Risk is an inevitable component of intermediation and trading activity. Given the fundamental trade-off between risks and returns, the objective of regulators is to determine when risk exposures either become excessive relative to the financial institution’s capital position and financial condition or have not been identified to the extent that the situation represents an unsafe and unsound banking practice.
Determination of whether the institution’s risk-management system can measure and control its risks is of particular importance. The primary components of a sound risk-management process are a comprehensive risk-measurement approach; a detailed structure of limits, guidelines, and other parameters used to govern risk taking; and a strong management information system for monitoring and reporting risks. These components are fundamental to both trading and nontrading activities. Moreover, the underlying risks associated with these activities, such as market, credit, liquidity, operations, and legal risks, are not new to banking, although their measurement can be more complex for trading activities than for lending activities. Accordingly, the process of risk management for capitalmarkets and trading activities should be integrated into the institution’s overall riskmanagement system to the fullest extent possible using a conceptual framework common to the financial institution’s other business activities.
Such a common framework enables the institution to consolidate risk exposure more effectively, especially since the various individual risks involved in capital-markets and trading activities can be interconnected and may transcend specific markets.
The examiner must apply a multitude of analyses to appropriately assess the riskmanagement system of an institution. The assessment of risk-management systems and controls may