself is better to be underestimated than overestimated. Those are the lessons from the large number of investment banks that went bankrupt during the financial crisis.

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