Volume 17 (2024)

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 17 are listed below:

Volume 17 Number 4

Editorial
Editorial: The changing face of operational resilience
Simon Hall, Head of Division, Prudential Policy Directorate, Bank of England
Practice Papers
Commercial real estate exposure and bank counterparty risk
Paul H. Kupiec, Senior Fellow, American Enterprise Institute

Detailed analysis of December 2023 bank regulatory data suggests that unrealised interest rate losses in the banking system amplify banks' true commercial real estate (CRE) loan concentrations making CRE exposures much more consequential than traditional supervisory CRE loan concentration measures suggest. Taken together, weak demand for several types of commercial properties, sustained unexpectedly high interest rates and the concentration of CRE loans in many bank portfolios may magnify the risk of many financial institution's uncollateralised exposures to bank counterparties.
Keywords: commercial real estate; CRE; bank counterparty credit risk
Silicon Valley Bank: What can be learned from its collapse
Steve Lindo, Co-Principal, Intelligent Risk Management LLC

The collapse of Silicon Valley Bank (SVB) in March 2023 and its resulting impact on global banking markets have already been exhaustively reported and analysed. This paper examines these events through two different but complementary lenses, root cause analysis and key assumptions check. Together, these methods provide a detailed picture of the causes and derive fact-based conclusions intended to prevent repetition of the mistakes made by SVB's executives and the US banking authorities.
Keywords: Silicon Valley Bank; SVB; risk management; root cause analysis; key assumptions check; bank asset-liability management; ALM
Model risk management in stress testing: The road up to here
Eduardo Canabarro, Financial Analyst and Investor

This paper reviews the historical evolution of the quantitative models, model usage and model risk management (MRM) in large US banks since the 1980s. It comments on the most significant model-related events through this period. Some of these events were associated with contexts of great stress to the financial system. The paper identifies the main features of modelling in finance and economics that distinguish it from its application in the natural sciences. Then it presents the different types of models used in the large banks' stress testing programmes, the specific characteristics and risks of each type of model and the best practices for the implementation of sound model risk management, and it suggests a proper way to interpret the results of stress testing and capital assessment in the presence of model risks. The paper discusses the future evolution of MRM towards the implementation of a `fully fledged risk management framework` along the lines of other risk management disciplines, including risk identification, measurement, monitoring, reporting, limiting and capitalisation. It acknowledges the enhancements and opportunities offered by advances in the use of artificial intelligence and machine learning as well as increases in computational power. The paper concludes by noting that the model risk management framework that has been enforced by the Federal Reserve's stress testing and capital planning programmes has substantially strengthened the capital position, profitability and resilience of the large banks in the US.
Keywords: stress testing; capital planning; model risk; models; CCAR; DFAST; banks
Dear CRO: Behavioural risk management is the new thing for you
Wieke Scholten, Managing Director, Co-Founder, BR Insights, and Alexandra Chesterfield, Head of Behavioural Risk, Group Internal Audit, NatWest Group, and PhD Candidate, London School of Economics

Behavioural risk management (BRM) helps to better prevent risk events that can hurt financial services firms, their customers, shareholders and society. Underpinned by methods and insights from across the behavioural sciences (such as organisational and social psychology, decision making and cognitive science, etc), this forward-looking risk management approach is increasingly encouraged by regulators and invested in by financial institutions globally. This paper provides a practical three-step approach to manage behavioural risk, illustrated with financial services case studies. Future developments are then discussed. The paper closes with common implicit beliefs that may hinder senior risk management professionals initiating BRM in their organisations and a manifesto for action to help get started.
Keywords: behavioural risk; risk management; audit; behavioural science; culture; ethics; financial services
Operational resilience implementation challenges and opportunities for the UK building societies
Adewale A. Ademowo, Technology Risk Manager, Bank of England

Operational resilience is the preparedness and existence of resilient IT systems, processes and resources to provide services continuously during a disruption. This study examines the operational resilience implementation challenges and opportunities for UK building societies and wider financial institutions. The key challenges are resource constraints, understanding regulatory requirements, supplier concerns, domain knowledge, legacy systems and manual-driven processes. Some challenges are being addressed with awareness and training, improved governance and risk management, recruitment and industry support networks. The opportunities include realising the actual state of IT systems, adopting cloud solutions, resources and capabilities, as well as improved domain knowledge and a better understanding of services and markets. Regulators need to be more explicit about their expectations and requirements, while the industry needs to collaborate on setting up common frames of reference for operational resilience frameworks. Lastly, the study provides a holistic view of operational resilience, including its implementation and management challenges, control measures and emerging opportunities.
Keywords: operational resilience; operational risk; risk management; financial services; resilience framework; business continuity; disaster recovery
Research Papers
Are ESG scores driven by financial information? Evidence from European banks
Luana Serino, Assistant Professor of Finance, Department of Economics and Management, Università Telematica Pegaso, Alessia Spignese, PhD student, University of Campania L. Vanvitelli, and Francesco Campanella, Full Professor in Corporate Finance, University of Campania L. Vanvitelli

In recent years, investors' increasing focus on sustainable investments and the sustainability orientation of companies has led to parallel growth in the market for environmental, social and governance (ESG) performance and ESG rating agencies. However, even though ESG rating agencies have become very influential institutions, the literature has found that ESG performance ratings provided by different agencies often differ from each other. This causes consequences that should be considered, such as complex evaluation of companies' ESG performance and uncertainty in ESG investment decisions. Therefore, it is necessary to identify which determinants influence ESG performance. This study aims to identify the internal determinants of an ESG score using bank-specific balance sheet indicators such as capital and risk ratios. The analysis focuses on the European banking sector from 2018 to 2022. Banks mainly foster the transition to a more inclusive and sustainable economy. Moreover, after the recent financial crises, banks have increased their social responsibility practices, strengthening their credibility, trust and reputation. Generalised estimating equations with standard error robust to heteroscedasticity were used. The results reveal that the factors that most influence the ESG score provided by ESG rating agencies are bank size and liquidity risk exposure. The larger the size of the bank and the lower the exposure to liquidity risk, the higher the ESG score assigned.
Keywords: banking system; credit risk; liquidity risk; ESG rating; financial risk; GEE model
Assessing stochastic dominance of downside and upside financial risk profiles using the block maxima method in extreme value theory
Simon Li, Postdoctoral Research Fellow, The Hang Seng University of Hong Kong

This paper aims to assess the stochastic dominance of the extreme downside (negative return) and upside (positive return) risk profiles of three US stock market indices, namely NASDAQ Composite, S&P 500 and Dow Jones Industrial Average (DJIA) based on the block maxima method in extreme value theory. The extreme downside and upside risk profiles were developed using two datasets of 360 monthly minimum and maximum daily log returns respectively (from January 1992 to December 2021). Extreme losses beyond the 80th percentile (corresponding to a tail probability of less than 0.2) of the theoretical extreme risk profiles were adopted to investigate stochastic dominance. Pairwise comparisons show that the DJIA stochastically dominates the other two indices in both extreme negative and positive returns. Moreover, the extreme upside risk profile of the DJIA stochastically dominates its extreme downside risk profile. The paper finds that investment in short positions (encountering upside risk) provides the least extreme risk compared with long positions (encountering downside risk) for the DJIA, as well as both short and long positions for the S&P 500 and NASDAQ Composite.
Keywords: extreme risk measurement; risk-aversion investment; stock market index

Volume 17 Number 3

Editorial
Editorial: Facing the polycrisis
Julie Kerry, Publisher
Practice Papers
Bank liquidity risk management through stable and volatile markets: The role of the asset-liability committee and lessons learned for the balance sheet governance operating model
Moorad Choudhry, Founder, The BTRM, Claire Trythall, Faculty, The BTRM, and Diyama Abu Laban, Department of Finance and Banking, Birzeit University
This study examines the balance sheet management governance operating model of selected failed banks from 2007, 2008, 2009 and 2023, with emphasis on the corporate governance structure in place and the position of the asset-liability committee (ALCO), and draws conclusions and recommendations for future policy. All failed sample banks exhibited near-identical governance frameworks for management and oversight of balance sheet risk: namely an ALCO that reported to the senior executive management committee, and was at least two levels, if not three levels, below board level. It is inferred that, as the ultimate responsible and accountable forum for ensuring balance sheet viability and continuing going concern of the bank, the board would benefit from being closer to the balance sheet risk management process. This implies changing the governance structure such that the ALCO is closer to the board itself, and able to provide direct comfort to the board that the bank's capital and liquidity risks are being managed appropriately. The following bank governance measures are recommended, to be imposed by regulatory fiat if necessary:
• Direct delegated authority of the ALCO to manage the balance sheet, from a long-term robustness and viability perspective, directly on behalf of the board.
• The ALCO to report directly to the board, rather than via the executive management committee (or as an alternative approach, changed to become a sub-committee of the board). This recognises that the asset-liability management (ALM) discipline is at least as important as, if not more important than, the ‘audit’ oversight function undertaken by the board audit committee.
• Technical expertise at ALCO and board level that is capable of discerning the genuine capital and liquidity risk exposure position of the bank, on a medium-term forward-looking basis, at all times.
Keywords: capital; liquidity risk; asset-liability management (ALM); asset-liability committee (ALCO)
Silicon Valley Bank case study: The role of the CRO in managing risk programmes to prevent bank failures
Steven Haynes, Director of Risk Management and Cybersecurity Programmes and Assistant Professor of Practice, University of Texas at Dallas

Financial disasters can have catastrophic consequences for economies that extend beyond the organisational walls. This case study will examine the downfall of Silicon Valley Bank by exploring ineffective risk management practices and the absence of the Chief Risk Officer (CRO). It will begin by establishing a basic understanding of the bank's history and client base before diving into the events that led up to the third-largest bank run in US history. In our upcoming discussion, we will delve into the risk management standards that financial organisations typically employ to avoid insolvency. Additionally, we will emphasise the pivotal importance of the CRO role within such institutions. Finally, the study will conclude by emphasising the critical role of robust risk management practices, effective regulatory oversight and organisational reforms in mitigating the risks associated with financial disasters and safeguarding the resilience of the banking ecosystem. Understanding the impacts and lessons of past financial disasters is essential to build a more stable and resilient economic landscape as the financial system evolves.
Keywords: financial disasters; Silicon Valley Bank; risk management; Chief Risk Officer; CRO; bank run; regulatory oversight; organisational culture
The blind spot in residential mortgages: Increasing default option value in the face of declining house prices
Bogie Ozdemir, Co-Founder, RiskVision

The interest rate hikes intended to combat inflation have not only significantly increased mortgage payments, but also significantly depressed house prices. The probability of default for mortgages is typically estimated through the debt servicing ability of the obligor. The alternative estimation based on the default option, although well studied in literature, is typically not used by practitioners. This option is normally ‘deep out of money’ and moves in the money if the loan to value (LTV) increases significantly, even creating negative equity. This is typically a remote probability due to the down payment requirements, but not as much under the current environment, where the house price depreciation has significantly increased LTVs, especially for newer mortgages underwritten when house prices were at their peak. This paper discusses the potential risk management oversights in this environment, illustrating that the increasing default risk is not adequately captured in probability of default (PD) models based on debt servicing ability alone. This is also true for the loss given default (LGD) risk if the contemporaneous LTV effects are not captured. Numerical examples are provided to demonstrate the material increase in PD, LGD and the combined expected loss risk with increasing LTV. It also discusses an alternative default option PD model, its calibration and its usage for stress testing along with LGD modelling, which together capture the contemporaneous LTV effects.
Keywords: credit risk management; stress testing; probability of default; PD; modelling; loss given default; LGD; modelling; residential mortgages; default option
An innovative approach for optimising CCP default management through agent-based modelling
Richard Wise, Group Chief Risk Office, Tao Chen, Group Head of Quantitative Risk Management, and Dingqiu Zhu, Head of Quantitative Solution, Quantitative Risk Management Department, Hong Kong Exchanges & Clearing Ltd

This paper develops a rigorous model to analyse the market impact of liquidation. Invoking innovative techniques from agent-based simulation, we construct the order book's reaction function to liquidation. A methodology is then developed for establishing the optimal close-out strategy which balances the velocity of positional liquidation with that consequential market reaction function. This model can be used in parallel to more traditional calculations of market volatility to ensure that the overall risk capitalisation of a central clearing counterparty remains robust. In the case of financial markets, agent-based models often seek to account for the so-called stylised facts of financial markets. Stylised facts are simply empirical regularities that appear to be stable across markets and over time. Such facts range from statistical concepts, such as the distribution of returns, to more abstract notions such as stock market bubbles and crashes.
Keywords: margin; concentration risk; liquidity risk; central clearing counterparty; CCP; default management; agent-based model; ABM
Navigating the storm: The intersection of geopolitical and financial crime risks
Rosamund de Sybel, Head of Geopolitical Risk, Financial Crime Compliance, ICBC Standard Bank

The world is facing an incredibly complex set of global risks, from conflict in Europe and the Middle East, to climate change and food and energy insecurity. As we progress into 2024, we are seeing an intensification of recent trends: geopolitical instability is accelerating the use of economic statecraft and asymmetric tools of financial conflict. These tools are used as both alternatives and additions to hard power. This paper argues that risks to global financial institutions are increasingly characterised by this nexus. Against a backdrop of multiplying wars, the geopolitical activities of treasury departments are becoming more pronounced. This paper addresses how some of these financial and economic tools are deployed and the nature of the risks that have emerged as a result, particularly as the targets of economic statecraft seek to counter them. The paper also considers how financial institutions can build resilience in their organisations by situating geopolitics effectively within financial crime compliance frameworks.
Keywords: geopolitics; sanctions; financial flows; economic statecraft; conflict; financial crime
Climate risk and financial stability: Assessing non-performing loans in Chinese banks
Hatem Brik, Assistant Professor in Finance, Taibah University and Member of Research Unit GEF2A Lab, University of Tunis

Climate change poses significant challenges across various sectors, particularly within the financial realm, where the stability of banking systems is paramount. Non-performing loans (NPLs), as critical indicators of financial health, may be considerably influenced by climatic factors. This study delves into the impact of climate change on NPLs within the Chinese banking sector from 2010 to 2022, focusing on the influence of greenhouse gas (GHG) emissions. Utilising a comprehensive dataset and advanced econometric models (including panel quantile regression, sensitivity analysis and balanced panel data models), this research illuminates the intricate relationship between environmental changes and financial health. The research also discovers a significant climate change impact on NPLs, with increased GHG emissions leading to varied responses among banks. This variation reflects the different risk profiles and adaptive capacities of banks to climate-related financial risks. Banks demonstrating higher adaptability to climate change exhibit lower NPL ratios, underscoring the importance of strategic risk management and proactive adaptation in the banking sector. The research significantly advances the understanding of the financial implications of climate change and the interplay of climate variables with financial stability. It offers crucial insights for policy makers and banking institutions, emphasising the need to integrate climate risk into financial decision making and develop robust climate-resilient strategies for the banking sector's protection. In conclusion, the study enriches the discourse on the financial impacts of climate change and serves as an informative guide for stakeholders in navigating and addressing these emerging challenges. It underscores the necessity of embedding environmental considerations within banking practices to promote a resilient and sustainable financial system in the face of environmental uncertainties.
Keywords: climate change; non-performing loans; NPLs; Chinese banking sector; financial risk management; panel data econometrics; sensitivity analysis; financial stability
Nature-related financial risks and central bank risk management
Olaf Barning, Economist, Dirk Broeders, Senior Financial Risk Manager, Marleen de Jonge, Economist, Isabelle Tiems, Economist, Niek Verhoeven, Senior Economist, and Catharine van Wijmen, Senior Responsible Investment Specialist, Central Bank of the Netherlands

Nature is undergoing a rapid decline, due to factors such as changes in land use, climate change and pollution, potentially leading to the sixth mass extinction of species. This process jeopardises ecosystem services and therewith the global economy. Over half of the global economy relies on nature and its degradation can affect supply chains, weather patterns, commodity prices and economic growth prospects. This paper finds that nature-related risks are in fact financial risks and offers empirical evidence that these risks are priced in corporate bonds, a relevant asset class for central banks. In light of this, central banks can acknowledge and evaluate the impact and dependency of their operations on nature, incorporating these considerations into their risk management framework, encompassing identification, assessment, mitigation and disclosure. This will help to ensure price stability and sustainable development, while enabling them to safeguard their balance sheets. The guidelines provided by this paper extend to other financial institutions, underscoring the need for a holistic approach to the challenges posed by nature loss.
Keywords: nature-related financial risks; biodiversity loss; central banks; risk management

Volume 17 Number 2

Special issue: Boards of Directors and Risk: The Governance of Risk-Taking and the Embrace of a Dynamic Future
Guest Editor: David R. Koenig, President and Chief Executive Officer, The DCRO Institute

Editorial
Learning to embrace risk: The board’s most important Duty of Care
David R. Koenig, President and Chief Executive Officer, The DCRO Institute
Special Issue Papers
Opinion Paper
Safeguarding financial resilience through digital trust and responsible innovation
Ingrid Vasiliu-Feltes, Ethicist, author, Corporate Leader and Digital Health Expert, RevExpo Consulting LLC
In the rapidly evolving financial industry landscape, the convergence of digital and physical realms, known as the ‘phygital era’, presents novel challenges for boards that aim to build digital trust and strengthen their financial resilience while fostering responsible innovation and maintaining their competitive edge in the global business arena. These encompass people management, processes and their digital technology portfolio. Building a new phygital culture, upskilling and reskilling the workforce, deploying a mix of intelligent automation and hybrid augmented workflows and deploying frontier technologies responsibly are now on the agenda for forward-thinking boards. The latest deep tech innovation trends in financial services offer exponential pathways for innovative solutions yet increase cybersecurity threats, create new ethical dilemmas and demand a new risk tolerance from board executives. Novel risk management styles, the value of harmonising cyber and ethics programmes, and leadership traits are potentially viable solutions for risk management at the board level in this phygital era. This paper proposes a trifecta that financial industry boards can embrace to adapt their risk governance to the demands of this phygital era: zero trust cybersecurity, ethics by design and risk management by design. By deploying this combination of strategies, boards within the finance industry can successfully navigate the complexities of the phygital era and steer their organisations towards a more secure, trustworthy and sustainable future.
Keywords: phygital; risk; governance; ethics; cybersecurity; innovation; leadership
Practice Papers
Dynamic board capabilities: Developing board practices that impact corporate renewal and performance
Liselotte Engstam, Founder, Digoshen, Adviser and Research Scientist, & Professional Board Member, KTH Royal Institute of Technology, Henrik Forzelius Doctoral Student, Department of Engineering Design, KTH Royal Institute of Technology, Mats Magnusson, Professor, Department of Engineering Design, KTH Royal Institute of Technology, Fernanda Torre, CEO, Next Agents & Affiliated with the House of Innovation, Stockholm School of Economics and Ludo Van der Heyden, Chaired Professor Emeritus in Corporate Governance, INSEAD & Distinguished Scholar, International Institute for Management Development

A crucial requirement for firms to remain competitive is to consistently and simultaneously engage in exploratory and exploitative activities. The academic literature has broadly accepted that the development of dynamic capabilities (ie firms' abilities to create, reconfigure and improve resources and capabilities to fit their changing environments) are vital to meeting this competitive requirement. Research has predominately addressed these dynamic capabilities from a management perspective. Little attention has been paid to the influence of the board of directors on these firm capabilities even though boards hold the fiduciary responsibility for the corporation and its long-term viability. Even less has been written on how boards ought to organise themselves and develop their dynamic board capabilities to support and govern corporate renewal and performance effectively. This paper aims to start addressing this gap by using two related aims. First, a process framework for board behaviours is proposed that ensures, and supports, a systematic way of building and developing corporate-level dynamic capabilities. Then, evidence is presented and reviewed from a survey of two board member communities which supports the idea that board capabilities are essential for a firm's successful renewal and economic performance, and need to be improved in practice. This framework is closely aligned with well-established components identified by the management literature but differs in having the board as the unit of analysis. A crucial question and action agenda is proposed for boards eager to acquire and develop their dynamic capabilities.
Keywords: board of directors; dynamic capabilities; governance; innovation; organisation; performance; strategy
The rise of sustainability oversight committees as part of modern board governance and oversight: Practical considerations
David Suetens, Independent Non-Executive Director

Given the constantly evolving landscape, the intersection between corporate governance and sustainability has become a key topic for board members, shareholders and regulators who are seeking to ensure that companies remain competitive as well as relevant. This paper outlines how boards can become more effective in formulating strategic responses to the sustainability agenda through the creation of a specific sustainability committee, which is distinct from the risk and audit committees. It presents arguments for the creation of such a capacity, illustrating them with specific examples (such as materiality assessments). Focus is placed on the interactions with other key governance bodies (the risk, audit and remuneration committees) when such a governance body is being created, and it is suggested that solely applying a risk or audit lens is not sufficient and may create additional gaps in oversight. Finally, the paper discusses how a sustainability committee can become a ‘learning’ governance body, accelerating a sound understanding of how sustainability considerations can affect the strategy, opportunities and risks facing the company at different levels.
Keywords: sustainability governance; sustainability oversight; corporate governance; climate agenda; sustainability strategy; ownership; sustainability education; board oversight
Risk appetite: A crucial consideration for effective board risk oversight
Christopher E. Mandel, Instructor of the ERM Practice, Embry-Riddle Aeronautical University and Soubhagya Parija, Former Chief Risk Officer, FirstEnergy Corp.

Progressive risk management has, among other things, inferred that effectively managing risk requires significant commitment to a risk appetite framework (RAF) that educates, trains and enables decision makers to make risk decisions in the context of understanding risk-taking capacity, preference and, ultimately, need. The starting point for this assumes a reliable measure of the current levels of risk has already been taken to understand the wherewithal to take incremental risk — taken for its potential to increase value. Yet, the need for commitment and investment by leadership can be hard to secure. Proving the value and reliability of a RAF is also not easily accomplished. Thus, RAFs have not been widely established across different industries, not nearly as much as in the financial services.
Research shows that proving RAFs' impacts on performance is necessary for successful implementation. Both the literature and testimonies of successful practitioners demonstrate that risk culture, strategic priorities, board risk oversight requirements, effective communications to stakeholders, reliable quantification of risk and a commitment to quality decision making that sufficiently considers relevant risks are all crucial to successfully managing risk taking guided by a RAF. Thus, after being properly designed, thoroughly tested and ultimately approved by senior management and the board, a risk appetite strategy (RAS) and RAF can be instrumental in more effectively managing and creating value, ultimately leading to a more resilient enterprise. This paper will delve into the many elements of RAFs, allowing the reader to fully understand why management and governance should support their use. It will cover the challenges that practitioners face and how to resolve them. It will also provide a step-by-step methodology for designing, implementing and operationalising a RAS, including the roles of key players in doing so.
Keywords: risk; risk appetite; risk oversight; risk tolerance; governance; performance; decision making
Risk Management Papers
Enterprise risk management in the insurance industry: Trends and future directions
Sonjai Kumar, Scholar in Enterprise Risk Management, Fortune Institute of International Business (FIIB), Purnima Rao, Associate Professor of Finance, Fortune Institute of International Business (FIIB), and Munim Barai, Professor of Finance, Graduate School of Management & Director, Ritsumeikan Center for Asia Pacific Studies, Ritsumeikan Asia Pacific University

The research aims to describe the state of enterprise risk management (ERM) in the insurance sector. It highlights emerging trends in the application of risk management in the insurance sector and thereby reports the prominent research gaps and new avenues for research in ERM. The research adopts a systematic literature review (SLR) approach, using 187 research papers spanning 44 years (1977–2021). The paper identifies the fact that most ERM and insurance sector research is performed in North America and Europe, while developing economies in Asia and Africa lag. The paper establishes a three-way relationship between ERM, risk management (RM) and risk-based capital (RBC) where RM is a subset of ERM and RBC is a driver of ERM. The research shows that very few studies are conducted on risk culture, three lines of defence and the role of chief risk officers. The determinants of ERM identified are board, firm size, audit and risk management committee and corporate governance. The determinants identified for firm value are return on assets, return on equity, profit, Tobin's Q, among others. This research provides a way for academicians, practitioners and policy makers to design effective strategies for implementing ERM in organisations.
Keywords: risk management; enterprise risk management; ERM; insurance; risk-based capital; RBC; risk culture; systematic literature review
Insuring deposits, ensuring stability: A critical evaluation of six decades of deposit insurance in the Indian banking sector
Varda Sardana, Assistant Professor, Jaipuria Institute of Management and Shubham Singhania, Researcher, Delhi Technological University

The deposit insurance system in India is one of the oldest in the world. Though deposit insurance is a well-researched area across the globe, it is relatively unexplored in India. This paper aims to critically evaluate some of the core aspects of the Indian deposit insurer, explicate the strengths and weaknesses of the system, highlight the risks that accrue to the system due to its features and the lessons learned from its 60 years of experience. The study suggests that the Indian deposit insurance system is marred by certain issues, such as irregular revisions of coverage limits, cross-subsidisation, delays in the recovery of settled claims, the restricted role of the insurer and the non-availability of a benchmark for the insurance fund. It further provides policy recommendations for practitioners to overcome these shortcomings and enhance the robustness of the deposit insurer by allowing better risk management under the scheme.
Keywords: deposit insurance; Indian banking; bank risks; risk management; DICGC; bank policies
The relevance of the country and sector effect in global equity returns around COVID-19 and developed and emerging markets
Francis Boateng-Frimpong, Former, Investment Analyst, Pictet Asset Management Ltd, and Amel Bentata, and Rémy Cottet, Senior Quantitative Analysts, Pictet Asset Management SA

This study explores the historical and current explanatory power of country classification and Global Industry Classification Standard sector classification on global equity returns in the equally weighted MSCI All Country World Index. R2 is a crucial statistical tool for risk and portfolio management professionals because it serves as a measure of how much of a portfolio's movements can be explained by factors. Its significance lies in its ability to quantify how dependent a portfolio's risk is on those factors. The country classification's adjusted R2 is dominant in global equities, driven by its dominance within emerging markets (EM). Within developed markets (DM), the country effect's slight dominance over the sector effect has decreased over time — the two have become more balanced since 2015, with the sector effect having a slightly higher adjusted R2 value. There was a drop in the R2 for all classifications during the COVID-19 pandemic. This drop was most significant in the country classification, with a sharp decline to 8.3 per cent, well below its previous historical minimum of 12 per cent, before it rebounded to its historical range. This change drove further analysis into the country effect across EM and DM, where the large drop and rebound were primarily within EM. During this time, the sector effect dropped but remained within its historical range, implying a larger loss of diversification benefit in country effect than in sector effect. The impact of Chinese stocks on country effect within EM is also investigated. In 2018, there was a large influx of Chinese companies into the index, which caused a decline in country diversification and hence a reduction in explanatory power within EM. China's rapid and strict COVID-19 response, early tight monetary policy and regulatory crackdown have since caused it to become increasingly differentiated from the rest of EM, increasing country diversification within EM and causing the accentuated rebound in explanatory power of the country effect post-COVID-19. Risk managers can use these results to validate the use of sector and country classifications in portfolio construction.
Keywords: GICS classification effect; country effect; diversification; portfolio construction; regression; emerging markets; China

Volume 17 Number 1

Special issue: The Value of New Data and Technology to Risk Management Practitioners
Guest editors: Thomas Wilson, CEO, President and Country Manager, Allianz Ayudhya and Christian Pedersen, Managing Director, Strategy & Consulting, Accenture London

Editorial
Thomas Wilson and Christian Pedersen, Guest-editors
Special Issue Papers
Opinion Papers
On data and models: Is more always better?
Thomas C. Wilson, Guest-editor

With regards to data and model sophistication, the new mantra for financial services and FinTech seems to be ‘the more the better’, supported by attractive business cases in risk underwriting, fraud detection, customer lifetime value management, conditional investment risk/return optimisation and improving customer journeys, to name a few. However, more data and more sophisticated models are not always a universal panacea and may lead to bad business outcomes if not managed appropriately in the context of the desired business outcome. This paper summarises the evolving business cases for increasing data and models in the risk management domain and their associated risks. Making the associated risks transparent naturally leads to the conclusion that a timeless risk mitigation approach — common sense — is critically necessary to complement the more structured model risk management (MRM) framework that is evolving.
Keywords: data; models; risk management; insurance; analytics; artificial intelligence
Trusted and open corporate data: Why adoption of the LEI/vLEI is key to enhancing risk management practices in the face of rapid digital transformation
Stephan Wolf, CEO, Global Legal Entity Identifier Foundation

As financial institutions increase their participation in the global digital economy, huge opportunities emerge: more efficient and accurate ways to fight fraud and crime through automated processes and real-time industry collaboration and action; the disinhibition of capital flows needed to fuel economic development; the growth of broader and trusted cross-border customer bases, partner networks and supply chains; and, as will be explored more fully through the presentation of a use case, the capability to advance environment stewardship. These are just some of many possibilities, yet new threats materialise as companies digitise and digitalise. Many are connected to the challenge of identity management and verifying the authenticity and integrity of associated entity reference data in digital environments. How do organisations verify the legitimacy of who they are interacting with online? Can they trust the origin and integrity of digital data associated with customers, partners and other stakeholders, and that the data they do have is current and accurate? Here, the Legal Entity Identifier (LEI) together with its digitally verifiable counterpart, the vLEI, can play a crucial enabling role. This paper examines the opportunities and risks that financial institutions face as they embark on digital transformation programmes. It explores the importance of high quality, verified and open legal entity data to enhanced risk management practices. An outline is given of how a universal ISO entity identification standard, the LEI and its digital counterpart, the vLEI, can be used to: verify the identity of companies, their corporate organisational structures and their authorised executives; and to connect an organisation to verified business data, other identifiers, company reports and multiple data sources. A risk management use case will be presented –— the use of the LEI as an environmental, social and governance data connector — to show how the LEI and vLEI can be harnessed by financial institutions to inform better business decision making and create enhanced, even automated, risk management practices within increasingly digital corporate ecosystems.
Keywords: digital identity; identity management; open data; digital transformation; ESG reporting
Practice Papers
Leveraging financial personality for inclusive credit scoring amidst global uncertainty
Diederick van Thiel, Founder/CEO, AdviceRobo, and John Goedee, Professor by special appointment at the Department of Organization Studies, and Roger Leenders, Professor of Intra-Organizational Networks,Tilburg University

The Ukraine war, high inflation and rising interest rates are jeopardising people's ability to afford essential items such as food and energy, causing a widespread sense of vulnerability worldwide. Consequently, access to finance has become increasingly challenging for vulnerable consumer groups, including young adults without established credit histories, senior citizens with fixed incomes, start-up entrepreneurs, sole traders, single parents, immigrants in Western markets. To address this issue, this study explores the potential use of individuals' financial personality for inclusive credit scoring in these uncertain environments. Examining a sample of low-income individuals in the USA and the Netherlands, our psychometric scoring models (PSMs) demonstrate that late payments can be attributed to factors such as financial capability, materialistic tendencies, impulsive buying behaviour, social desirability and attitudes towards debt. These findings provide evidence that PSMs offer a viable solution to advance financial inclusion for vulnerable customer segments amidst global uncertainty.
Keywords: access to finance; inclusive finance; behavioural finance; psychometric credit scoring; financial crisis; responsible lending
Lost in noise? Some thoughts on the use of machine learning in financial market risk measurement
Peter Quell, Head of Portfolio Analytics, DZ BANK AG

Machine learning has permeated almost all areas in which inferences are drawn from financial data. Nevertheless, in financial market risk measurement most machine learning techniques struggle with some inherent difficulties: Financial time series are very noisy, not stationary and mostly considerably short. This paper contains an easy to implement sequential learning algorithm that overcomes some of these disadvantages. It is based on a Kalman filtering mechanism for quite general stochastic processes and provides a first step in the direction of separating parameter dynamics from the ubiquitous noise component. The core idea here is to use some stylised facts inherent to financial markets time series such as time varying measures of volatility. The new approach is tested using real market data in two different settings. First, a hypothetical portfolio containing credit spread and equity risk is analysed over a time frame containing the outbreak of the global pandemic in 2020 and the beginning of the Russian attack on Ukraine in 2022. Another analysis is focused on US$/EUR exchange rate during a time span containing the global financial crisis of 2008 and the subsequent European sovereign crisis. In all test calculations the proposed sequential learning algorithm performs better than the historical simulation approach used by many firms in the banking industry to meet regulatory capital requirements. Due to its simplicity this method has a high degree of explainability and interpretability which will decrease the inherent model risk. The paper concludes with a discussion of model risk for machine learning in financial institutions. Compared to classical model risk frameworks, the emphasis must be put on the more prominent role of data. The simple approach described in this paper shows that machine learning in financial market risk does not have to get lost in noise.
Keywords: market risk; machine learning; Basel regulation; Kalman filter; adaptive methods; model risk
The wicked problem of quantifying and managing non-financial risks: The role of digital technology in providing solutions
Tom Butler, Professor, Business Information Systems, University College Cork and Robert Brooks, European Managing Director, Accenture, Cyber Risk and Regulation

The management of operational risk in financial institutions has all the characteristics of a ‘wicked problem’. Certainly, the repeated efforts of the Bank of International Settlements, (BIS) Basel Committee on Banking Supervision (BCBS) to have banks control and mitigate their operational risks speak to the tractability of extant approaches to addressing them effectively. The original ‘Principles for the Sound Management of Operational Risk’1 and its recent revisions,2 the BCBS ‘Principles for Effective Risk Data Aggregation and Risk Reporting’3 and the ‘Principles for Operational Resilience’,4 collectively offer a sound foundation for addressing this enduring problem. Why then are solutions so elusive for banks to implement? This paper first outlines the institutional and social web of conditions and factors that contribute to the existence of this ‘wicked problem’. It then identifies how AI-based digital technologies can once and for all effectively address the problem of operational risk in large banks. Nevertheless, as powerful as today's digital technologies are, they require an organising vision, particularly if they are to contribute to the management of operational risk. This paper informs such a vision and identifies a comprehensive artificial intelligence-based digital architecture to realise it.
Keywords: operational risk; wicked problem; digital technology; artificial intelligence; enterprise data fabric
The potential impacts of the digital revolution on the operational risk profiles of banks
Michael Grimwade, Managing Director, Operational Risk, ICBC Standard Bank Plc

Society is undergoing a digital revolution. This is altering the business profiles of banks in terms of their systems, processes, controls and usage of third parties; their competitive landscape, ie competition from both digitising incumbents and new BigTech and FinTech entrants; and the behaviours of stakeholders, ranging from customers to cyber-criminals. This digital revolution is amplifying some of their existing risks, while also creating new risks, eg the potential for artificial intelligence (AI) tools to change behaviours over time (AI model drift). Some of these changes in operational risk profile will be transient, as they are associated with digital transformation, while others will be both ongoing and characterised by a high degree of dynamism. In this digitised endstate higher frequency/lower value human errors, may be replaced by lower frequency/higher impact systemic losses, arising from both catastrophic and silent failures. The influence of the digital revolution spans almost all of the Basel operational risk event categories, and may also lead to the enhancement of some controls (eg surveillance), while others may be undermined (eg by voice-spoofing). There is no silver bullet to mitigate these risks; instead, a portfolio of existing control frameworks need to be enhanced, including the following: change management; model risk management; third party vendor management; business continuity management, disaster recovery and operational resilience; and cybersecurity, with new controls required to address the new risks associated with AI. This will be a key factor in the operational risk losses of banks over the next decade.
Keywords: digital revolution; digitisation; artificial intelligence; AI; BigTech; FinTech; operational risk
Risk Management Papers
A generalised latent Poisson factor modelling approach for default correlations in credit portfolios
Mohamed Saidane, Associate Professor, College of Business and Economics, Qassim University

Default risk is one of the major concerns for lending institutions and banking regulators. This paper focuses on the analysis of default data, using a new approach based on generalised latent Poisson factor models. In this case, the correlation structure of the default events is driven by a small number of common latent factors. Conditional to these factors, the defaults become independent and each default sequence is fitted to a generalised linear model with Poisson response and log-link function. This model provides a flexible framework for the computation of the value-at-risk and the expected shortfall of a credit portfolio. The practical implementation of the proposed local Fisher scoring estimation algorithm is illustrated by a Monte Carlo simulation study. Then, a real scenario, with default data taken from a large database provided by Standard & Poor's, is used to analyse the empirical behaviours of the different risk measures. The achieved results show promising performance.
Keywords: default correlation; factor analysis; generalised linear models; expectation-maximisation algorithm; credit value-at-risk; expected shortfall
The mediating role of firm risk: The case of the insurance sector in Saudi Arabia
Shanar Shafi Alsuyayfi, PhD student, Roslan Ja’afar, Senior Lecturer, and Rasidah Mohd Said, Assistant Professor, UKM Graduate School of Business, Universiti Kebangsaan Malaysia

This study aims to examine the mediating effect of firm risk on the relationships between board structure and firm performance. The multivariate panel data regression technique is employed to analyse the mediating impact of firm risk on 27 listed insurance companies on the Saudi Stock Exchange (Tadawul) from 2016 to 2021. The findings of this study indicate that firm risk partially mediates the relationship between audit independence and Tobin's Q. In contrast to the existing literature, the study reveals that boards composed of independent members may lack effectiveness in their monitoring role, leading to higher risk-taking behaviour. This paper contributes to the literature on corporate governance and firm performance by examining the association through the lens of firm risk.
Keywords: firm risk; board structure; mediation; insurance sector; Saudi Arabia
Book Reviews
Handbook of business and climate change by Anant K. Sundaram and Robert G. Hansen
Reviewed by Krzysztof Jajuga, Professor, Department of Financial Investments and Risk Management, Wroclaw University of Economics and Business
Non-financial risk management: Emerging stronger after Covid-19 by Thomas Kaiser
Reviewed by Krzysztof Jajuga, Professor, Department of Financial Investments and Risk Management, Wroclaw University of Economics and Business