Every single chapter in the book is worthy of study. I am very enthusiastic about the chapters on ALM gap and hedging. The author places everything in context, and ties in market risk and banking book risk, together with credit risk – a rare, combined approach that plays to my own strong belief about how risk management in banks should be governed by the Asset-Liability Committee (ALCO). Balance sheet risk needs one oversight body that operates with board authority, and as the balance sheet is impacted by ALM, market and credit risk together, it makes sense to view these from the ALCO table.
As a young man I used to play the bass guitar. Being asked to write this Foreword is a bit like being asked by Paul McCartney to play bass on his next album, it is that much of a privilege! Professor Bessis has made a fantastic and most worthwhile contribution to the financial economics literature with this book, right from its first edition, and I am lucky to have had a copy on the desk with me ever since it was first published. I do hope that this exciting and interesting new edition makes balance sheet risk in banking something that is more mainstream at the board level, and furthermore spurs readers on to their own research and investigation – if they follow the application and dedication evident in this work, they will not be going far wrong.
PREFACE
Risk management in banks became, and remained, a hot topic after the financial crisis. Addressing risk management in this context is challenging given that the magnitude of the crisis suggests that risk management was inefficient, that risk models were inadequate and that regulations failed to meet their goal of avoiding a major crisis. Indeed, it is ironic that the crisis started when the new Basel 2 regulations were enforced.
Risk management has made considerable progress, however, as the practices became more sophisticated and as the regulations put pressure on enhancing the resilience of banking firms. It has become a core management field in banking with a large concentration of resources dedicated to better identify, assess and control risks.
The book addresses risk management in three main core sections dedicated, respectively, to asset-liability management, market risk and credit risk. It has been largely inspired from the observation of gaps in the knowledge of the field of risk management in banks.
In business schools and other graduate programs, students are comfortable with corporate finance and capital markets, but much less so with the finance of financial firms. The financial management of banks has not much to do with the corporate finance of commercial and industrial firms. Still many would like to better understand the inside mechanisms of banks and many aim at developing themselves in banking careers. These students of finance do not need standard finance, but rather be acquainted with the specifics of the financial management of banks and the technicalities of risk management. This book is designed to address these needs.
Many professionals in banks perceive themselves as specialists of their own fields and feel that they need more background, conceptual and practical, on the expanding core area of risks. Furthermore, the usage of risk models remained in the hands of a relatively small group of “quants”. Experts are embedded in banks, but being embedded does not imply that expertise is shared. The financial literature is broad, specialized and often highly technical in the field of risks. For those professionals of finance who are not model specialists, navigating through the variety of contributions is a challenge. This text is designed to provide a balanced background in risk techniques. The main risk models are introduced through a number of examples that should shed some light where more theoretical texts cannot help.
The volume of literature on market risk and credit risk has grown considerably, but less so in the field of asset-liability management, of which coverage is relatively limited, notably for non-specialists of banks. However, asset-liability management is a core function in banking. It concentrates the financial issues of banks and the attention of regulators who impose new rules on the balance sheet structure of banks. The text provides the minimum background on the area that all students or managers interested in banking should be acquainted with.
In short, this text is designed to address all that is needed to know for students and practitioners to be comfortable with the field and able to navigate further in related areas by themselves, but not more.
This edition has been streamlined compared to previous editions, with a focus entirely on financial issues, and technical developments have been reduced to the minimum for making the text self-contained. Many of my former colleagues and professionals with whom I have had the chance of working in the risk departments of banks have contributed to this text as they shared their experience. All participants in risk management seminars have also helped by raising many excellent and challenging questions, which allowed to refine the approach of the book. They all deserve many thanks for the enrichments that they inspired to this text.
ABOUT THE AUTHOR
Joël Bessis is Professor of Finance at HEC Paris, the leading French business school, where he conducts training in risk management throughout Europe, the US and Asia. Over the course of his career Joël has developed a dual expertise – as an academic and as a practitioner, holding permanent consulting assignments in corporations and, later, in banks. Joël worked for over 15 years in risk management departments of financial institutions – as a consultant to the risk departments of several banking institutions in Europe, including Banque Paribas and the European Bank for Development (EIB). Joël took a leave of absence from HEC Paris between 2000 and 2007 where he held positions as Director of Research at Fitch, Head of Risk Analytics and Model Validation at the Risk Department of IXIS, a Paris-based investment bank, and at the Groupe Caisse d'Epargne, a major financial institution in France. Joël graduated as an engineer from École Centrale in Paris, before earning a Master's in Business Administration from Columbia University in New York, and a PhD in Finance from the Université Paris-Dauphine. As an academic, Joël has published various papers and books in the fields of corporate finance, industrial economics and financial markets.
1
RISKS AND RISK MANAGEMENT
For risk managers and regulators of banks, risk refers to the uncertainty of outcomes and to the negative consequences that it may have on a firm, and both aim at enhancing the resiliency of firms to adverse situations. As a result of their efforts, risks became better identified, assessed and monitored, risk practices improved and risk models became more widespread. Today, risk management has become a core central function for financial firms, banks, funds and insurance companies.
This introductory chapter presents the definitions of financial risks in banking and introduces typical organizations of the risk management function in banks, defining who should be accountable for risk controlling and processes.
1.1 Uncertainty, Risk and Exposure to Risk
Risk has been defined in various ways across time. Some definitions focus on the probability of an event, others refer to the uncertainty of outcomes, positive or negative, and others to risks as the subset of uncertainty that can be quantified.1
Risk in finance is defined as the randomness of the return of investments, including both positive and negative outcomes. Under this view, a greater expected return is associated with a greater variability of outcomes.
In the financial industry, the view of risk is different. Risk is defined by the uncertainty that has adverse consequences on earnings or wealth, or the uncertainty associated with negative outcomes only. This view is that of regulators and risk managers. Regulations aim at enhancing the resiliency of financial firms and of the financial system in stressed conditions. Risk managers see their role as being accountable for identifying, assessing and controlling the likelihood and the consequences of adverse