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A Dictionary of Finance
Risk management: How do you know when a swan is black?
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An event that carries risk can generate harm or a loss. A certain level of risk has to be accepted by, for example, a bank, in order to generate profit. Risk is calculated by assessing the probability that a borrower will default on its repayments.
Did you ever take a calculated risk? Whether you were at the top of a ski slope or invading Yakutsk in a game of “Risk,” you probably have done so. But can you really calculate risk? This episode is about how banks and other financial players tot up their risks—and guard against potential losses.
In fact we’ll learn that there are a lot of different kinds of risk. They have very specific names, like credit risk and liquidity risk. But don’t worry. The European Investment Bank’s experts will define them all for you. The podcast will also tell you what a black swan is…
To talk about risk, we turned to two senior EIB managers. Luigi Armeli is in the Transactions Management and Restructuring directorate, while Giancarlo Sardelli works in the Risk Management directorate. Here are a few of the subjects these clever fellows touched upon in the podcast:
The risk appetite of a bank, says Luigi, represents the boundaries of the risk the bank is willing to take as part of its ongoing business.
Exposure is the credit that a bank has lent to a given counterparty, as it appears on the bank’s balance sheet. This does not coincide exactly with what the bank risks losing in the case of a default. Normally a bank wouldn’t expect to lose the full exposure in the event of a default, Luigi explains.
How complicated is the maths involved in all this? To estimate risk involves mathematical modelling, though calculated risks aren’t only about maths. Giancarlo tells us common sense is just as important to a risk manager, as well as knowledge of law, accounting and other fields.
A black swan is a risk that is highly unlikely or almost impossible—until it happens. Where does the phrase come from? For centuries swans were thought only to be white. Black swans were considered an impossibility—until they were discovered in Australia. When a black swan event happens, it has disastrous financial consequences.
Liquidity risk is the capacity at any time to ensure the funding of the portfolio of assets on your balance sheet.
Credit risk represents the likelihood of getting back money a bank has lent.
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