Volume 18 (2025)

Each volume of Journal of Risk Management in Financial Institutions consists of four, quarterly, 100-page issues published both in print and online.

The papers published in Volume 18 are listed below.

Volume 18 Number 2

Editorial
Weighing risk in an uncertain world
Julie Kerry, Publisher
Opinion
A new framework for comparing financial stability risks
Colin Ellis, Visiting Professor of Finance, Hult International Business School

Since the global financial crisis of 2007/08, policymakers and market participants alike have paid more attention to financial stability risks, alongside a more longstanding focus on macroeconomic developments. While the emphasis on such risks is welcome, however, it can often be focused solely on specific concerns or issues; there has been relatively little attempt to assess different financial stability risks relative to one another. This opinion piece proposes a simple approach for doing so, based on the building blocks of classical credit analysis. It describes and illustrates a new way of presenting different financial stability risks relative to one another, which would enhance the analysis of both risk managers and policymakers alike.
Keywords: financial stability; systemic risk; relative rank assessment
Practice Papers
Operational risk stress testing: Challenges and approaches
Michael Grimwade, Head of Operational Risk, ICBC Standard Bank

Over the course of the last three decades, arguably, operational risk’s most important characteristic has been its sensitivity to economic shocks, making it correlated with both credit and market risk losses. Outside of periods of economic stress it is decidedly idiosyncratic. This sensitivity is underpinned by very complex interactions between rapid and significant changes in economic metrics and human behaviours. Consequently, while stress testing operational risk is clearly important, it remains challenging for companies and regulators alike. In order to address this problem, this paper analyses historical loss data to demonstrate that economic shocks may variously influence the occurrence of operational risk events, trigger the detection of both historical and on-going events, and exacerbate the severity of any resulting losses. This leads to a variety of inherent challenges for quantifying this economic sensitivity, including the difficulties of predicting how the behaviours of different stakeholders may change, and also of assessing the detection of previously unknown issues. Additionally, existing Pillar 1 and 2A capital requirements may already reflect operational risk losses suffered during previous economic shocks, as there is no recognised methodology for excluding operational risk losses that are sensitive to economic shocks from a bank’s minimum capital requirements. There are a range of differing approaches to stress testing propounded by the Bank of England (BoE)/the Prudential Regulation Authority (PRA), the European Banking Authority (EBA) and the US Federal Reserve, which variously address these challenges. This paper concludes that there is no magic bullet, and hence it proposes that companies triangulate between a portfolio of approaches, including qualitative and quantitative assessments, stressed modelled losses, and the EBA’s floor calculations. It also suggests that the balance between minimum capital requirements and loss-absorbing buffers should be fundamentally shifted to reflect how operational risk actually behaves, to address the current double counting of stresses within Pillar 1 and 2A capital requirements, and to make operational risk capital more useable by banks. Finally, a significant part of the value of the stress testing process arises from companies identifying their vulnerabilities and determining the mitigating actions that need to be taken at the outset and during an economic shock.
Keywords: operational risk; stress testing; scenario analysis; real options
Dynamic deposit behaviours in IRRBB: Enhancing risk management through sensitivity analysis
Chih Chen, Senior Vice President, Asset Liability Management, East West Bank

The banking industry is inherently exposed to interest rate risk, which arises from the mismatch between the interest rate sensitivities of assets and liabilities. This mismatch can lead to significant fluctuations in a bank’s net interest income (NII) and economic value of equity (EVE) when interest rates change. In recent years, dynamic deposit behaviours have emerged as a significant factor influencing interest rate risk in the banking book (IRRBB). Conventional asset liability management (ALM) models often overlook the evolving nature of deposit betas, product mixes and decay rates, resulting in suboptimal risk assessments. This paper advocates for integrating dynamic modelling approaches while acknowledging the importance of sensitivity analysis to bridge the gap between static and dynamic frameworks. By embedding these techniques into ALM practices, banks can improve IRRBB management, effectively balancing complexity and simplicity while better addressing depositor behaviour in fluctuating interest rate environments.
Keywords: deposit modelling; sensitivity analysis; interest rate risk in the banking book (IRRBB); deposit betas; net interest income (NII); economic value of equity (EVE); asset liability management (ALM)
Unveiling market turning points: Analysing skewness, kurtosis and Hurst exponent in intraday data
Clemens Kownatzki, Associate Professor of Finance and Associate Dean of Academic Programs, Pepperdine Graziadio Business School, and Jungjun Park, Assistant Professor of Economics, St. Lawrence University

Predicting major turning points in the market has often been dismissed as a fool’s errand, and yet, there is no shortage of practitioners or researchers attempting to do so. This paper offers such an attempt, as it examines intraday market dynamics during significant reversals using skewness, kurtosis and the Hurst exponent as primary variables of interest. The paper analyses minute-by-minute data of the S&P 500 (SPX) and NASDAQ 100 (NDX), with the goal of identifying patterns that precede market peaks and troughs. Focusing on specific periods during the COVID-19 pandemic and the great financial crisis (GFC), the findings of this study reveal that during market tops, skewness becomes more negative, kurtosis increases and the Hurst exponent is trending upwards. The exact opposite trends were observed just before a market bottom. These results provide valuable insights and a good analysis framework to better understand market dynamics at a high-frequency level. The paper also proposes numerous extensions for further research to transform these observations into actionable strategies for investors as well as risk managers.
Keywords: market reversals; risk management; risk models; high-frequency data
Review of theoretical advancements in AI/ML classification models for credit risk assessment
Lingling Fan, Senior Manager in Retail Models and Analytics, Scotiabank

In the realm of credit risk assessment, the utilisation of artificial intelligence (AI) and machine learning (ML) classification models has become increasingly prevalent. This paper thoroughly investigates latest advancements in AI/ML classification models for credit risk assessment, which are crucial for assessing the creditworthiness of individuals and businesses. Key findings reveal that modern AI/ML techniques, particularly Random Forest and XGBoost, outperform traditional logistic regression methods. Additionally, interpretability techniques, including Shapley Additive exPlanations (SHAP) and feature importance analysis, improve the understanding and transparency of model predictions. This paper synthesises recent research findings and industry developments to provide practitioners and researchers with insights into model selection, evaluation metrics and explanation techniques, thereby contributing to the ongoing evolution of credit risk management strategies in the financial sector.
Keywords: credit risk assessment; artificial intelligence; machine learning
Risk transfer for MDBs: Transferring risk to lend more
William Perraudin, Managing Director, Risk Control Limited, Federico Galizia, Risk and Finance, Andrew Powell, Distinguished Visiting Professor, Williams College and Non-Resident Fellow, Center for Global Development, and Timothy Turner, Senior Adviser, Trade and Development Bank

Long-term development finance provided by multilateral development banks (MDBs) is key to advancing the United Nations’ Sustainable Development Goals (UN SDGs). MDBs are, however, constrained by the availability of capital. Risk transfer can shift risk from their balance sheets to expand lending. This paper explains how ground-breaking securitisation transactions have been used by MDBs and argues that, while there are challenges, this technique has significant potential to increase development lending.
Keywords: risk transfer; international financial architecture; G20; multilateral development banks; securitisation; rating agencies; preferred creditor treatment; development

Volume 18 Number 1

Editorial
Julie Kerry, Publisher
Opinion/Comment
The human factor in operational risk management
Bart Martens, Independent Contractor, BaGaRaMa LLC

Since the conception of operational risk management and the need for regulators to calculate and require adequate levels of capital, this discipline has developed and matured, supported by an ever-growing amount of data, techniques and taxonomies. This paper seeks to escape from the complex technical aspects of the discipline for just a moment, and to refocus on the human factors and their limitations when designing and applying an operational risk management framework in the first place. Consequently, this is a personal and perhaps somewhat philosophical view on how an operational risk management framework could be infused with a more explicit and uniquely human perspective, to embed the technical aspects of the discipline in a broader sense of purpose and meaning. More than merely pondering, the paper concludes with some initial recommendations on how to follow through and to apply the consequences of these thoughts onto an operational risk management framework.
Keywords: operational risk; operational risk management; operational risk management framework; oversight; governance; decision hygiene; humanities; philosophy
Practice Papers
Risk management, the board and the C-suite: The adaptive art of communication in times of change
Rosa Cocozza, Professor of Banking and Finance, University of Naples Federico II

Financial institutions have always been tasked with mitigating risks due to their role in financial markets. Risk management is a fundamental component of financial intermediation, which since the late 1970s has become more structured, demanding more sophisticated tools and techniques and requiring Chief Risk Officers (CRO) to possess advanced technical skills, particularly in the hard sciences. Nevertheless, technical skills are not the sole expertise required nowadays; the participation of risk managers in strategic meetings calls for negotiation skills to interact with those responsible for drafting the business plan, typically the Chief Financial Officer (CFO), and communication skills to connect with board members who set the strategic direction. While negotiation can be mediated through the General Manager (GM) or the Chief Executive Officer (CEO), communication with the board is direct and immediate. Traditionally, effective communication is not generally regarded as a typical quality of financial risk managers, since this is a substantially different skill from the technical expertise needed. Regulators require that banks implement company-wide risk management frameworks with the use of analytical models for the measurement and control of quantifiable risks. In addition, corporate governance guidelines advocate for the ‘business partner’ role in risk management. The question is: how do risk officers balance their dual role as a ‘compliance champion’ and a ‘business partner’? Effective communication may provide a solution. This paper outlines the goals and tools for effective communication for risk management to enable sound decision making and thereby counteract the group thinking that may lead to poor decisions, often resulting in an imbalance between risk taking and control that can undermine the operational resilience of banks.
Keywords: Chief Risk Officer; corporate governance; effective communication; group thinking; reporting; risk culture; soft skill
Transitioning to a low-GHG economy: ESG differentiated pricing as a dynamic transition tool and its calibration
Bogie Ozdemir, Co-Founder, RiskVision Inc.

This paper provides an in-depth discussion on the challenging task of transition that financial institutions (FIs) face in the context of key regulatory, market and competitive dynamics. In response to the necessary transition to a low-greenhouse gas (GHG) economy, FIs will need to adjust their business model and strategy to ensure future viability. Consequently, they need to change their asset mix from brown industries to green industries and direct their financing towards green activities and companies with favourable environmental, social and governance (ESG scores). They will need to do this in an orderly fashion, striking the right balance between future readiness and remaining sufficiently competitive and profitable along the way. To do that they need transition tools that allow them to steer their portfolio mix and activities towards the future low carbon economy, enable them to get paid for the ESG risks they take and ensure that they remain in control so that they can adjust and correct their lending mix as needed. In this paper, a transition tool that incorporates ESG risk into pricing is discussed. The proposed three-layer framework incorporates industry and loan purpose effects, as well as borrowers’ ESG scores as an idiosyncratic element. The calibration of the tool is explained using numerical examples.
Keywords: environmental risk; pricing; transition risk; ESG; green financing; banking capital and funding
Navigating the storm: How can insurers better prepare for the impact of climate change
Hala Naseeb, Trainer, Bahrain Institute of Banking and Finance

Climate change is forever changing the risk environment for insurers and their customers. A recent example of this is the intense storm witnessed by the people of Bahrain and around the region on the eve of 16th April, 2024. There were minimal preparations made by either insurers or their customers, resulting in severe disruptions to daily life and property damage. To mitigate this, insurers need risk management programmes that move beyond traditional solutions to deal with climate change. These risk management solutions must be varied to cover all aspects of an insurance operation and provide customer value. Solutions can be focused on changing policy cover terms, new product development, altered investment strategies, use of technology and innovation, and engagement with the public. There are challenges, however, such as the availability and credibility of data, affordability and social equity, uncertain regulations and rising costs. Yet, the consequences of not acting on climate change will be higher for insurers eventually.
Keywords: climate change; weather events; disasters; storm; insurance; risk management; property damage
New legal risks for banks related to climate change and possible mitigation strategies
Udo Milkau, Digital Counsellor

Anthropogenic global warming and climate change-related risks are facts. While physical risk (which can cause damage and losses) and transition risks (due to disorderly policies and transition pathways) are generally understood, new types of risk for financial institutions are emerging in banking supervision and in so-called climate change litigation. An example of the former is the new ‘risk from misalignment’ of banks with European Union (EU) climate objectives, as recently discussed by the European Central Bank (ECB). This risk is caused by the requirement to align with EU climate change goals, which may not be compatible with the path a financial institution in a market economy might choose to adopt during the transition to cleaner energy. The second development is driven by climate activists suing banks in ‘strategic litigations’ based on the concept of ‘duty of care’, which may not require causality as a legal precondition. While these developments can be debated, they are likely to be the ‘new normal’ for financial institutions. It is proposed that these new types of climate change-related legal risks can be managed through a four-step mitigation approach as an iterative process of awareness, monitoring, active mitigation and observing emerging trends.
Keywords: climate change-related legal risks; strategic litigation; alignment to objectives; causality; transition plans; mitigation approach
Cyberwashing: The disconnect between cyber security claims and real practices
Nigel Phair, Professor, Information Technology, Monash University

Cyber security continues to be an issue for organisations, particularly those that collect and use personal information. The implementation of a robust risk assessment and detailed control framework which is focused on addressing key threats is critical to achieving cyber resilience. Some organisations are keen to espouse their cyber security credentials, often in an effort to satisfy regulators, assure stakeholders and placate consumers. Regardless of this rhetoric, however, some of these organisations still suffer from a cyberattack. What does it mean when these words are not put into practice?
Keywords: cyber washing; cyber; risk management; incident response; cyber resilience; regulation
China Trade Exposure Index: Using principal component analysis to compare countries’ exposure to the Chinese economy
Tuuli McCully, Senior Economist, Bank of Finland Institute for Emerging Economies

This paper studies countries’ economic dependence on China through trade. As China’s importance in the world economy has grown significantly in recent years, developments in China will increasingly be reflected in its trading partners’ economic performance. Therefore, measuring and identifying countries’ economic exposure to China has become increasingly relevant. Responding to the need by risk management practitioners in financial institutions, the paper builds a tool to measure and compare countries’ exposure to the Chinese economy through trade channels, using principal component analysis. The resultant China Trade Exposure Index ranks countries based on their economic dependence on trade with China. The utilisation possibilities of the index are broad, yet the most obvious application is in financial institutions’ stress testing exercises. Indeed, the index can be used in a China-specific stress testing scenario to transmit a shock to other countries according to their China dependence. To validate the relevance of the index, the paper further shows that the China Trade Exposure Index is significant in explaining countries’ cyclical economic growth co-movement with China, with a higher ranking implying a stronger real gross domestic product (GDP) growth correlation. Therefore, the China Trade Exposure Index helps global investors, risk professionals and policymakers in analysing potential China-related country risks.
Keywords: trade exposure; economic dependence; principal component analysis; risk management; stress testing