Synopsis for the CISI module on Managing Operational Risk in Financial Institutions

With thanks to The Chartered Institute for Securities & Investment (The CISI) for providing this module and I hope you continue following these series.

General Business Model of Key Financial Institutions

This chapter provides an overview of the general business models and associated risks of key financial institutions, including insurance, retail banking, investment banking, investment management, and stockbroking/wealth management.

1. Insurance Institutions:

Revenue Generation: Insurance companies primarily generate income through two activities—underwriting (accepting liability in exchange for premiums) and investing the premiums collected. Underwriting typically results in losses, but investment of premiums is the main source of profit.

Risk Management: Setting accurate premiums requires complex actuarial analysis based on statistical data. Reinsurance is another method insurance companies use to limit risk.

Types of Insurance: Life assurance (e.g., term assurance, whole life, endowments) and general insurance (e.g., motor, buildings, and accident insurance) differ in the nature of liabilities and investment strategies.

Key Policies: The chapter also outlines the difference between occurrence policies and claims-made policies, which affect the timing and scope of liabilities.

Retail Banking: Business Model: Retail banks generate profit by charging interest on loans and offering savings and transaction services. They earn a margin (net interest income) from the difference between the interest on loans and savings.

Risk-Based Pricing: Retail banks use risk-based pricing, where higher interest rates are charged to higher-risk customers.

Investment Strategy: Excess cash is invested in low-risk, short-term instruments such as Treasury bills and commercial paper.

2. Investment Banking:

Services Offered: Investment banks provide advisory services for mergers, takeovers, and the issuance of securities. They engage in both sell-side (securities creation and sale) and buy-side (advisory on investments) activities.

Strategic Relationships: Investment banks aim to build long-term relationships, offering sophisticated risk management services, including proprietary trading for their own gain.

3. Investment Management:

Portfolio Management: Investment managers professionally manage clients’ portfolios to meet specific financial objectives, utilizing diversification and hedging to minimize risk. Discretionary vs. Non-Discretionary Services: Discretionary services allow managers full control over investment decisions, while non-discretionary services require client approval for each transaction.

Stockbroking and Wealth Management: Stockbroking: Firms act as intermediaries for buyers and sellers of securities, earning commissions on transactions.

Wealth Management: Focused on high-net-worth individuals, wealth management provides comprehensive advice on investment, tax planning, and asset protection, earning fees for these services.

4. Other Financial Institutions: Central Counterparties (CCPs): Facilitate clearing and settlement by assuming the credit risk between buyer and seller in transactions, ensuring the smooth transfer of funds.

Exchanges and Central Banks: Provide regulated marketplaces for securities trading and execute monetary policy, respectively.

5. Payment Institutions: Enable the processing of large volumes of financial transactions, critical for the movement of funds between banks and customers.