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The challenges of risk management in diversified financial companies

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In recent years, financial institutions and their supervisors have placed increased emphasis on the importance of consolidated risk management. Consolidated risk management, also referred to as integrated or enterprise-wide risk management, can have many specific meanings, but in general it refers to a coordinated process for measuring and managing risk on a firm-wide basis. Interest in consolidated risk management has arisen for a variety of reasons. Advances in information technology and financial engineering have made it possible to quantify risks more precisely. A wave of mergers, both in the United States and overseas, has resulted in significant consolidation in the financial services industry as well as in larger more complex financial institutions. The 1999 Gramm-Leach- Bliley Act seems likely to heighten interest in consolidated risk management, as the legislation opens the door to combinations of financial activities that had previously been prohibited. This article examines the economic rationale for managing risk on a firm-wide, consolidated basis. Both financial institutions and supervisors agree on the importance of this type of risk management. However, the ideal of consolidated risk management, which may seem uncontroversial or even obvious, involves significant conceptual and practical issues. As a result, few if any financial firms have fully developed systems in place today. The absence thus far of fully implemented consolidated risk management systems suggests that there are significant costs or obstacles that have historically led firms to manage risk in a more segmented fashion. We argue that both information and regulatory costs play an important role here by affecting the trade-off between the value derived from consolidated risk management and the expense of constructing complex risk management systems. In addition, substantial technical hurdles remain in developing risk management systems that span a wide range of businesses and types of risk. All of these factors are evolving in ways that suggest that the barriers to consolidated risk management are increasingly likely to fall over the coming years.

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Article provided by Capco Institute in its journal Journal of Financial Transformation.

Volume (Year): 3 (2001)
Issue (Month): ()
Pages: 89-95

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Handle: RePEc:ris:jofitr:1274
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  1. Michael S. Gibson, 1998. "The implications of risk management information systems for the organization of financial firms," International Finance Discussion Papers 632, Board of Governors of the Federal Reserve System (U.S.).
  2. Bengt Holmstrom & John Roberts, 1998. "The Boundaries of the Firm Revisited," Journal of Economic Perspectives, American Economic Association, vol. 12(4), pages 73-94, Fall.
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  4. Froot, Kenneth A. & Stein, Jeremy C., 1998. "Risk management, capital budgeting, and capital structure policy for financial institutions: an integrated approach," Journal of Financial Economics, Elsevier, vol. 47(1), pages 55-82, January.
  5. Grossman, Sanford J & Hart, Oliver D, 1986. "The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration," Journal of Political Economy, University of Chicago Press, vol. 94(4), pages 691-719, August.
  6. Holmstrom, Bengt & Milgrom, Paul, 1994. "The Firm as an Incentive System," American Economic Review, American Economic Association, vol. 84(4), pages 972-991, September.
  7. Thomas G. Labrecque, 1998. "Risk management: one institution's experience," Economic Policy Review, Federal Reserve Bank of New York, issue Oct, pages 237-240.
  8. Merton H. Miller & Franco Modigliani, 1961. "Dividend Policy, Growth, and the Valuation of Shares," The Journal of Business, University of Chicago Press, vol. 34, pages 411-411.
  9. Morris, Stephen & Shin, Hyun Song, 1999. "Risk Management with Interdependent Choice," Oxford Review of Economic Policy, Oxford University Press, vol. 15(3), pages 52-62, Autumn.
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