Private Information and Risk Management in Banking

Abstract

In this chapter we describe the risk management challenges faced by financial institutions. The very nature of the banking business requires that financial firms become experts at risk assessment in order to manage their own inventories of risk, obtained during day-to-day business transactions with bank customers. Banks are exposed to interest rate risk, currency risk, liquidity risk, credit risk, and operational risk. The first step in a risk management program is accurate risk measurement. A useful risk measurement tool is the Value at Risk (VaR) model. The 99% VaR model produces predictions such as the worse loss that may occur 1 in every 100 days (or years). In contrast, the 99% Expected Shortfall denotes the average of all losses that occur with a one percent probability. We show that the roots of the global financial crisis of 2007–8 can be found in the failure of financial intermediaries to measure and manage risk properly.