Financial institutions often hold large investment portfolios in addition to running their main business in various segments of the financial market. For example, insurers’ main line of business is to underwrite life or property policies, collect premiums, and manage claim payouts. In the meantime, they typically hold large fixed-income portfolios. Investment banks’ main business is to advice corporate clients on securities issuance, restructuring, and M&A activities, but they often have proprietary trading desks that bet large amount of firm capital. At some financial institutions, investment activities generate a large proportion of profit as well as a large amount of risk.
How do financial institutions manage investment risk versus the risk they face in their main business is a prominent issue. Are these two types of risks managed independently regardless of each other, or managed as compliments or substitutes? At the firm level, these questions are part of the big issue on financial institutions’ risk management practice that we strive to understand.
While there is a large amount research on risk management at commercial banks, relatively little empirical research exists so far on risk management at non-bank financial institutions. At the market level, researchers have been trying to understand why seemingly unrelated segments of the financial market may suddenly act together, giving rise to financial contagion.
Part of the answer may lie in the way institutions manage risk across market segments although the risks of various market segments (i.e., the securities market an institution invests and the market segment it mainly operates in) may be unrelated, the risk-taking decisions of institutions across these segments may be dependent. Finally, the issue is also relevant from a policy-making or regulatory perspective. Consider the debate on regulating excessive risk taking in banks’ proprietary trading activities. In order for the regulators to decide a proper limit on investment risk an institution should take, it is necessary to know what level of investment risk is considered proper or prudent given the business risk it already faces.