Quantitative Risk Management: A Practical Guide to Financial Risk, + Website

7.2 Typology of Financial Institution Risks

Before turning to the details of measuring risk, I want to provide a high-level view of the types of risk faced by a financial institution.

We have defined risk as: the possibility of P&L being different from what is expected or anticipated; risk is uncertainty or randomness measured by the distribution of future P&L. In this sense, there is no distinction between, for example, market risk versus operational risk: Both encompass the possibility of gains or losses different from what is expected. Nonetheless, the sources, circumstances, and results of risk arising from different parts of a financial business are so different that there is considerable benefit from distinguishing between different risks within a financial organization.¹

I discuss five major categories of risk:

1. Market risk

2. Credit risk

3. Liquidity risk

4. Operational risk

5. Other (legal and regulatory, business, strategic, reputational)

These are discussed in somewhat greater detail further on and in later chapters. I spend the most time on market and credit risk because these are the most amenable to mathematical analysis and thus have been the most studied. The areas of liquidity, operational, and other risks, however, should not be downplayed simply because they are less amenable to analysis with sophisticated mathematical tools. Remember, as we saw in Chapter 4, that many of the worst financial disasters can be traced to operational issues.

Market Risk

This ...