Institutions American Risk and Insurance Association Association of Insurance and Risk Managers in Industry and Commerce Global Association of Risk Professionals Global Risk Institute Institute of Risk Management Professional Risk Managers' International Association Risk and Insurance Management Society Certifications Certified Futures and Options Analyst (CFOA) Certificate in Quantitative Finance (CQF) Certified Risk Analyst (CRA) Certified Risk Management Professional (RIMS-CRMP) Certified Risk Professional (MIRM designation) Chartered Enterprise Risk Analyst (CERA; Society of Actuaries) Chartered Enterprise Risk Actuary (CERA; Institute and Faculty of Actuaries) Financial Risk Manager (FRM) Professional Risk Manager (PRM) Financial risk management is the practice of protecting economic value in a firm by managing exposure to financial risk - principally credit risk and market risk, with more specific variants as listed aside - as well as some aspects of operational risk. As for risk management more generally, financial risk management requires identifying the sources of risk, measuring these, and crafting plans to mitigate them.Financial Risk Management, Finance Glossary. Gartnergartner.com See for an overview.
Financial risk management as a "science" can be said to have been bornW. Kenton (2021). "Harry Markowitz", investopedia.com with modern portfolio theory, particularly as initiated by Professor Harry Markowitz in 1952 with his article, "Portfolio Selection"; see .
The discipline can be qualitative and quantitative; as a specialization of risk management, however, financial risk management focuses more on when and how to hedge, often using financial instruments to manage costly exposures to risk. In the banking sector worldwide, the Basel Accords are generally adopted by internationally active banks for tracking, reporting and exposing operational, credit and market risks.Van Deventer, Nicole L, Donald R., and Kenji Imai. Credit risk models and the Basel Accords. Singapore: John Wiley & Sons (Asia), 2003.Drumond, Ines. "Bank capital requirements, business cycle fluctuations and the Basel Accords: a synthesis." Journal of Economic Surveys 23.5 (2009): 798-830. Within non-financial corporates,John Hampton (2011). The AMA Handbook of Financial Risk Management. American Management Association. the scope is broadened to overlap enterprise risk management, and financial risk management then addresses risks to the firm's overall strategic objectives. Insurers manage their own risks with a focus on solvency and the ability to pay claims. Life Insurers are concerned more with longevity and interest rate risk, while Short-Term Insurers emphasize catastrophe-risk and claims volatility. In investment management risk is managed through diversification and related optimization; while further specific techniques are then applied to the portfolio or to individual stocks as appropriate.
In all cases, the last "line of defence" against risk is capital, "as it ensures that a firm can continue as a going concern even if substantial and unexpected losses are incurred".
Economic perspective Neoclassical finance theory prescribes that (1) a firm should take on a project only if it increases shareholder value.See for example, "Corporate Finance: First Principles", in Aswath Damodaran (2014). Applied Corporate Finance. Wiley. Further, the theory suggests that (2) firm managers cannot create value for shareholders or investors by taking on projects that shareholders could do for themselves at the same cost; see Theory of the firm and Fisher separation theorem.
Given these, there is therefore a fundamental debate relating to "Risk Management" and shareholder value.See § "Does Corporate Risk Management Create Value?" in Capital Budgeting Applications and Pitfalls. Ch 13 of Ivo Welch (2022). Corporate Finance, 5 Ed. IAW Publishers. Jonathan Lewellen (2003). Financial Management - Risk Management. MIT OCWWhy Corporations Hedge; Ch 3.7 in Baranoff et al. The discussion essentially weighs the value of risk management in a market versus the cost of bankruptcy in that market: per the Modigliani and Miller framework, hedging is irrelevant since diversified shareholders are assumed to not care about firm-specific risks, whereas, on the other hand hedging is seen to create value in that it reduces the probability of financial distress.
When applied to financial risk management, this implies that firm managers should not hedge risks that investors can hedge for themselves at the same cost. This notion is captured in the so-called "hedging irrelevance proposition": "In a perfect market, the firm cannot create value by hedging a risk when the price of bearing that risk within the firm is the same as the price of bearing it outside of the firm."
In practice, however, financial markets are not likely to be perfect markets. This suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management, wherein they are able to determine which risks are cheaper for the firm to manage than for shareholders. Here, market risks that result in unique risks for the firm are commonly the best candidates for financial risk management.
Application As outlined, businesses are exposed, in the main, to market, credit and operational risk. A broad distinction exists though, between financial institutions and non-financial firms - and correspondingly, the application of risk management will differ. Respectively: For Banks and Fund Managers, "credit and market risks are taken intentionally with the objective of earning returns, while operational risks are a byproduct to be controlled". For non-financial firms, the priorities are reversed, as "the focus is on the risks associated with the business" - ie the production and marketing of the services and products in which expertise is held - and their impact on revenue, costs and cash flow, "while market and credit risks are usually of secondary importance as they are a byproduct of the main business agenda". (See related discussion re valuing financial services firms as compared to other firms.) In all cases, as above, risk capital is the last "line of defence".
Banking
Banks and other wholesale institutions face various financial risks in conducting their business, and how well these risks are managed and understood is a key driverOffice of the Comptroller of the Currency (2019). Comptroller's Handbook: "Corporate and Risk Governance" behind profitability, as well as of the quantum of capital they are required to hold.Fadi Zaher (2022). Using Economic Capital to Determine Risk, investopedia. Financial risk management in banking has thus grown markedly in importance since the 2008 financial crisis.The Rise of the Chief Risk Officer, Institutional Investor (March 2017). (This has given rise to various dedicated degrees and several professional certifications.)
The broad distinction between Investment Banks, on the one hand, and Commercial and Retail Banks on the other, carries through to the management of risk at these institutions. Investment Banks profit from trading - proprietary and flow - and earn fees from structuring and deal making; the latter includes listing securities so as to raise funding in the capital markets (and supporting these thereafter), as well as directly providing debt-funding for large corporate "projects". The major focus for risk managers here is therefore on market- and (corporate) credit risk. Commercial and Retail Banks, as deposit taking institutions, profit from the spread between deposit and loan rates. The focus of risk management is then on loan defaults from individuals or businesses (SMEs), and on having enough liquid assets to meet withdrawal demands; market risk concerns, mainly, the impact of interest rate changes on net interest margins. All banks will focus also on operational risk, impacting here (at least) through regulatory capital; (large) banks are also exposed to Macroeconomic systematic risk - risks related to the aggregate economy the bank is operating in (see Too big to fail).
Central to both commercial and investment banking is the function of maturity transformation,See discussion in: Lara Coulier, et al (2023) [ https://www.ecb.europa.eu/press/financial-stability-publications/fsr/special/html/ecb.fsrart202311_01~bbbe8e63be.en.html#toc2 Assessing risks from euro area banks’ maturity transformation], European Central Bank where institutions fund long-term assets using short-term liabilities. Commercial banks typify this by issuing demand deposits (which can be withdrawn at any time) to fund long-dated assets like mortgages, while investment banks often finance longer-term trading inventory or structured products through short-term repurchase agreements (repos). While this "borrowing short and lending long" strategy is profitable — normally capturing the spread between lower short-term rates and higher long-term rates — it creates an inherent mismatch on the balance sheet. This structural mismatch generates the primary risks that banks must manage - outlined in the preceding paragraph - but here especially: liquidity risk (the inability to meet short-term obligations without selling assets) and interest rate risk (changes in the yield curve affecting asset and liability values differently), making Asset and liability management (ALM) a critical discipline.
The Basel Accords mandate the predominant risk management framework. Under "Pillar I" regulators define the minimum regulatory capital requirements for quantifiable risks — principally credit risk, market risk, and operational risk as outlined — using either standardised or approved internal‑model approaches. Under "Pillar II", banks must conduct an internal capital adequacy assessment (ICAAP) to capture all material risks, holding sufficient "economic capital" for those. Some jurisdictions (or banks) complement these with additional buffers, stress testing, and supervisory review.
Investment banking
For investment banks - as outlined - the major focus is on credit and market risk. Credit risk is inherent in the business of banking, but additionally, these institutions are exposed to counterparty credit risk. Both are to some extent offset by margining and collateral; and the management is of the net-position.
Risk management hereMartin Haugh (2016). "Basic Concepts and Techniques of Risk Management". Columbia UniversityRoy E. DeMeo (N.D.) "Quantitative Risk Management: VaR and Others" . UNC Charlotte is, as discussed, simultaneously concerned with (i) managing, and as necessary hedging, the various positions held by the institution - both trading positions and long term exposures; and (ii) calculating and monitoring the resultant economic capital, as well as the regulatory capital under Basel III — which, importantly, covers also leverage and liquidity — with regulatory capital as a floor.
Correspondingly, and broadly, the analytics are based as follows: For (i) on the "Greeks", the sensitivity of the price of a derivative to a change in its underlying factors; as well as on the various other measures of sensitivity, such as DV01 for the sensitivity of a bond or swap to interest rates, and CS01 or JTD for exposure to credit spread. For (ii) on value at risk, or "VaR", an estimate of how much the investment or area in question might lose as market and credit conditions deteriorate, with a given probability over a set time period, and with the bank then holding "economic"- or "risk capital" correspondingly; common parameters are 99% and 95% worst-case losses - i.e. 1% and 5% - and one day and two week (10 day) horizons. These calculations are mathematically sophisticated, and within the domain of quantitative finance.