Financial institution risks

Financial institutions are either implementing customer and relationship profitability-measurement processes or thinking about doing so. Although much progress has been made on building mechanisms to perform matched-term funds-transfer pricing and activity-level standard unit costing, two of the basic calculations that support such measurement, there has been relatively little progress made on the third major measurement issue: customer-level capital assignment.
Financial institutions hold capital to cover risks in excess of reserves and to fund investments in physical plant and equipment. To the extent that one customer is riskier than another, more capital is required to cover the higher level of risk.
In the rush to better understand an individual customer's contribution to a bank's overall bottom line, it is important to ensure that an adequate basis of comparison exists in order to determine relative winners and losers. Two customers may use the exact same volume of assets and produce exactly the same amount of net income. However, it is impossible to understand which customer's contribution is more valuable without some measure of the capital that is required to support their transactions. The customer that requires the least amount of capital is the more valuable one, given the same relative amount of net income (return on assets).
Because the two instruments are similar but not identical there will be basis risk which arises whenever there are imperfectly-matched offsetting risk positions. Therefore even a risk-averse firm must establish a good risk control system, because financial risks are part and parcel of today’s corporate life.
A sound risk management process starts with identifying the major risk types facing a firm. They are credit, market, legal, liquidity and operations. Senior managers must draw up risk management procedures for each type of risk.
There is a great deal of activity these days related to the measurement of customer profitability in financial...

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