Enterprise Risk Management: From Incentives to Controls, 2nd Edition

CHAPTER 16

Financial Institutions

The financial-services industry is in the throes of a transformation that is redefining both the competitive landscape in which financial institutions operate, and the dynamics of risk and return that shape their businesses. In the aftermath of the global financial crisis, banking regulators have dramatically increased their regulatory capital requirements and examination standards. If existing financial institutions are to survive and thrive in this new business and regulatory environment, they must adapt their business models and improve their risk management capabilities.

Financial institutions1 are different from other companies in the sense that their ability to measure and manage risk is central to their competitiveness. Risk management has always been a core competence for financial institutions, and risk performance a key determinant of profitability. As Gary Wendt, the former CEO of GE Capital, put it: “If you don't get the risk management part of the equation right, then nothing else will matter.” Put another way, the key to a financial institution's survival and prosperity is its ability to identify, quantify, price, and manage risk better than its competitors. As a manager of other people's money, the ability to gain and maintain the trust and confidence of clients is an absolute requirement for business success.

Moreover, the business of financial risk management involves some level of expected losses, which represent an important ...