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Extreme Events – Specimen Answer A.8.2(b) – Answer/Hints

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Q. Summarise the main risks to which the following types of entity might be most exposed (and which it would be prudent to provide stress tests for if you were a risk manager for such an entity): (b) An investment bank

 

-          Market risk. Investment banks commonly have significant market exposures, either in the form of inventory that they are using to provide market making services, or in the form of proprietary positions. The types of market risk (e.g. equity, credit, commodity, interest rate) that any particular bank is exposed to can vary significantly both by bank and through time. Investment banks may also be particularly exposed to warehousing risk during M&A transactions.

 

-          Credit risk. Investment banks may nowadays trade credit exposures using CDS etc. These sorts of credit risk exposures would usually be thought of as a form of ‘market risk’, being just another type of market making activity. Investment banks may also have more traditional forms of counterparty credit exposure via their trading activities (which they may aim to mitigate using collateralisation techniques).

 

-          Liquidity risk. Investment banks fund their businesses in a variety of ways, many of which explicitly or implicitly require the instruments they have on their balance sheet to be acceptable collateral to others. If liquidity dries up then (and particularly if the instruments they might otherwise have then been relying on to provide them with access to alternative funding sources at the same time prove difficult to value) then investment banks can become very exposed to liquidity squeezes.

 

-          Credit rating downgrade. Some of the funding sources that an investment bank may be relying on can be sensitive to the credit rating assigned to the bank (e.g. because this interacts with the collateralisation processes applicable on derivative contracts it may have entered into). Thus a significant credit rating downgrade can in effect freeze availability of fund from one type of source, which can lead to a loss of confidence on the part of others and difficulties accessing other sources as well.

 

-          Operational risk. The large sizes and speed of transactions that an investment bank might enter into seem to make investment banks particularly prone to very large operational risk losses even if they previously thought that they had well managed staff and business processes.

 

P.S. Similar types of risk (but in other guises) usually arise with other types of financial services entities, which may be one contributory factor in the increasing popularity of the discipline of Enterprise Risk Management.

 


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