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Risk Management

The goal of risk management is controlling risks. Control is feasible when quantitative and qualitative assessments of risks exist. Such risk measurements are detailed throughout this book. This chapter is dedicated to a brief overview of bank-wide risk management practices and organization.

Risk oversight is both a major principle of risk management and a challenge for financial firms as well as for regulators. The organization and processes of risk management should be bank-wide, across all business lines. Unfortunately, bank-wide processes face serious challenges, as illustrated by the 2008 financial crisis. On the other hand, most financial firms have adopted standard organizations and processes that should, theoretically, work smoothly. Although the efficiency of risk management organization and processes raises some doubt, the standard organization, properly implemented, serves as a reference. Moreover, there are technical tools that allow moving up and down along the hierarchy and those have added value that is independent of internal discipline.

There are four main sections in this chapter.

• Section 4.1 addresses challenges of bank-wide risk management.

• Section 4.2 introduces the standard risk management organization along the well-known "three lines of defense" concept, and the standard risk processes, which rely on setting up limits and delegations for risk-taking decisions. Limits cap the risk of any single transaction or pools of transactions in retail banking. Delegation allows decentralizing the risk process according to certain rules in order to make the risk decisions smoother and speedier whenever a central assessment of the risk is not necessary. The same basic principles apply to all risks.

• Section 4.3 provides representative criteria for setting limits and enforcing them, for all main financial risks, providing more details on credit limits since other risks rely on similar processes.

• Section 4.4, the final section, discusses the techniques that make bank-wide risk management feasible, allowing moving both top-down and bottom-up along the hierarchy for controlling the risk-return tradeoff that all financial firms face and controls of risks. Two pillars of bank-wide risk management are the fund transfer pricing (FTP) system and the capital allocation system. Together, they allow breaking down global bank earnings and risks into earnings and risk allocations from transactions or pools of transactions in a consistent way. Bank-wide risk management implies the capability of moving bottom-up by aggregation of individual risks and top-down for identifying the sources of aggregated earnings and risks.

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