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Investment - Risk Management Functions
Risk management duties differ by organization, however it is customary for companies in the investment industry to have a stand-alone risk management function with a senior head, generally named the chief risk officer, who is capable of independent judgement and action.
The chief risk officer often reports directly to the board of directors. The purpose of building a robust independent risk management function is to build checks and balances to guarantee that risks are seriously considered and balanced against other objectives, such as profitability.
Companies will typically employ a three-lines-of-defence risk management methodology.
Three Lines of Defence
Frontline Employees / supervisors during their daily responsibilities operate as first line of protection.
Risk management and compliance groups operate as a second line of defence, aiding and advising employees and managers while maintaining independence.
Internal audits operate as third line of defence.
Internal audit is an independent role. Internal auditors implement risk-based internal audit programmes, digging into the minutiae of business operations and ensuring that information technology and accounting systems appropriately reflect transactions. Proactive auditors may also advise managers on ways to improve risk management, controls, and efficiency.
Best practice indicates that internal auditors should report directly to the audit committee of the board of directors to ensure their independence. Thus, risk and audit committees of the board will commonly receive presentations from the heads of risk management, compliance, and internal audit.
Benefits and Costs of Risk Management
Risk management delivers a wide range of benefits to a company:
Supporting strategic and business planning
Incorporating risk considerations in all business activities to ensure that the company’s risk profile is consistent with its risk tolerance
Limiting the amount of risk a company takes, limiting excessive risk taking and potential related losses, and lowering the possibility of bankruptcy
Bringing greater discipline to the company’s operations, which leads to more effective business procedures, better controls, and a more efficient deployment of capital
Recognising responsibility and accountability
mproving performance evaluation and ensuring that the remuneration system is compatible with the company’s risk tolerance
Enhancing the flow of information throughout the firm, which results in better communication, enhanced transparency, and higher knowledge and understanding of risk
Assisting with the early detection of unlawful and fraudulent actions, thereby supporting compliance procedures and audit testing
The expenses of creating risk management systems include tangible costs, such as the following:
Hiring dedicated risk management personnel
Establishing procedures
Investing in systems
The costs of creating risk management systems often include intangible costs, such as slower decision making and missed opportunities.
So, allocation of resources to risk management should be based on a cost–benefit analysis. It is difficult to weigh the costs and benefits of risk management precisely because it is impossible to observe, let alone estimate, the cost of potential catastrophes that are averted.
It is only in hindsight that the cost–benefit trade-offs can be discovered. A case in point is Barings Bank’s bankruptcy in 1995, which was sparked by trading losses hidden in the bank’s Singapore unit. At the time, there was no suitable and effective method for reconciling customer orders and trades on a global scale.
Such a method could have exposed the losses before they wiped out all of the bank’s equity capital. It is believed that installing this system would have cost roughly GBP10 million, a minor price to pay compared to the GBP827 million loss that brought down Barings.
Risk management duties differ by organization, however it is customary for companies in the investment industry to have a stand-alone risk management function with a senior head, generally named the chief risk officer, who is capable of independent judgement and action.
The chief risk officer often reports directly to the board of directors. The purpose of building a robust independent risk management function is to build checks and balances to guarantee that risks are seriously considered and balanced against other objectives, such as profitability.
Companies will typically employ a three-lines-of-defence risk management methodology.
Three Lines of Defence
Frontline Employees / supervisors during their daily responsibilities operate as first line of protection.
Risk management and compliance groups operate as a second line of defence, aiding and advising employees and managers while maintaining independence.
Internal audits operate as third line of defence.
Internal audit is an independent role. Internal auditors implement risk-based internal audit programmes, digging into the minutiae of business operations and ensuring that information technology and accounting systems appropriately reflect transactions. Proactive auditors may also advise managers on ways to improve risk management, controls, and efficiency.
Best practice indicates that internal auditors should report directly to the audit committee of the board of directors to ensure their independence. Thus, risk and audit committees of the board will commonly receive presentations from the heads of risk management, compliance, and internal audit.
Benefits and Costs of Risk Management
Risk management delivers a wide range of benefits to a company:
Supporting strategic and business planning
Incorporating risk considerations in all business activities to ensure that the company’s risk profile is consistent with its risk tolerance
Limiting the amount of risk a company takes, limiting excessive risk taking and potential related losses, and lowering the possibility of bankruptcy
Bringing greater discipline to the company’s operations, which leads to more effective business procedures, better controls, and a more efficient deployment of capital
Recognising responsibility and accountability
mproving performance evaluation and ensuring that the remuneration system is compatible with the company’s risk tolerance
Enhancing the flow of information throughout the firm, which results in better communication, enhanced transparency, and higher knowledge and understanding of risk
Assisting with the early detection of unlawful and fraudulent actions, thereby supporting compliance procedures and audit testing
The expenses of creating risk management systems include tangible costs, such as the following:
Hiring dedicated risk management personnel
Establishing procedures
Investing in systems
The costs of creating risk management systems often include intangible costs, such as slower decision making and missed opportunities.
So, allocation of resources to risk management should be based on a cost–benefit analysis. It is difficult to weigh the costs and benefits of risk management precisely because it is impossible to observe, let alone estimate, the cost of potential catastrophes that are averted.
It is only in hindsight that the cost–benefit trade-offs can be discovered. A case in point is Barings Bank’s bankruptcy in 1995, which was sparked by trading losses hidden in the bank’s Singapore unit. At the time, there was no suitable and effective method for reconciling customer orders and trades on a global scale.
Such a method could have exposed the losses before they wiped out all of the bank’s equity capital. It is believed that installing this system would have cost roughly GBP10 million, a minor price to pay compared to the GBP827 million loss that brought down Barings.
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