Wk10

Question 1

What is risk?

Answer 1

• Risk in wealth management is the potential for loss associated with uncertainty.
• In broader finance, it involves randomness and volatility, without a directional bias.
• Wealth management’s regulatory risk focuses on managing exposure to potential losses through practices like Anti-Money Laundering (AML), Know Your Customer (KYC), and Counter-Terrorism Financing (CTF).
• These measures aim to reduce uncertainty, which in turn reduces risk exposure.

Question 2

What are the classes of risk ?

Answer 2

Key risk classes include:

• Credit Risk: Risk of borrower default.
• Market Risk: Risk from changes in market prices.
• Liquidity Risk: Risk of being unable to meet short-term obligations.
• Rates Risk: Risk from interest rate fluctuations.
• FX Risk: Foreign exchange risk due to currency changes.
• Solvency Risk: Risk of insolvency and inability to meet long-term obligations.
• ## Operational Risk: Risks from operational failures (internal processes, systems).
• Mitigants and Hedges for these risks may include diversification, hedging through derivatives, setting risk limits, and holding capital reserves.

Question 3

Where is wealth
management in the
Bessis’ book framework?

Answer 3

• Wealth management aligns with Commercial and Retail Banking as well as Advisory Services in the Bessis framework (refer to figure).
• It involves retail financial services for high-net-worth individuals and often touches on investment banking functions, especially in advising and managing assets.

Question 4

How does risk management apply within wealth management?

Answer 4

• Private wealth clients, including family offices, face similar risks as institutional clients, such as credit and market risks.
• Wealth management focuses on asset management and banking, with risks appearing different but being fundamentally similar.
• Effective risk management involves adjusting exposure based on client profiles and aligning investments with risk tolerances.

Question 5

Risk management - Are risks management, or quantified?

Answer 5

• Risks in wealth management are both managed and quantified.
• Processes include identifying, monitoring, and controlling risks, with specific limits on risk exposure, particularly in areas like credit risk.
• Quantification enables better risk assessment, but effective management requires active monitoring and mitigation strategies.

Question 6

Banking risk regulation
* What is the purpose
* Is it to prevent individual bank(s) from failing, or is it to prevent systemic risk?
* Moral hazard in banking
* Too big to fail?

Answer 6

*** Purpose: To prevent systemic risk rather than just individual bank failures.
* Regulatory measures aim to avoid moral hazard (excessive risk-taking by institutions with safety nets) and address issues with “too big to fail” banks.
* Involves limits on market risk and trading, hedging practices, and delegations to manage volatility and prevent excessive risk-taking.

Question 7

Capital adequacy
* Core concept is of tier 1 or core capital
* Theory is this puts a limit to risk taking
* Simple example from Bessis is c.8% in Basel 1,
which was credit risk focused
* Where does 8% come from?
* Capital = [8%] * Risk weight * Asset size
* Where do risk weights come from ? (examples: 0% for sovereign, 20% for OECD country
banks, 50% for RMBS, 100% for unlisted businesses… etc)

Answer 7

• Core Concept: Tier 1 or core capital requirements act as a risk-taking limit for banks.
• Example from Basel I: Required capital ratio of 8%, mainly for credit risk.
• Formula: Capital = 8% * Risk Weight * Asset Size.
• Risk Weights vary by asset type (e.g., 0% for sovereign debt, 20% for OECD country banks, 50% for RMBS, and 100% for unlisted businesses).
• Capital Adequacy Ratio (CAR) serves as a safeguard, indicating financial health and risk tolerance.

Question 8

** Today’s regulations - Where would family office and wealth management exposures sit?**

Answer 8

• Family offices and wealth management exposures typically fall under private wealth management regulations.
• They face stricter regulations than in previous years due to increased complexity in financial products and global regulatory standards.
• Their exposures, though lower in systemic impact than banks, still require careful monitoring within the regulatory spectrum.

Question 9

What are the key lessons from the financial crisis?

Answer 9

** Liquidity issues: Central banks had to intervene to address credit crunches.
** Fair value and illiquidity: **Market illiquidity led to unreliable asset valuations.
* Solvency risks: Many institutions faced solvency challenges due to high leverage.
* Pro-cyclicality and leverage: Over-reliance on credit and leverage created circular risk patterns.
** Securitisation and contagion: **Risk spread through credit products (like mortgage-backed securities).
* Ratings agencies: Over-reliance on ratings and counterparties (CDS) revealed systemic weaknesses.