Financial institutions exist to improve the efficiency of the financial markets. If savers and investors, buyers and sellers, could locate each other efficiently, purchase any and all assets costlessly, and make their decisions with freely available perfect information, then financial institutions would have little scope for replacing or mediating direct transactions. However, this is not the real world.
In actual economies, market participants seek the services of financial institutions because of the latter's ability to provide market knowledge, transaction efficiency, and contract enforcement. Such firms operate in two ways. They may actively discover, underwrite, and service investments made using their own resources, or merely act as agent for market participants who contract with them to obtain some of these same services. In the latter case, investors assemble their portfolios from securities brought to them by these same firms.
In light of the two ways in which institutions may operate in the financial sector, several issues immediately arise. First, when and under what circumstances should these firms use their own resources to provide financial services, rather than offering them through a simple agency transaction? Second, to the extent that such services are offered through the use of the institution's own resources, how should it be managing its portfolio so as to achieve the highest value added for its stakeholders.
The purpose of this paper is to address these two issues. It defines the appropriate role played by institutions in the financial sector and focuses on the role of risk management in firms that use their own balance sheets to provide financial products. A key objective is to explain when risks are better transferred to the purchaser of the assets issued or created by the financial institution and when the risks of these financial products are best absorbed by the firm itself. However, once these risks are absorbed, they must be efficiently managed. So, a second part of the current analysis develops a framework for efficient and effective risk management for those risks which the firm chooses to manage within its balance sheet. The goal of this activity is to achieve the highest value added from the risk management undertaken.
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The Place of Risk Management in Financial Institutions
