Question

"What are the constraints and risks against investment banking businesses and how would they alleviate the restrictions and control the risks？Provide real life example.（JP Morgan，Morgan Stanley etc.）

Answer 1

Constraints affect the investment Banking:

Liquidty Risk:

Liquidity risk is the risk that a company or bank may be unable to meet short term financial demands. This usually occurs due to the inability to convert a security or hard asset to cash without a loss of capital and/or income in the process.

Credit Risk :

Credit risk is the biggest risk for banks. It occurs when borrowers or counterparties fail to meet contractual obligations. An example is when borrowers default on a principal or interest payment of a loan. Defaults can occur on mortgages, credit cards, and fixed income securities. Failure to meet obligational contracts can also occur in areas such as derivatives and guarantees provided.

While banks cannot be fully protected from credit risk due to the nature of their business model, they can lower their exposure in several ways. Since deterioration in an industry or issuer is often unpredictable, banks lower their exposure through diversification.

By doing so, during a credit downturn, banks are less likely to be overexposed to a category with large losses. To lower their risk exposure, they can loan money to people with good credit histories, transact with high-quality counterparties, or own collateral to back up the loans.

Operational Risk :

Operational risk is the risk of loss due to errors, interruptions, or damages caused by people, systems, or processes. The operational type of risk is low for simple business operations such as retail banking and asset management, and higher for operations such as sales and trading. Losses that occur due to human error include internal fraud or mistakes made during transactions. An example is when a teller accidentally gives an extra $50 bill to a customer.

On a larger scale, fraud can occur through the breaching a bank’s cybersecurity. It allows hackers to steal customer information and money from the bank, and blackmail the institutions for additional money. In such a situation, banks lose capital and trust from customers. Damage to the bank’s reputation can make it more difficult to attract deposits or business in the future.

Market Risk :

Market risk mostly occurs from a bank’s activities in capital markets. It is due to the unpredictability of equity markets, commodity prices, interest rates, and credit spreads. Banks are more exposed if they are heavily involved in investing in capital markets or sales and trading.

Commodity prices also play a role because a bank may be invested in companies that produce commodities. As the value of the commodity changes, so does the value of the company and the value of the investment. Changes in commodity prices are caused by supply and demand shifts that are often hard to predict. So, to decrease market risk, diversification of investments is important. Other ways banks reduce their investment include hedging their investments with other, inversely related investments.

Additional (nonfinancial) risk:

Types are emerging Although management of financial risks has advanced significantly over the last 20 years, this is not the case for other risk types, particularly nonfinancial ones. The tremendous increase in fines, damages, and legal costs related to operational and compliance risk over the past five years has forced banks to pay much more attention to these risks. This will probably increase even further, due to the regulatory trends discussed earlier and given the expected rise in capital requirements for operational risk.

Example: Accenture Navigating Uncertainity

1.Demographic challenges Widely reported, most developed economies are struggling to come to terms with seismic demographic challenges. To varying degrees, these are set to transform the way people live and work. Life cycle savings and ageing populations point to the need to save in developed economies, making asset management an increasingly vital source of revenue growth for investment banks.

2.Emerging markets growth Economies experiencing rapid growth, combined with little well established competition, offer exciting opportunities for investment banks. But the risks, and operational challenges, of expansion into these new geographies are still being potentially underestimated.

3.Technology commoditisation Technology has repeatedly demonstrated its ability to commoditise banking offerings – particularly in non-relationship based, low value added areas. With commoditisation increasingly dominating ‘flow’ businesses, clearsighted strategic decision-making is vital. Banks must either make the substantial investments in straightthrough processing capabilities needed to achieve economies of scale, or concentrate on areas such as advisory, that cannot be commoditised.

4. Ultimate value to investors Investment banks have to concentrate on services and offerings where they deliver value to their clients, not just margins to themselves. This makes it essential for banks to develop deep, real-time insights into the risk/reward balance of their products and services.

5. Re-evaluation of capital Savings deposits may be the most desired form of capital, undemanding and sticky, but those attributes also make it rare and likely to become rarer. Investors have many more choices on where to place their capital and the amount placed in savings has been one of the slowest growing of all areas for over a decade. With this in mind, investment banks need to re-evaluate capital’s importance in any service of product and charge accordingly.

6. Resource constraints Mounting resource constraints point to gradually rising input costs becoming a universal backdrop to all business and banking activity. With oil approaching peak output, and basic commodity costs responding to wide demands of emerging markets, a reordering of economic priorities looks to be the likely result. Sustainability is now on the agenda (as a serious business issue) across all business sectors and investment banks must overcome their institutional cynicism and follow suit (as well as capitalise on the opportunities presented).

Accenture on Controlling Risk:

Reassuring regulators while continuing to satisfy shareholder expectations:

There are strong indications that in the future, regulators will move away from ‘deep dive’ transaction-level audits towards a more macro approach. This will be geared to gauging the resilience (or otherwise) of banks’ strategic risk and control frameworks. In the UK, the abolition of the existing tripartite regime between the FSA, Bank of England and HM Treasury (effectively scrapping the FSA) is symptomatic of this trend. So what challenges does this shift create for investment banks? At a high level, bank CEOs and CFOs will have to develop effective relationship-based links with the regulators

This looks inevitable and there is already evidence that some banks are becoming more proactive in this respect. These new relationships see bank CEOs communicating their in-depth understanding of existing front-to-back infrastructures and processes, as well as whatever plans have been developed to address weaknesses from both tactical and strategic perspectives.

The writing is on the wall. With little warning and at short notice, C-suite bank leaders will increasingly have to be equipped to provide macro-level assurances on the state of their risk and control environments. Inevitably, therefore, the compliance director (who will need to support this relationship-based approach) will become increasingly influential.