What Is Financial Risk Management in Banking?

Financial risk management in banking describes taking steps to mitigate and attempt to control unpredictable events and patterns. It covers a wide range of types of risk. Most financial risk management involves hedging, which is effectively to carry out a plan B that will pay off if plan A goes badly, but will otherwise be an expense. The measures a bank takes are a mixture of those mandated by regulators and those the bank does voluntarily.

Financial risk derives from exposure, which means being open to the effects of an independent, uncontrollable "force" such as a financial market. One definition is that risk is the potential that this exposure will have negative consequences. Most banks and financial analysts view risk as a combination of both the actual likelihood of suffering a loss and the size of the potential loss. A very small risk of losing a lot of money could be viewed as the same overall level of risk as a very large risk of losing a tiny amount of money.

Two of the most prominent dangers that make financial risk management in banking so important are credit risk and market risk. Credit risk is the danger that a person or organization a bank has lent money to will fail to repay and that the bank will not recover its losses through seizing collateral. Market risk is the danger that a bank's investments will lose rather than gain money. In some cases the two risks can be combined: for example, a credit default swap is an investment asset whose price depends on whether or not an unconnected third-party loan is repaid. Other common risks include the effects of foreign currency rates on a bank's finances.

One common form of financial risk management in banking is hedging. This involves hedging one investment by making a smaller investment that pays off in the opposite circumstances. This limits the losses if things don't go the way the bank expects, but also limits the gains if the bank's forecast was correct. Such hedging allows the bank to deal in high quantities, often getting better terms, without a matching level of risk.

Financial risk management in banking can also involve looking at the overall picture rather than individual investments or loans. This means attempting to increase diversification, thus reducing the potential effects of any specific risk. To give an extreme example, if a bank gave out half of all its loans to tobacco companies and then smoking was made illegal, the bank would likely suffer high levels of default and face financial difficulties. Diversification means spreading risk among both multiple types of transactions, and between multiple types of partners for each type of transaction.