In addressing these two issues, we define the appropriate role for institutions in the financial sector and focus on the role of risk management in firms that use their own balance sheets to provide financial products. Our objective is to explain when an institution is better off transferring risks to the purchaser of the assets that the firm has issued or created, and when the firm itself should absorb the risks of these financial products.
In fact, a well-known textbook in the field devotes an entire chapter to motivating financial risk management as a value-enhancing strategy using the arguments outlined above. For discussion of the shortcomings in simple linear risk-sharing incentive contracts for assuring incentive compatibility between principals and agents, see:M. This is why value-at-risk has become an attractive risk management tool in proprietary trading.


The recent disasters at Bankers Trust, Barings, and BancOne demonstrate that risk management systems in themselves do not prevent risk taking.
For a presentation of the techniques used by the banking and insurance industry, respectively, see:E.
So, we have developed a framework for efficient, effective risk management for the firm that chooses to manage risks within its balance sheet and achieve the highest value added. For research that suggests that these managers did not allow their risk management systems to prevent devastating losses, see:P. To develop our analysis of risk and return in financial institutions, we first define the appropriate role of risk management.


Next, we detail the services that financial firms provide, define several different types of risks, and discuss how they occur as an inherent part of financial institutions’ business activities.



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