ENtERPRISE RISK MANAgEMENt
Risk Taxonomy:
A Closer Look at Integration
The credit crisis has heightened the need for banks to analyze and man-
age risk in a unified and cohesive manner. To achieve risk integration, a
bank must classify its different risks and then figure out how those disci-
plines interact and how they should be melded into an ERM framework.
BY WILLI BRAMMERTZ AND RAMI ENTIN
istorically, liquidity risk has been a primary
concern of bankers. Venetian goldsmiths,
for example, were already aware of the dangers associated with the paper money they
helped invent, and lived in constant fear of
too many creditors demanding gold for their
receipts. Unsatisfied creditors often took action by breaking
the goldsmith’s table. Broken tables, or banca rotta in Italian,
is a term that would not be unfamiliar to modern ears.
Credit risk was the other relevant risk for early bankers,
since unpaid loans reduced their capabilities to redeem receipts. Consequently, the focus of banking regulation until recent times has been liquidity and credit risk.
More recently, with the advent of modern financial instruments such as options and futures, market risk has gained
prominence. This was highlighted, in a regulatory context, in
the 1996 amendment to the first Basel capital accord. Several
years later, the treatment of credit risk was overhauled in the
Basel II accord, which also introduced the operational risk
category.
Lately, various regulatory bodies have proposed new ways
to measure and manage the seemingly long-forgotten category
of liquidity risk. What’s more, parallel to these developments
in banking supervision, the Solvency II framework for insurance regulation (which covers life and non-life insurance risk)
has evolved.
Although the concept of integrating all types of risks is
H
not new, it received a strong boost from Basel II, which requires that the capital charge set aside to cover unexpected
losses should include specific charges for market, credit and
operational risks. The financial crisis fueled further calls for
integration, which is now often referred to as enterprise risk
management (ERM).
In this article, we discuss the when and how of risk integration, namely in which cases this makes sense and how this
should be done.
1 We will proceed using a logical sequence,
starting with market risk, followed by credit risk, insurance
risk, operational risk and liquidity risk.
Market and Credit Risk
Market risk direct corresponds with the major asset classes of
bonds, foreign exchange, equities and commodities. A financial contract is driven by sets of rules that determine which
cash flows are exchanged under it, when these exchanges
takes place, and, in the case of contingent cash flows, how
these cash flows should be determined. Market risk arises
from unpredictable changes in risk factors effecting values and
cash flows. Which risk factors affect which contracts depends
on the terms of the particular contract. Exchange rates affect
only contracts denominated in a foreign currency; commodity indices affect commodity-linked contracts, etc..
While market risk factors affect financial contracts, they are
also mutually dependent. Although sophisticated mathematical descriptions of this interdependency are possible, a corre-
