The Place of Risk Management in Financial Institut

FinancialInstitutionsCenterThePlaceofRiskManagementinFinancialInstitutionsbyGeorgeS.OldfieldAnthonyM.Santomero95-05-BTHEWHARTONFINANCIALINSTITUTIONSCENTERTheWhartonFinancialInstitutionsCenterprovidesamulti-disciplinaryresearchapproachtotheproblemsandopportunitiesfacingthefinancialservicesindustryinitssearchforcompetitiveexcellence.TheCenter'sresearchfocusesontheissuesrelatedtomanagingriskatthefirmlevelaswellaswaystoimproveproductivityandperformance.TheCenterfostersthedevelopmentofacommunityoffaculty,visitingscholarsandPh.D.candidateswhoseresearchinterestscomplementandsupportthemissionoftheCenter.TheCenterworkscloselywithindustryexecutivesandpractitionerstoensurethatitsresearchisinformedbytheoperatingrealitiesandcompetitivedemandsfacingindustryparticipantsastheypursuecompetitiveexcellence.CopiesoftheworkingpaperssummarizedhereareavailablefromtheCenter.IfyouwouldliketolearnmoreabouttheCenterorbecomeamemberofourresearchcommunity,pleaseletusknowofyourinterest.AnthonyM.SantomeroDirectorTheWorkingPaperSeriesismadepossiblebyagenerousgrantfromtheAlfredP.SloanFoundationGeorgeS.OldfieldisattheSchoolofBusinessoftheCollegeofWilliamandMary.AnthonyM.1SantomeroisattheWhartonSchooloftheUniversityofPennsylvania.ThePlaceofRiskManagementinFinancialInstitutions1ThisVersion:January1997Abstract:Thepurposeofthispaperistoaddresstwoissues.Itdefinestheappropriateroleplayedbyinstitutionsinthefinancialsectorandfocusesontheroleofriskmanagementinfirmsthatusetheirownbalancesheetstoprovidefinancialproducts.Akeyobjectiveistoexplainwhenrisksarebettertransferredtothepurchaseroftheassetsissuedorcreatedbythefinancialinstitutionandwhentherisksofthesefinancialproductsarebestabsorbedbythefirmitself.However,oncetheserisksareabsorbed,theymustbeefficientlymanaged.So,asecondpartofthecurrentanalysisdevelopsaframeworkforefficientandeffectiveriskmanagementforthoseriskswhichthefirmchoosestomanagewithinitsbalancesheet.Thegoalofthisactivityistoachievethehighestvalueaddedfromtheriskmanagementundertaken.11.IntroductionFinancialinstitutionsexisttoimprovetheefficiencyofthefinancialmarkets.Ifsaversandinvestors,buyersandsellers,couldlocateeachotherefficiently,purchaseanyandallassetscostlessly,andmaketheirdecisionswithfreelyavailableperfectinformation,thenfinancialinstitutionswouldhavelittlescopeforreplacingormediatingdirecttransactions.However,thisisnottherealworld.Inactualeconomies,marketparticipantsseektheservicesoffinancialinstitutionsbecauseofthelatter'sabilitytoprovidemarketknowledge,transactionefficiency,andcontractenforcement.Suchfirmsoperateintwoways.Theymayactivelydiscover,underwrite,andserviceinvestmentsmadeusingtheirownresources,ormerelyactasagentformarketparticipantswhocontractwiththemtoobtainsomeofthesesameservices.Inthelattercase,investorsassembletheirportfoliosfromsecuritiesbroughttothembythesesamefirms.Inlightofthetwowaysinwhichinstitutionsmayoperateinthefinancialsector,severalissuesimmediatelyarise.First,whenandunderwhatcircumstancesshouldthesefirmsusetheirownresourcestoprovidefinancialservices,ratherthanofferingthemthroughasimpleagencytransaction?Second,totheextentthatsuchservicesareofferedthroughtheuseoftheinstitution’sownresources,howshoulditbemanagingitsportfoliosoastoachievethehighestvalueaddedforitsstakeholders.Thepurposeofthispaperistoaddressthesetwoissues.Itdefinestheappropriateroleplayedbyinstitutionsinthefinancialsectorandfocusesontheroleofriskmanagementinfirmsthatusetheirownbalancesheetstoprovidefinancialproducts.Akeyobjectiveistoexplainwhenrisksarebettertransferredtothepurchaseroftheassetsissuedorcreatedbythefinancialinstitutionandwhentherisksofthesefinancialproductsarebestabsorbedbythefirmitself.However,oncetheserisksareabsorbed,theymustbeefficientlymanaged.So,asecondpartofthecurrentanalysisdevelopsaframeworkforefficientandeffectiveriskmanagementforthoseriskswhichthefirmchoosestomanagewithinitsbalancesheet.Thegoalofthisactivityistoachievethehighestvalueaddedfromtheriskmanagementundertaken.Inessence,wewishtodefinetheroleofriskinfinancialinstitutions,identifywhentheserisksshouldbemanagedandwhentheyshouldbetransferred,and,inthebroadestsense,thetypeof2proceduresthatmustbeestablishedforsuccessfulriskmanagementactivityatthefirmlevel.Todevelopouranalysisofriskandreturninfinancialinstitutions,wefirstdefinetheappropriateroleofriskmanagementinSection2.Then,inSection3,wedetailtheservicesthatfinancialfirmsprovide,withspecificreferencetotherisksthatarefundamentaltothefinancialsector.Wedefineseveraldifferenttypesofrisksanddiscusshowtheyoccurasaninherentpartoffinancialinstitutions'businessactivities.Someinstitutionaltypesmanagetheseriskswhileotherscontracttoavoidthem.ThecontrastbetweenthesetwomethodsofdealingwithfinancialrisksisfacilitatedbythecomparisonoftwodifferenttypesofinstitutionsinSection4ofthepaper.Thefirstoftheseisapassiveinstitution,namely,arealestatemortgageinvestmentconduit,orREMIC.Passiveinstitutionsdonotengageinactivefinancialmanagementoftheirportfolios.Further,theycontractoutformostservicesofferedtoinvestors.Debtandequity,orresidual