Extreme Events – Specimen Answer A.8.2(b)
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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
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
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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