2009 International Conference on Business Intelligence and Financial Engineering

An Integrated Risk Management Model for Financial Institutions

Xiaofei Peng
Economics and Management School
Wuhan University
Wuhan, Hubei, 430072, China
Pengxiaofei0901@163.com

Abstract—Financial institutions are affected by various risk
factors. With the wide spreading subprime crisis, more and
more people are paying attention to risk management.
order to enhance the mechanism, techniques and skills of risk
management, this paper firstly describes the traditional
models of risk management, then presents an integrated risk
management model, which consists of three stages as risk
mechanism, quantification analysis system and optimizing
decision-making. Next, this paper analyzes the three stages
respectively. Lastly, by comparing the traditional risk
management models and the integrated one, the paper finds
the integrated risk management model creates a new approach
for risk assessing and calculating to achieve the expected
profits.
Keywords-financial risks; risk management; integrated risk
management;financial institutions;expected profits
I. INTRODUCTION
With the rapid spreading financial crisis, more and more
people are paying their attention to the risks of financial
institutions. One of the fundamental roles of banks and
other financial intermediaries is to invest in illiquid assets
which may bring risks to them. Globally, financial
institutions are running in complex and dynamic
environments resulting in high uncertainty and risk. With
financial derivatives, there are more risks for financial
system. So what are financial risks? The financial risks are
usually associated with adverse or harmful events. And it is
necessary for us to identify risks and manage risks to make
a choice according to the levels of risks. According to
Kostov and Lingard(2003)[1], risk management is a process
of simplifying the decision problem aimed at restructuring
it in such a way that the risk is excluded.
In Many dissertations have studied common risks.
According to David and Moeschberger (1978)[2] , the
history of risks analysis can be traced back to the great
French mathematician Daniel Bernoulli's research on the
risks about the smallpox inoculation in 1760. What
Bernoulli addressed was an extremely significant medical
and social issue. Before the 1980s, the dominant
mathematical theory of risks analysis was to describe a pair
of random vectors. The simplification assumptions and
methods used by classical competing risks analysis caused
controversy and much criticism. Starting around the 1980s,
an alternative formulation of risks analysis was developed,
with the hope to better resolve the issues of failure
dependency and distribution identifiability. The new
formulation is univariate analysis. According to Crowder
(2001) [3], David and Moeschberger (1978) [2] and
Hougaard (2000) [4], univariate survival analysis has been
dominantly based on the i.i.d assumptions (independent and
identically distributed) or, at least, on the independent
failure assumption. Ma and Krings( 2008a[5], 2008b[6] &
c[7]) discuss univariate and multivariate analysis(shared
frailty and multi-state modeling).
There are also many articles about financial risks. These
articles can be divided in three types. The first type is
brought out by the government or the supervision
department , such as the New Basel Capital Accord(Basel II,
2001) brings out Standardized Approach and Internal
Rating-Based Approach(IRB) to assess the risks of banks.
The second type is about the ways to cover the risks, such
as Future, Option , Swap and other financial derivatives.

978-0-7695-3705-4/09 $25.00 © 2009 IEEE 414

DOI 10.1109/BIFE.2009.100
The third type is about the effects of risk management. Jerry
L.Jordan(1994)[8]thinks financial derivatives have no more Optimizing Decision-making (Third stage)
risks for financial institutions, on the contrary, they can help
the financial institutions to manage risks. While Philip
H.Dybvig and William J.Marshall(1997) [9] discuss that Quantification Analysis System(Second stage)
using financial derivatives to manage risks would add more
risks for financial institutions, for the theory of financial Risk Mechanism (First stage)
derivatives is based on some rigid hypotheses, if the actual
environment does not satisfy the hypotheses , there will be Figure1. A three-stage framework for integrated risk management
more risks in risk management.
From above discussion, we can see these articles mostly B. Functions and purpose
study the common risks and the ways to assess and The integrated risk management framework includes
calculate financial risks. Few articles discuss how to five main functions as follows:(1) Improving the efficiency
manage financial risks as a system. So in this paper, we of cooperation and coordination in risks
will discuss the definition of integrated risk management, management.(2)Committing to forming a work team, and
the three stages of integrated risk management, and the keeping alert to risks and creating a risk management
advantages of integrated risk management. environment.(3) Contributing to the technology innovation
This paper is organized as follows: Section 1 is of risks control.(4)Sharing risks reasonably among
introduction. Section 2 presents definition and functions of cooperators, and ensuring the legality of all related
integrated risk management. Section 3 studies the three actions.(5) Distributing specific risk management duty to
stages of integrated risk management for financial different departments and controlling risks according to
institutions. Section 4 concludes. different requirements.
There are some fundamental purposes of the integrated
II. DIFINITION AND FUNCTIONS OF INTEGRATED RISK
risk management of financial institutions. Firstly, the
MANAGEMENT
purpose is to identify, treat and control risks more
A. Difinition of integrated risk management coherently, accurately and timely. Secondly, to establish a
Gheorghe and Mock(1999)[10] think integrated risk complete system to analyze the risks and allocate resources
management refers to managing various risks unified, and according to different types of risks. Last but not least, to
this interpretation focuses on the correlation and establish specialized risk management departments to avoid
overlapping between the different risks. Seung and or reduce risks and decrease the related costs.
Won-suk Jang(2008)[11] think integrated risk management
III. INTEGRATED RISK MANAGEMENT MODEL FOR
refers to managing risks using all available resources and
FINANCIAL INSTITUTIONS
energies, and this interpretation focuses on the various
aspects of a certain risk management. While Zhen-Yu The reasonable framework of integrated risk
Zhao(2008)[12] thinks the integrated risk management management for financial institutions is to provide a
should be taken as a comprehensive understanding, which is necessary risk management environment and contribute to
not only to stress the overlaps of different risks, but also the risk management goal. In order to analyze the
emphasize the coordination of resources and power. This management structure, this paper presents a series of risk
paper presents a three-stage framework for integrated risk management models, which can be divided into three
management as shown in Fig. 1. categories: management model, system model and
quantitative analysis model.

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 A. Management model risk management model. The model is a combination of
In order to realize the dynamic supervising and qualitative and quantitative, including four stages: plan,
management of the financial risks, and based on the design, implementation, evaluation. Each of the four
Nine-Stage Model submitted by the government of stages has some factors. We can show them as the
Canada and Continuous Risk Management, this paper following table:
presents a new management model, which is a dynamic
TABLE I. THE FOUR STAGES OF MANAGEMENT MODEL

Plan Design Implementation Evaluation

Identifying issues and Calculating the likelihood of the risks and Developing some options , Monitoring, evaluating and
assessing key risk factors analyzing the impacts, ranking risks, setting selecting the most reasonable adjusting
desired results strategy and implementing it

The four stages are the main content of the Continuous
and Dynamic risk management in the back-to-back process
of risk management. Risks have their own life cycle
including latent, outbreak, development and dying-out as
we try our best to handle them and risk management works
during the entire risk life cycle. And therefore, this
management model focus on a life-cycle analysis and risk
management method.
B. System model
The system model of risk management for financial
institutions includes risk environment, risk factors and risk
undertakers.
The risk environment can be divided into natural
environment and humanities environment
perspective of broad view. The natural environment
includes the natural environment of a specific institution
where it locates, such as climate, natural catastrophe and
lithosphere. The humanities environment consists of
anthroposphere and technosphere, such as the risk
management skills and the risk management culture of the
financial institutions. The risk factors consist of natural and
human-induced factors. The natural factors refer to
earthquake, fires, flood, typhoon, hurricane, torrential rain,
torrent, debris flow, extraordinary climate and so on. The
human-induced factors also includes lots of risks, such as
political risk, economic risk, technical risk, credit risk,
operational risk and market risk. The risks undertakers have
some relations with all the participants of financing,
including the investors, owners, customers and to some
extent, we can say all the people affect by the financial risks.
from the
We can illustrate all the elements as the following table:
TABLE II. THE ELEMENTS OF SYSTEM MODEL

Risk environment Risk factors Risk undertakers

Natural environment Humanities environment Natural factors Human-induced

factors

Climate, natural Risk management skills and Earthquake, fires, Political risk,
catastrophe and risk management culture flood, typhoon, economic risk,
lithosphere hurricane, torrential technical risk, Investors, owners, customers
rain, torrent, debris credit risk,
flow, extraordinary operational risk
climate and market risk

From the above table, we can see that this model focuses on the factors and the structure of the risk

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management.
C. Quantitative analysis model
The above mentioned models do not focus on
quantitative analysis and the most common used
quantitative analysis models are probability statistical
model and multi-objective decision model. This paper puts
forward a three-stage risks management model as shown in
Fig. 1 and the model may apply to assess risks from a fresh
perspective. The three stages in this model are: risk
mechanism, quantification analysis system and optimizing
decision-making.
1) Risk mechanism stage: Nowadays, most financial
institutions have set up specific departments to manage
risks, but the existing risk management mechanism is not
sound and efficient, and therefore the abilities to resolve
and withstand risks are weak. With financial derivatives,
there are more risks for financial institutions, but the
government supervsion departments do not strengthen the
risk monitoring mechanism and the financial institutions do
not pay more attention to financial derivatives which have
high risks.So there are more and more financial crises
which affect most people.
In order to cultivate advanced risk management culture,
strengthening risk awareness should not only in words or
just giving risk control training, but also need to establish
and strengthen a series of mechanism to resist risks in
financial institutions, including risk management planning
process, risk management organizational mechanism, and
risk management functional division. Especially, the
financial institutions should put more funds and energy to
the risk management department and appoint more
professionals or a team who are responsible for risk
identification, control and management, and pay more
attention to the financial derivatives and the new-coming
financial product.
2) Risk quantification analysis stage: Generally, the
financial institutions are operating in risk environment and
there are abundant and changeable risks factors may
affect the profits of the financial intermediaries . Therefore,
how to effectively identify, assess, calculate and deal with
Risk mechanism Risk
analysis
Culture, organizational
mechanism, functional Benefit
division, planning transfer
process transfer
the risks has become an important field for people to
study.We will present a model to analyze and assess
financial risks quantitatively from three dimensions:benefit
evaluation, risk transfer ways and risk transfer path.
The benefit evaluation comprises economic evaluation
and social evaluation. Many ways are used to assess and
calculate the benefit and the risk, such as Value-at-Risk
(VaR), Credit Monitor Model(CMM) and Creditmetrics.
We can also calculate the Economic Net Present Value
(ENPV) and Economic Internal Rate of Return (EIRR) for a
specific project, then to make an arrangement to realize the
maximum economic profits. At the same time, we should
consider the effect of the society, employment, and local
economic development.
The ways of risk transfer includes two methods:
simulation method and state combined method. Monte
Carlo Simulation is a typical mean to simulate the risk.
State combined method is a traditional method, which
calculate the size and the possibility of the risk from the
discrete probability estimates based on the probability
synthesis principles.
The risk transfer path model includes risk identification,
risk transfer calculation, risk evaluation and risk sources
analysis. The risk transfer path model consists of relational
type, structural type, reticular type and arbores cent type. It
is helpful for managers in financial institutions to choose an
optional strategy, implement an investment successfully and
achieve the expected profits.
3) Optimizing decision making stage:There are many
risks for financial institutions.With a full understanding and
systematic evaluation of the risks, the risk management
department should make out risk contingency plans based
on the risk management mechanism, risk management
functional division, and risk management planning process,
and select the proper strategy to allocate the resources to
achive the expected results. For a specific program or an
investment, some special symposiums should be held, and
management experts, senior engineers from information
management department and representatives of customers
should evaluate the effects of risk management plan and
adjust the strategy for the future.
From the above discussion, we can show the elements
of quantitative analysis model in the following figure:
quantification Optimizing decision
making
evaluation, Discussion,
ways, contingency plans,
path adjusting
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 Figure2. The three stages of quantitative analysis model

Charles Fogg, IEEE-AIAA, AeroSpace Conference,Montana,

From the above discussion, we can find that the Springer, March 1-8,2008(b),in press.
quantitative analysis model considers the risks before a [7] Z. S.Ma, and A. W. Krings, “Multivariate Survival Analysis (II):
Multi-State Models in Biomedicine and Engineering Reliability,”
project or an investment, assesses and calculates the risks David Woerner, IEEE International Conference on Biomedical
using all kinds of ways and adjusts the operation according Engineering and Informatics (BMEI 2008). May 27th-30th,2008(c),
in press.
to the changeable environment. So the quantitative model [8] Jerry L.Jordan, “Specialization in Risk Management”,Econimic
commentary,Oct.15,1994,pp.30-42.
forms a system to manage the financial risks.
[9] Philip H.Dybvig and William J.Marshall, “The New Risk
Management:the Good, the Bad, and the Ugly”Federal Reserve Bank
of ST.Louis,Nov./Dec.1997,pp.9-21.
IV. CONCULUSIONS [10] Gheorghe and Mock, “Risk Engineering Bridging Risk Analysis with
the Stakeholders Values,”Dordrecht Kluwer Academic,1999,pp.30.
With the wide spreading subprime crisis, more and more [11] Seung and Won-suk Jang, “A Web-based Integrated System for
International Project Risk Management,”Automation in
people are turning to study risks. Risk management is an Construction,vol.17, 2008, pp.342-356.
important concept for every financial institution. A [12] Zhen-Yu Zhao, “An Integrated Risk Management Model for
Construction Projects”, Portland International Center for
successful institution should understand how to identify, Management of Engineering and Technology 2008(PICMET 08)
Proceedings, July, 27-31, 2008, pp.1389-1394.
analyze, treat, and administer the risks in the operation.
Based on the modern management theory, this paper
develops an integrated risk management model. The
proposed model is a dynamic risk management model, with
a combination of both qualitative and quantitative analysis.
The integrated risk management model includes three
stages and the paper describes and analyzes the specific
stage respectively. By analysis, we find that the integrated
risk management model has many advantages over the
traditional ones, which will enable financial institutions to
make rational decisions to reduce risks, and help financial
institution operate more smoothly to achieve the expected
profits. With an increasingly complex and rapidly changing
financial environment, more comprehensive and systematic
study on financial risks is needed in the near future.

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