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Show, with illustrations, how a firm's functional units depend on one another in managing risk.

FRM® Part I · Foundations of Risk Management · The Governance of Risk Management · FRM1.FR.3.e

The idea

Risk management only works when the firm's functional units rely on one another, and weak links in any unit become risk events elsewhere. Front-office business units originate positions and own the risk. Risk management measures and challenges, but depends on position data from operations and technology. It also depends on valuations verified by finance through independent price verification, and on documentation reviewed by legal, for example whether netting agreements are enforceable. Treasury manages funding and liquidity and sets internal funds transfer prices that shape business behaviour. Compliance monitors rules. Human resources and the compensation committee shape incentives, and internal audit tests the whole system. A failure in one place, such as unconfirmed trades or traders marking their own positions, misstates market and credit risk elsewhere. Questions ask you to trace exactly that chain.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which functional unit manages the firm's funding and liquidity and typically sets the internal funds transfer prices charged to business units?

  1. ComplianceWhy not: Compliance monitors adherence to laws and rules; it does not manage funding or set transfer prices.
  2. Internal auditWhy not: Internal audit gives independent assurance on controls and does not manage funding or liquidity.
  3. LegalWhy not: Legal handles contracts and legal risk, not funding, liquidity management or transfer pricing.
  4. Treasury - correct

Treasury runs funding and liquidity and, through funds transfer pricing, passes its cost of funds to the business units, which affects their risk-taking.

A harder one

Which statement best illustrates the dependence of market risk measurement on the finance function?

  1. Finance sets each desk's VaR limit according to the desk's budgeted revenueWhy not: Setting limits is done by risk management within board-approved appetite, not by finance on revenue budgets.
  2. Finance independently verifies the prices used to value positions, so that risk figures are not based on marks chosen by traders - correct
  3. Finance approves trades before execution to confirm that they are within limitsWhy not: Pre-trade limit checks are a front-office and risk function control, not finance's role.
  4. Finance confirms trade terms with counterparties after executionWhy not: Confirmation of trade terms is an operations function, not finance.

Independent price verification by finance (product control) gives risk management reliable valuations; without it, traders could mark their own books and misstate P&L and risk.

The hardest tier

A bank trades four derivatives with one counterparty, with values to the bank of +80, -35, +25 and -50 (in millions). Risk measures exposure on a net basis under a netting agreement. Legal then concludes that netting is not enforceable in the counterparty's jurisdiction. By how much, in millions, did the net-basis measure understate the exposure, closest to?

  1. 105Why not: This is the gross exposure itself (80 + 25), not the amount by which the net figure understated it.
  2. 20Why not: This is the netted exposure (80 - 35 + 25 - 50); it is what the firm had measured, not the understatement.
  3. 85 - correct
  4. 190Why not: Sums the absolute values of all four trades, including those the bank owes, which is not credit exposure.

With enforceable netting, exposure = 80 - 35 + 25 - 50 = 20. Without it, exposure = 80 + 25 = 105. The understatement is 105 - 20 = 85, the sum of the negative values.

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