Risk Management Practices in Modern Investment Banking. A Case Study of RBS

Risk Management Practices in Modern Investment Banking. A Case Study of RBS


Chapter One: Introduction

  • Background

Investment banking is increasingly becoming an important of the modern economy due to the need to raise and utilise capital efficiently towards increased returns to the individuals or companies acquiring assets or starting business ventures (Morrison and Wilhelm Jr, 2019). Many companies are interested in raising capital through stocks and bonds and thus investment bankers play a vital role in ensuring maximum revenues within the stipulated regulatory framework. Some of the examples of the functions of investment banks include underwriting that entails selling and packaging security on behalf of an entity as well as being financial advisors for institutions and facilitate mergers and corporate reorganizations (Tang, 2019). While investment banking is essential in the adoption of the best way to raise funds through a legally accepted approach, the process is associated with various risks and rewards

The rewards include increased access to capital that can enable the growth of businesses through elements like asset acquisition or funding of operations like sales, marketing, and research and design. Access to capital is also essential in the enhancement of a business’ competitiveness through superior product delivery and acquisition of unique competencies (Stowell, 2017). On the other hand, examples of risks in investment banking can be categorised in levels as macro, industrial, exterior, and corporate levels. The identified categories are based on the sources of risks as well as the coverage of the extent of their impact (Tang, 2019).

  • Purpose Statement

The management of potential risks in investment banking is vital in ensuring that the possible loss of funds is prevented (Morrison and Wilhelm Jr, 2019). On the same note, the risk management exercise is undertaken to ensure that maximum returns are obtained in the process involved in raising the capital. The risk of investment occurs since the value of the capital or asset can rise or fall and thereby necessitating the adoption of the appropriate strategies to prevent the possible loss. The loss in value of the investment due to the market and economic conditions is a significant risk requiring the adoption of specific strategies and techniques to cushion the investors against the potential shocks (Stowell, 2017). The purpose of this study is to investigate some of the practices that are used in the management of risks while focusing on the case of the Royal Bank of Scotland (RBS).

  • Research Objectives

The main of this study is to outline the various risk management practices that are used in modern investment banking while focusing on the case of RBS. The specific objectives that are pursued in the study therefore include:

  • To explore the various categories of risks that are associated with modern investment banking
  • To identify the risks encountered by RBS in Manchester as an investment bank as well as the risk management practices adopted by the institution
  • To discuss the techniques that can be used in improving the effectiveness of the risk management practices in investment banks
  • Research Questions

The proposed study seeks to answer the question regarding the specific management practices that are implemented by investment banks to manage risks. The research questions that are related to the objectives are:

  • What are some of the examples of risks that are associated with modern investment banking?
  • How does RBS in Manchester manage the various specific categories of risks to which it is exposed as an investment bank?
  • What are some of the strategies that can be used in increasing the effectiveness of risk management practices in investment banks?
  • Justification of the Study

Risk management is a significant element in any business due to the vital role in the protection of the entity from the potential loss of assets (Morrison and Wilhelm Jr, 2019). A study of the risk management practices that are adopted by a institution is therefore essential in presenting the strategies that are used in the investment banking industry to mitigate the unfavourable events in the operations of the organization. Additionally, the findings of this research will be vital in contributing to the literature regarding the practices that can be implemented by the investment banks to mitigate the risks to which they are exposed.

Chapter Two: Literature Review

2.1. Chapter Introduction

The literature review section provides an analysis of the existing studies regarding the various types of risks that exist in modern investment banking as well as the associated risk management practices. The section outlines the conceptual framework adopted towards understanding the topic followed by a thematic review of the key elements associated with the selected studies that encompass risk management in modern investment banking.

2.2. Conceptual Framework

The proposed study will mainly use the concept of financial risk management towards answering the research questions. According to Valaskova, Kliestik, and Kovacova (2018), financial risk management entails the process of identifying, analysing, and accepting or mitigating the uncertainty of investment decisions. Similarly, Moles (2016) outlines that the financial risk management process involves the attempts by the business leaders to quantify or measure the potential risks associated with a management decision and hence take appropriate mitigation measures.

As a holistic process, Moles (2016) outlines that financial risk management is undertaken through various models. An example of a risk management model entails the consideration of a five-step process that includes risk identification, qualitative risk analysis, quantitative risk assessment, risk response planning, and risk monitoring and control. Despite the importance of risk management models in the understanding of how risks occur and how they can be mitigated, Moles (2016) observes that a major disadvantage is based on the fact that there is no standard model that can be used in understanding and mitigating all the types of risks that are associated with the financial investment decisions. The other common approaches to risk modelling include statistical, computational, and mathematical that form the basis of a quantitative approach to the analysis of risks (De Rocquigny, 2012). The statistical modelling can be undertaken even in cases that the causes of risks are not known such as in the establishment of the correlation between the risks such as price volatility and other variables.

Zopounidis, Doumpos, and Kosmidou (2018) further highlight that financial modelling is used as strategies for risk management due to the ability of the models to provide a representation of the financial conditions in the real world. On the same note, Chan and Wong (2015) assert that the financial modelling techniques are critical towards the definition of risks since the process of risk management entails the determination of the relationship between the outcomes of an investment decision. The modelling process thus entails the determination of the probability that a negative outcome (risk) will occur while the overall risk is obtained from multiplying the associated monetary impact and the probability (Chan and Wong, 2015). The equation below can be used in the definition of risk from a financial modelling perspective.

2.3. Importance of Financial Risk Management in Investment Banking

Inadequate risk management practices can lead to negative consequences on businesses, economies, and individual investors. For instance, the subprime mortgage meltdown in 2007 was associated with inadequate risk management measures that resulted in the financial recession starting in 2008 (Aebi, Sabato, and Schmid, 2012). Some of the poor risk management decisions that were associated with the mortgage meltdown include the lenders providing mortgages to people with poor credit history as well as the investment entities that bought, package, and resold the mortgages (Aebi, Sabato, and Schmid, 2012). A proper risk management strategy should be part of an investment bank’s daily operations and should determine how the organisation function to avoid possible financial losses. Similarly, the implementation of a risk management strategy is essential in assisting the businesses to mitigate the fact that risks always exist in the organization’s operations even in instances when normalcy is presumed.

Morrison and Wilhelm Jr (2015) assert that the management of risks in the modern investment banking is not only a vital element in ensuring that the businesses comply with the regulatory framework but also for maintaining a commitment to the customers. The commitment to the customers also reflects the financial institutions’ efforts to address the concerns of the investors regarding the potential deviation from the expected outcomes and the associated losses. Consequently, measures such as value at risk (VAR) is used by organisations to determine the returns available to the investors in the instances of negative deviation (Stowell, 2017). The commitment to managing risks while safeguarding the investors’ or customers’ therefore forms the basis for decision-making for the prospective customers. Apart from reducing the chances of the loss of capital, the risk management strategies also enhance the commitment to increase the success of the organisation towards value creation in the customers’ wealth or capital.

According to Fiordelisi, Girardone, and Radić (2018) risks occur in the investment banking sector due to the competitive pressures to which the organisations are exposed requiring the need to adopt measures towards outperforming the rivalries. Consequently, risk management is important in ensuring that the decisions that are taken by the firms towards gaining a competitive edge in the market do not expose the bank to the high instances of situations that can lead to the loss of capital. The risks can thus be measured in terms of capital-at-risk as well as return volatility. Vives (2019) also asserts that the promotion of competition in modern banking is associated with increased financial instability and hence increasing the extent of risks to which the firm’s operations are exposed.

The importance of risk management in modern investment banking is further underscored in the work of Stowell (2017) who highlights that investment banks have changed dramatically in the two decades preceding the 2008 financial crisis. Some of the changes include the shift from the traditionally low-risk approach to the adoption of a considerable amount of risk on the investment bankers’ account and for their customers (Stowell, 2017). On the same note, Wójcik et al (2018) highlight that the global financial crisis of 2008 led to changes in investment banking such as the contraction in the market shares in the global financial system. The technological advancements in modern investment banking also warrant the need for the adoption of appropriate risk management practices. Willcocks and Craig (2020) observe that technologies such as service automation, cloud computing, robotics, and artificial intelligence are increasingly being adopted across various sectors including investment banking. According to Chernyakov and Chernyakova (2018), the technological risks that are associated with the digital economy like data breaches also present significant risks to modern investment banks.

2.4. Types of Risks in Investment Banking

The management of risks depends on the identification of the types of risks and hence the development of an approach method for the mitigation of the associated negative outcomes (Dionne, 2013).  For instance, the Basel Accord that provides regulations for the supervision of banks provides that any risk management framework should incorporate the identification of the main categories of risks (McAleer, Jiménez-Martín, and Pérez-Amaral, 2013). A further purpose of the Basel series of agreements

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