Why Manage Financial Risk? Shareholder, Societal, and Quantitative Views

Regulation compels banks to hold capital against their loss distributions, but the regulatory mandate alone is an incomplete answer to the question of why firms manage risk. Many non-financial corporations — airlines hedging fuel costs, multinationals hedging FX exposure, industrial firms managing commodity price risk — are subject to no prudential regulation yet devote significant resources to risk management. And even among regulated banks, the design of a risk-management programme reflects choices — which risks to hedge, how much capital to hold above the regulatory minimum, which tail quantile to target — that cannot be answered by citing a Basel document.

This note closes the introductory topic by examining three distinct rationales for risk management: the societal view (financial stability and systemic risk); the shareholder view (corporate finance arguments for why reducing firm-level volatility can increase firm value); and the quantitative view (what the mathematical toolkit of QRM contributes beyond qualitative risk management, and the nature of the challenge it faces).

Learning objectives. By the end of this note you should be able to: