Financial Institutions, Markets, and Money, Eleventh Edition

CHAPTER TWENTY

Risk Management in Financial Institutions

IN THE 1960S AND 1970S, bankers managed by the so-called 3-6-3 rule. According to this rule, a smart banker would borrow at 3 percent from depositors, lend at 6 percent to borrowers, and be on the golf course by 3 o’clock. Banking was a much simpler business at the time.

For better or worse, the financial services industry has evolved into a much more challenging business. Just as it was in the 1960s and 1970s, financial institution managers are in a constant quest for profits. However, profits must be earned without sacrificing safety; that is, managers must maintain adequate liquidity and capital. Furthermore, banks and other financial institutions must manage the risks they face in order to protect their liquidity and capital positions. Failure to manage these risks effectively can lead to, at a minimum, greater regulatory scrutiny. At worst, a failure to maintain adequate capital and liquidity can lead to a financial institution being taken over by regulators, shareholders losing their investments, and managers being the target of legal action. A financial institution that takes very little risk, however, will not generate enough profits to satisfy the demands of shareholders.

Risk management is about balancing the desire to generate profits against the need for safety.

Among the differences between today and the 1960s ...