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Basics I - Terminology & Concepts

What does risk management refer to?

Risk management in the financial industry refers to the process of identifying, assessing, analyzing, and taking steps to control or eliminate exposure to various types of risk. These risks can include, but are not limited to, market risk, credit risk, liquidity risk, operational risk, and legal risk. The overarching goal of risk management is to maximize an organization's value by minimizing the potential for loss and ensuring financial stability.

The process involves several key steps:

  1. Risk Identification: Recognizing the various risks that an organization faces in its operations, financial transactions, investments, and market activities.

  2. Risk Assessment and Analysis: Evaluating the identified risks to understand their potential impact and the likelihood of their occurrence. This often involves quantitative measures such as Value at Risk (VaR) or qualitative assessments based on expert judgment.

  3. Risk Mitigation Strategies: Developing and implementing strategies to manage, reduce, or transfer risk. This can include diversifying investments, implementing operational controls, purchasing insurance, or setting aside capital reserves.

  4. Monitoring and Reporting: Continuously monitoring the risk environment and the effectiveness of risk management strategies, and reporting to relevant stakeholders, including management, the board, and regulatory bodies.

  5. Compliance and Governance: Ensuring that the risk management practices align with regulatory requirements and ethical standards, and that they are integrated into the corporate governance structure.

Risk management is a fundamental aspect of financial institutions' operations, guiding strategic decision-making and operational practices. By effectively managing risk, organizations can protect themselves against significant losses, ensure regulatory compliance, maintain their reputation, and support their long-term success and stability.

What does risk mitigation refer to?

Risk mitigation is defined as the process of reducing risk exposure and minimizing the likelihood of an incident. It refers to the measures taken to reduce the severity of potential loss or damage from an identified risk. The key aspects of risk mitigation include:

  1. Risk Identification: Recognizing threats or vulnerabilities that can adversely impact people, assets, environment, or organizational objectives.

  2. Risk Impact Analysis: Evaluating the potential frequency, likelihood and magnitude of loss or consequences if the risk event occurs. This determines the priority for mitigation efforts.

  3. Mitigation Plans Development: Creating and implementing practical measures to reduce risk exposure or minimize impact. Common mitigation technique categories include:

  • Risk Avoidance - Eliminating high-risk activities

  • Risk Control - Implementing policies, controls to minimize risk

  • Risk Transfer - Shifting responsibility to third parties

  • Risk Financing - Having contingency funds ready

  1. Monitoring and Reporting: Tracking the identified risks and mitigation plans over time and keeping stakeholders aware through periodic reports.

The difference between managing and mitigating risks:

Risk management is the overarching process that includes risk assessment, risk mitigation, and risk monitoring. It provides a structured way of managing uncertainty related to a threat. Risk mitigation, on the other hand, is focused specifically on reducing the impact of risks to an acceptable level as part of the risk management process.

What do the credit rating agencies do

Rating agencies help in providing trust and confidence in financial markets by rating borrowers on their creditworthiness of outstanding debt obligations.

What is credit risk modelling

Credit risk modelling is a method that is used by lenders in order to determine the level of credit risk associated with extending credit to a borrower. Credit risk analysis models can be based either on financial statement analysis, default probability and/or machine learning.

What are the different kinds of financial ratios ?

The five kinds of financial ratios are:

Liquidity ratios

Efficiency ratios

Profitability ratios

Market valuation ratios

Leverage ratios

What is a solvency ratio:

A solvency ratio indicated whether the protocol's cash flow is sufficient to meets its long term liabilities and thus is a measure of financial health.

What are Basel III liquidity risk measures?

The Basel III LCR standard is designed in a way to ensure that a bank is maintaining an appropriate level of unencumbered, high-quality liquid assets that can be converted into cash to meet its liquidity needs for thirty days under a severe liquidity stress scenario.

Clearing house

Will clearinghouses be disintermediated?

He also responded to a question about whether clearinghouses might be disintermediated. “Clearinghouses are a risk mitigation effort,” said Kerstens. So, if the technology stack develops and the business model develops in such a way that the risks currently caught by clearinghouses are no longer in the system, then you can do away with the clearinghouse. But if that risk is still there, you need a clearinghouse.”

Kerstns also posed the question of what would happen if FMIs didn’t have all the current legacy infrastructure. “If you had to start from a clean slate, I am convinced that DLT would be a much, much bigger part of the technology stack.”

What is a Risk Model?

In TradFi, a risk model is a mathematical framework or tool used to quantify and manage the potential losses associated with financial investments or decisions. These models assess the likelihood of various risk factors, such as market volatility, credit risk, or operational failures, and their potential impact on an investment's return. Risk models are crucial for making informed decisions, optimizing portfolio management, and complying with regulatory requirements. They rely on historical data, statistical analysis, and financial theories to predict future risk and guide strategic planning.

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