How to manage risk in investment banking

Published on June 18, 2022

Before diving straight into ways to manage risks in investment banking, it is better to understand risk management .

What is risk management?

In the financial setup, risk management is the course of identifying, investigating and acknowledging or alleviating vulnerability in investment processes. Basically, risk management happens when an investor or asset manager breaks down and attempts to measure the potential for losses in an investment, such as an ethical hazard, and afterwards makes the fitting move given the asset’s venture targets and risk resistance.

Risk is indivisible from return. Each venture implies some level of risk, which is viewed as near-zero or extremely high for something like developing business equities or real estate in profoundly inflationary business sectors. Risk is quantifiable both outright and in relative terms. A strong understanding of risk in its various structures can assist investors with the ability to comprehend the opportunities, trade-offs better, and finances included within different venture approaches.

In the same line, risk advisory service providers enable businesses to anticipate and remodel regulatory environment changes, alongside creating vital programs and control to mitigate potential regulatory risks and regulations.

Classification of risk in investment banking

Investment banks work with different types of businesses that come with differentiated nature, which makes each of them unique. Every business is related to a specific set of risks. Based on the source and effects, the risks can be classified as under:

1. Credit risk – It is the potential loss that occurs when the debtor fails to repay a loan to fulfill the contractual obligations. In simple words, credit risk relates to the lender when he doesn’t gain back the owned principal and interest that causes an interruption in cash flow.

2. Market risk – It is affected by movements in market variables like change stock prices, interest rates, exchange rates, commodity prices, or value of equity instruments. It is one of the three core risks (credit risk and operational risk being other twos) that every bank is liable to report and store capital against.

3. Operational risk – It happens due to flawed or failed internal processes, policies, systems, or circumstances that can adversely affect the business operations. Several factors can trigger operational risks like human error, unethical practices, and physical events.

4. Liquidity risk – It occurs when payment obligations are not met within a decided timeline by an individual investor, business, or financial institution. The factors that lead to such events might be the unavailability of buyers or an inefficient market that prevents the conversion of assets to cash.

5. Reputation risk – It can affect every business regardless of the size or industry; reputational risk occurs when a company doesn’t meet its stakeholders’ expectations and is therefore negatively perceived. It can even lead to negative public opinion that can end up with client loss.

6. Legal risk – It refers to the loss that arises due to regulatory or legal action triggered by an individual’s or business’s actions, falsified products or services, or any other controversial event. The trigger factors can be anything from non-performances, legal errors, compromised legal systems to the absence of legal regulations.

How does risk management operate?

‘Risk’ is commonly perceived as a negative term. However, it doesn’t necessarily mean something terrible is about to happen in the investment banking world. It is crucial to calculate risk in order to increase the chances of generating desirable performance. Typically, investment banking is perceived as a divergence from contemplated income. This divergence might refer in absolute terms or relative to variables like a market benchmark.

Again divergence can be perceived as a negative sign, however investment professional agrees on the fact that divergence might be a give-out expected outcome in return of investment. It is a general saying in the same line that ‘higher risk yields higher returns.’ In the investment banking domain, higher risks come with higher volatility, which can be dealt in some extent with trial and error methods.

How much volatility an investor or entity can bear relies entirely upon their capacity of risk tolerance or how much resilience their investment goals permit on account of a venture professional. Perhaps the most commonly absolute risk metric is the standard deviation. It is a statistical measure of dispersion around a central tendency. One can derive the standard deviation on investment by looking at the average return of an investment over the same time period.

Tips for managing risks at investment banks

1. Market risk management –

Harness an all-encompassing dynamic framework to overlook and measure liquidity, interest rate, foreign exchange, and more.
Use stress testing to assess potential problems.

2. Credit risk management –

Maintain credit exposure in set parameters.
Apply lending decisions on credit score.
Measure the amount the bank loses on the credit portfolio.

3. Operational risk management –

Create an internal audit system.
Find out and cut off inefficient control procedures.
Impart training to the staff at all levels.

4. Legal risk management –

Conduct activities that fall under regulatory frameworks.

5. Liquidity risk –

Conduct backup funding.
Fill in the cash flow gaps.

6. Reputational risk –

Showcase business strategy.
Overlook social media, reviews, and forums.
Protect data and data integrity.
Create a productive workplace.

Bottomline

This blog features information that might aid businesses in one area; however, it may not address an investor’s issues wholly. It is not easy to gauge a risk hazard as it largely depends on how an individual sees gains and losses. It is advisable to seek risk management advisory to obtain holistic risk prevention.