Volume 15 (2022)

Each volume of Journal of Risk Management in Financial Institutions consists of four 100-page issues, published both in print and online. Articles scheduled for Volume 15 are available to view on the Forthcoming content page.

The papers and case studies confirmed for Volume 15 are listed below:

Volume 15 Number 2

  • Editorial
    Klaus Böcker, Senior Manager, PricewaterhouseCoopers and Editorial Board Member, Journal of Risk Management in Financial Institutions
  • Practice papers
    The strategic risks facing start-ups in the financial sector
    Patrick McConnell, Consultant

    The majority of start-ups fail. But some succeed, and a very small number succeed spectacularly. And it is the stories of the sometimes vast wealth unlocked by the rare successes that drive entrepreneurs, with stars in their eyes, to embark on a start-up venture. Even though the odds are stacked against them, people still invest their time, effort and wealth pursuing their dreams. Start-ups are risky — very risky — and thus any efforts to reduce the enormous risks facing start-up founders must increase the odds of ultimate success. Risk management, therefore, should be a key focus for entrepreneurs and their investors. One of the many types of risk facing every firm is ‘strategic risk’, although for established companies this overarching risk is somewhat mitigated by their deep knowledge of the industries in which they operate and not least by their ready access to capital to grow their business (provided of course that the firm is not already in trouble). There are very many definitions of ‘strategy’ in business, but one, from the guru of competitive strategy, Michael Porter, is simple and clear: ‘[a strategy is] a broad formula for how a business is going to compete, what its goals should be and what policies will be needed to carry out those goals.’ So, if the founders of any company do not know how and with whom the firm is going to compete, what the goals/objectives should be, and how founders plan to achieve those goals, then their venture is unlikely to succeed. This paper identifies some of these critical ‘strategic risks’ by first identifying what is ‘strategy’ and why it is important, especially for start-ups. Then, using common strategy models, key risks for any company and some of the key strategic risks facing start-ups in finance are described. In particular, one extremely important aspect of strategic risk, that of strategic positioning risk, is covered in detail. There is no ‘magic bullet’ to eradicate risks, especially strategic risks, but to illustrate how strategic risks may, to a degree, be mitigated, the paper references three case studies of start-ups in the financial sector: one that has succeeded (to date), one that has failed and one somewhere in the middle. In these cases, the paper does not claim that success or failure is a result of formalised risk management processes, more that key decisions taken along the way addressed some critical strategic risks. The purpose of this paper is not to frighten entrepreneurs with the enormous task confronting them, but to provide a rough map of some terrain to avoid along their journey. There will be many potential pitfalls for every start-up — it makes sense to try to avoid some of the more obvious.
    Keywords: FinTechs, start-ups, strategic risk, strategic positioning risks, strategic execution risks, strategic governance risks

  • Satisfying exclusions in portfolio construction: The ESG case
    Amel Bentata, Senior Quantitative Analyst and Laurent Nguyen, Team Leader, Pictet Asset Management SA

    In this paper, we show that quantitative portfolio construction techniques can deal with ‘reasonable’ constraints and deliver most of the expected (ie before constraints) value-added. To do so, we use the case of a hypothetical environmental, social and corporate governance (ESG) investor who chooses to not invest in companies typically excluded for ESG reasons (eg weapons manufacturing, nuclear energy generation, tobacco or high carbon intensity) back in the late 1980s. While satisfying ESG objectives, we capture the market’s exposure using several portfolio constructions such as pro-rata cap-weighting and minimum tracking. We also capture other ‘styles’ that could mimic exposures some asset owners want to be exposed to, such as value or momentum. Our results are helpful to deliver an appropriate, risk-controlled investment experience to asset owners who must integrate externally defined constraints in their long-only equity investments.
    Keywords: ESG, constraints, optimisation, Markowitz, equities

  • Outsourcing insurance in the time of COVID-19: The cyber risk dilemma
    Hala Naseeb, Insurance Practitioner, Bahrain Institute of Banking and Finance and Abdelmoneim Metwally, Assistant Professor, Assiut University

    With the shift towards teleworking/working from home in recent years and accelerated by the COVID-19 pandemic, insurers are finding themselves relying on outsourcing as a way to cope with changes in business models and requirements. This has augmented the risk of cyberattacks and is ultimately considered a high risk for insurers of any size, not only because it subjects insurers to litigation concerning data breaches, but also because of the harm to the insurer’s reputation when an attack happens, which is further magnified by resultant loss of system use. Clients already have the perception that insurers are too invasive when it comes to personal data (especially in the medical and life insurance fields), so they are blamed for not handling cyber risk meticulously regardless of whether it is the outsourcing provider’s fault. Risk managers in insurance companies need to apply enterprise risk management (ERM) principles and identify cyber risks across the entire process to manage these risks. The paper proposes some potential policy solutions that would help insurers mitigate outsourcing cyber risks. Further research is required in this field, specifically into what strategies insurers are implementing to deal with the risks posed by the outsourcing provider’s cyber risk and which of those strategies have fared better than others thus far.
    Keywords: cyber risk, telework, COVID-19, insurance, outsourcing, technology

  • Banks’ concurrent risks during the COVID-19 pandemic: A road map for risk officers and risk management
    Ahmed A. Diab, Assistant Professor, Prince Sultan University, Abdelmoneim Metwally, Assistant Professor, Assiut University, Abdulkarim M. AlZakari, Chief Risk Officer, Khaleeji Commercial Bank and Aisha Fazal, Senior Lecturer, British University of Bahrain

    In the banking literature, the global financial crisis of 2008/09 is cited as one of the key challenges that faced the modern risk management profession. When we look at the current situation of the COVID-19 pandemic, however, we realise that banks worldwide are facing more concurrent risks that need interventions. This paper analyses the impact of the COVID-19 pandemic on the banking sector worldwide, focusing on emerging markets such as Bahrain. In doing so, a road map for banks’ risk managers is proposed. In particular, we present specific recommendations for local and central banks to manage the emerging risks following the pandemic, including operational resilience and increased financial, market and credit risks. Further, we provide some insights and recommendations for the Bahraini banking sector, as an example of an emerging financial market.
    Keywords: risk management, banks, COVID-19, financial risks, operational resilience

  • Research papers
    Impact of COVID-19 on commercial banking risk management practice: Survey evidence recommendations for practitioners
    Jamal M. Shamieh, Assistant Professor, American University of Madaba

    This study aims to discuss the impact of COVID-19 on commercial banking risk management practice. The study used a qualitative study design based on three different approaches: use of primary sources such as journal articles, focus groups and observations on digital trends. The impact of COVID-19 on risk management in commercial banks manifested in many areas such as deteriorating credit quality, increased cash outflows and reliance on digital systems. This study offers practical solutions for mitigating risk in various areas for the banking industry through survey evidence recommendations for practitioners. Although other studies identify the major risks, this study focuses on how to deal with each of these risks.
    Keywords: COVID-19, stress event, risk management, commercial banking, qualitative design, focus group

  • Managing the COVID-19 pandemic: Preliminary evidence from global banks
    Paolo Agnese, Associate Professor, Faculty of Economics, International Telematic University UNINETTUNO, Paolo Capuano, Contract Professor, LUISS University of Rome and Alberto Romolini, Associate Professor, International Telematic University UNINETTUNO

    The COVID-19 pandemic represents the most complex test for financial institutions since the global crisis of 2007. During this period, the boards of financial institutions, especially banks, had to make strategic decisions quickly, to address the effects of this crisis efficiently and effectively. Boards had to make the right decisions to withstand the shocks caused by the pandemic. The role of the board (or supervisory board) in managing banks has been under scrutiny by academic researchers and professionals during the current pandemic crisis. Since the outbreak of COVID-19, boards have faced many tough decisions. Boards promptly facilitated the introduction of a number of COVID-19 response policies, including the establishment of specific teams to prevent and control the effects of the pandemic, to support the community, and to the protect and support employees and clients. The objective of this paper is to understand the role of boards of global banks during the COVID-19 pandemic, in particular to determine which were the most effective policy decisions and to outline the related underlying trends. The results of this research may allow the identification of best practices for the management of financial institutions,and provide a useful reflection for the various stakeholders, including regulatory and supervisory authorities.
    Keywords: global systemically important banks (G-SIBs), board of directors, corporate governance, COVID-19 pandemic

  • Building bridges: From the probability of a country crisis to a country risk assessment
    Alexandre H.O. Siqueira, Senior Credit Risk Analyst, BNDES

    Country risk is often misconceived, leading to misunderstanding and, consequently, misapplication. This paper aims to provide an alternative way to assess country risk, based on quantitative tools where the link between country crises, firms’ characteristics and country risk ratings are presented. This paper reviews the literature on country risk concepts and develops a theory for the impact of country risk on the real economy, in particular how the outcome, provoked by a country crisis, effects firms’ assets. A statistical model based on the probability of a crisis adjusted to firm idiosyncratic exposure to country risk is built with respect to the type of exposed asset. The proposed assumptions that country risk alone does not exist, and that country risk must be combined with the primary source of risk to be measured, are rooted in natural science concepts about vulnerability and hazard and are the essence of this paper. The model is forward looking based on the probabilities of the occurrence of countries’ crises, providing an economic foundation for the additional cost of capital that country risk represents. This methodology could provide additional help to investors and banks.
    Keywords: Country risk, country crises, sovereign risk, country risk ratings

Volume 15 Number 1

Special Issue: Advances in ESG: Integration, risk management and thematic investing

Guest Editors: Dr. Luis Seco, CEO, Sigma Analysis & Management, Professor of Mathematical Finance, University of Toronto and Alik Sokolov, CEO, SR.ai, PhD Candidate, Mathematical Finance, University of Toronto

  • Editorial
    Dr. Luis Seco, CEO, Sigma Analysis & Management, Professor of Mathematical Finance, University of Toronto and Alik Sokolov, CEO, SR.ai, PhD Candidate, Mathematical Finance, University of Toronto
  • Opinion piece
    Is ESG investing contributing to transitioning to a sustainable economy or to the greatest misallocations of capital and a missed opportunity?
    Dr Madelyn Antoncic, Member of the Board of Directors ACWA POWER, Saudi Arabia; S&P Global Ratings & FinTech Acquisition Corp VI, USA

    Environmental, Social and Governance (ESG) investing has become a focus not only of the asset management industry but also among policy makers as a way to mobilise capital for sustainable economic development. While this could be the mechanism through which capital is allocated to companies and technology of the future to help transition to a net-zero sustainable economy and to deliver on the UN SDGs, all of the ‘noise’ around ESG reporting coupled with the ESG ‘investing frenzy’ may more likely end up being the greatest misallocation of capital and a missed opportunity. Asset owners’ strong interest in investing in ‘green’ assets to transition to a net-zero sustainable economy has led to a growing trend of asset managers labelling and rebranding mutual funds and ETFs as ESG and even mainstream funds are advertising employing ‘ESG integration’. At the same time, significant ‘greenwashing’ exits at the company reporting level due to the lack of agreed standards. Moreover, poor correlations across ESG score providers for a given company as well as intentional built-in biases introduced into the scoring and the total lack of any analysis taking into account ecological ceilings, sustainability thresholds and outer boundary limits of natural resources, will all likely lead to material capital allocation distortions. ‘Greenwashing’ at both the asset manager and the corporate level and the resultant misallocation of capital is likely setting the stage for potential risks including significant macroeconomic and geopolitical risks, as well as risks to the financial markets and financial institutions.
    Keywords: ESG, transition to a net-zero sustainable economy, Paris Agreement, UN SDGs, European Green Deal, climate risk

  • Practice papers
    How can climate risk stress testing be implemented?
    Greg Hopper, Managing Director, Goldman Sachs

    This paper is a practical introduction to the nascent methodology of climate risk stress testing. After giving a general overview of the physical climate models that underlie climate risk projections, it discusses how a financial institution can leverage open-source physical risk data and climate models employed by the scientific and policy communities to perform both physical and transition risk stress tests. The paper develops two examples of physical risk stress testing: 1) a stress test of the effect of temperature increases on labour productivity; and 2) a stress test of the physical damage of hurricanes. The paper goes on to explain what transition risk is and then explores how models already in use by the climate policy community can serve as a foundation for transition risk stress testing.
    Keywords: Stress testing, climate risk management, physical risk, transition risk, climate scenarios, climate models

  • Quantifying climate risk uncertainty in competitive business environments
    Jorge R. Sobehart, Managing Director and Head of Credit and Obligor Risk Analytics, Citi

    As the impact of climate change and CO2 emissions gain more visibility globally, there is increased interest in understanding how the industry landscape will be reshaped in response to the changing physical, economic and political environment. This paper introduces an approach for quantifying the risks associated with the release and adoption of competitive products and services for the long-term uncertainty generated by climate risk scenarios. Our approach can be used for assessing the risks of business strategies whose revenues are used for the repayment of obligations in industries affected by climate risk or CO2 emission costs, and for estimating the probability of default on those obligations under different scenarios. Our approach can also help gain insight into the uncertainty of different net-zero emission strategies and into the uncertainty of outcomes due to nonlinearities, synergies and model misspecification.
    Keywords: Climate risk, transition risk, competitive environments, earnings uncertainty, credit risk, disruptive technologies

  • Managing climate change risks: The role of governance and scenario analysis
    Laurent Clerc, Director for Research and Risk Analysis, Autorité de Contrôle Prudentiel et de Résolution

    Climate-change and environmental risks, as illustrated by extreme weather events and biodiversity losses, pose a fundamental threat to humanity. Calls for action have intensified and pressures on the financial sector have significantly increased. As a result, environmental, social and governance (ESG) disclosures and risk assessment have improved. In this context, this paper highlights the crucial role of governance and scenario analysis in enhancing the effectiveness of climate-change and environmental risk management. Concrete examples are given, drawing on some results of the unprecedented ACPR pilot climate exercise, to illustrate the importance of scenario analysis.
    Keywords: ESG, climate change, risk management, governance, stress testing, scenario analysis

  • How to improve the ESG profile of portfolios while keeping a similar risk-adjusted return
    Antoine Kopp, Dominic Barber, Rémy Cottet and Gabriele Susinno, Pictet Asset Management

    This paper identifies the potential to improve ESG credentials of a given reference portfolio whilst broadly maintaining risk-adjusted return characteristics, hence anchoring the portfolio to a better ESG profile. ‘Improving’ in this case means allocating a higher weight to better ESG stocks according to the variables employed. Using different MSCI benchmarks as reference portfolios, the research shines light on interesting subsector dynamics in the ESG-tilting process. Namely, Banks and Pharmaceuticals are replaced by Insurers and Real Estate Investment Trusts, in addition to Healthcare providers. The paper provides significant findings for investment managers in the context of ever-increasing pressure to ‘do good whilst doing well’. The opinions expressed in this paper are solely those of the authors.
    Keywords: ESG, portfolio construction, risk-adjusted return, sustainable investing, socially responsible investing, convex optimisation

  • ESG rating as input for a sustainability capital buffer
    Martin Neisen, Partner, Benjamin Bruhn, Manager and Dieter Lienland, Director, PricewaterhouseCoopers

    In this paper, we give a state of the art overview of what ESG ratings are, which different types of these ratings can be distinguished and how they could be used in banking regulation to adjust banks’ capital requirements with the goal to promote green finance and reduce climate-related risks within the investments of banks. Based on experience collected with other supporting factors within banking regulation, like the SME supporting factor, we show how a Green Supporting Factor or a Brown Penalty Factor could be implemented to promote green finance or punish brown finance, respectively, and include climate risk into Pillar I capital requirements. We also discuss an approach combining these two binary factors and conclude with a proposition to use ESG ratings to derive capital requirements add-ons. After all, ESG ratings take a broader perspective on sustainability and provide a more granular scale ranging from sustainable to non-sustainable rating classes. This approach ensures that green finance investments can be promoted via adjustments of capital requirements without a significant decrease of the total capital in the banking sector and, therefore, without the reduction of the stability of the financial market.
    Keywords: Basel IV, ESG ratings, green supporting factor, capital buffer, SREP, sustainability buffer

  • Climate change risk: The next frontier in banking risk management
    Hanna Sarraf, Group Chief Risk Officer, Bankmed Group

    Extreme weather events are becoming more frequent, more intense and, to a certain extent, more predictable, according to global climate research. Over time, the effects of climate change could alter dramatically the environment upon which communities, societies and economic activity depend. Meanwhile, a correlating impact on firms, sectors and geographies could render traditional business models ineffective or obsolete. Rapid developments in environmental, social and governance (ESG) initiatives, and rising stakeholder demand for improved sustainability performance, will require banks to take a more integrated and strategic approach to climate risk management. This paper explores the practicalities of integrating climate-related risks into existing risk management frameworks, strategies and processes. It examines the key components and attributes of an effective climate-risk framework. And it elaborates on some of the unique characteristics and business model adaptations that are needed to incorporate climate-change considerations into decision-making processes, including capital allocation, loan approval, portfolio monitoring and reporting. In this way, business models can become more economically efficient and strategically resilient to climate risk and equipped to deliver long-term sustainability and value creation.
    Keywords: ESG, climate change, environmental risk, climate risk management, banking business model sustainability, strategic resilience

  • Winning a seat at the ESG table
    Jonny Frank, Partner, Jim Barolak, Partner and Germari Pieterse, Managing Director, StoneTurn

    Financial Institutions (FIs) struggle to identify, assess and develop appropriate responses that proactively address potential events for more traditional known risks let alone new, emerging and imprecise risks in the often difficult-to-quantify Environmental, Social & Governance (ESG) space. ESG-related risks present even greater challenges to established risk management frameworks such as COSO because ESG risks are generally not well known to the business and include ‘black swans’ or other unforeseen events that can challenge the entities’ short-term or long-term performance or even survival; tend to be longer term in nature than the timeline with which strategy is set or risks have been considered historically; and beyond the scope of any one entity. The good news is that FIs’ existing — and often highly sophisticated risk, compliance and legal functions (Risk Team) — are well equipped to integrate and mitigate these significant ESG-related risks into the FI’s risk management framework. The authors, drawing upon first-hand experience as government-appointed monitors for large, global financial institutions, provide a practical roadmap for defining and mapping ESG-related risks. They also explain why Chief Risk Officers, Chief Compliance Officers and Chief Legal Officers must seize this unique opportunity to not only avoid the financial, legal, regulatory, and reputational losses that will inevitably follow without an ESG risk management program — but also enhance the value the Risk Team delivers as ESG priorities become pervasive across FIs worldwide. Acknowledging that sustainability and/or ESG professionals are uniquely qualified to provide critical guidance defining and communicating the FI’s objectives, the authors provide a proven framework and methodology for compliance and risk practitioners to leverage as they reach across the aisle to their counterparts in Sustainability or Corporate Social Responsibility to elevate the ESG risk conversation and their own visibility.
    Keywords: ESG/environmental social & governance, ESG risks, greenwashing, sustainability, ESG integration, CSR