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When sourcing and signing any financial deal, there’s going to be risk involved. How the deal could go sour and what are the quantifiable losses are part and parcel to understanding and analyzing risk. This risk analysis is how investment banks set themselves up for a successful business deal. These models of risk management are influenced by large pools of resources from global and local market information, specific firmographic data with the specific company they’re dealing with, and other material sources.
Risk is inseparable from reward when partaking in investment banking deal sourcing; they’re two sides of the same coin. So when pushing forward on deals, risk managers need highly specific tools integrated into their valuation models that help with market analysis and better understanding the potential losses involved. While M&A software is a reliable tool to use, there are other techniques that can also be beneficial for financial risk management professionals. To learn more about these market analysis tools, read ahead.
What is Involved in Risk?
Risk and risk management isn’t a one-shoe-fits-all factor. In fact, the sheer number of ways stock prices can fluctuate, deals can go awry due to asymmetric information, and markets can change through unavoidable global shifts (i.e., war, annexation, isolationism policy, government seizure of assets, etc.). Because of this, there are ways of separating and categorizing the different types of risk and loss, and thus, there are different risk software and market analysis tools that can measure and evaluate.
- Strategic risk – This type of risk surrounds the business model. What about an organization’s strategy and objectives make it susceptible to risk? Answering this gives insight into combatting strategic risk.
- Operational risk – Considering the strategic objectives, operational risks are the external and internal factors that will affect the success of these goals.
- Financial risk – These risks are geared toward the credit risks, faulty valuation models, inaccurate financial reporting, some controllable; others not.
- Uncontrollable risk – Sometimes considered compliance risk, these are risks with causes outside of your immediate control. Think government regulation, environmental risk, and reputational risk.
Since each of these risks poses threats to the firm, it’s important to break each risk type down into individual scenarios and plan accordingly. This allows you to define an entire risk management portfolio that accounts for as many worst-case scenarios as possible.
Creating a risk management portfolio involves a series of steps, including:
- Identifying risk factors through worst-case scenarios, historical examples, and similar deals
- Analyzing the risks by determining both the likelihood of the risk occurring and the potential losses involved
- Comparing the risk and ranking it amongst the other risk factors involved. This hierarchy constitutes how to properly allocate resources
- Considering risk treatments and measures to put in place to avoid the worst-case scenarios or avoid the fall out of the losses
- Monitoring the risk and reassessing at key intervals
The more specific you can be with each form of risk, the more effective your methods of prevention and assessment can be.
How Important Is Risk Management In Today’s Climate?
The fact of the matter is, risk management has always been (and will always be) critical in financial decisions. However, in the investment banking world, Deloitte notes that there is an increasing pressure on IBs to create profit in the current, slow economy. In their 2017 Strategic Risk Management in Banking magazine, they state:
…the ongoing low-growth, low-interest rate economic environment is putting pressure on traditional sources of profitability. Banks are increasingly searching for new avenues for growth—developing new and innovative retail products, seeking yield through alternative investment vehicles, and implementing new sales and marketing strategies to increase volume.
Deloitte’s report continues, stating that the manner in which IBs must operate is through the simple idea that risk and reward are inseparable.
Institutions are more effective at anticipating change and achieving the right outcomes if they don’t consider strategy and risk management as separate and parallel mindsets.
The question then becomes, how do investment banks and any other financial institution create this union of strategy and risk management?
Tools for Risk Management Investment Banking
Investment banking risk management begins and ends with the software, technology, and market analysis tools brought to the table. There’s no question that large portions of a company’s budget dump directly into cutting-edge technology for that very reason. Like information technology, gaining an edge can be the difference between a deal blowing up and the company taking on heavy losses, and your competitor suffering those very same losses.
Thus, let’s dive into the tools needed to operate under the heavy burden of potential loss and risk.
- Risk Calculation Engines – Known as just Risk Engines (RE), these are software systems that provide exactly what you’d imagine—market risk assessment and investment analysis. By proposing future behavior of markets, REs can create probability charts for everything from yield curves in the market to client behavior. You control the stress factors (the boundaries and conditions) and the engine will do its magic.
- Expected Tail Loss – ETL software can help when you have a Value at Risk (or VaR), and you want to know what the average expected loss would be between the conditional VaR and the average VaR. This will offer insight into the anticipated downside of your VaR.
- Target Market Analysis – Market analysis informs everything from your deal sourcing efforts to finding strategic buyers in M&A. By having as much information possible on potential leads and firmographic data at hand, you can lessen the amount of risk you take on due to lack of information. Asymmetric information typically occurs when the buy-side is less informed than the sell-side, resulting in an improperly proposed deal. SourceScrub offers target market analysis software as well as M&A software for IBs to help reduce and manage risk by providing key insights about different financial markets.
- Standard Deviation Analysis – While this is more of a strategy than a tool, understanding standard deviation analysis helps to put data values into context. What does it mean when an investment offers an annual return of 7%? Not much by itself. If the investment fluctuated between a loss of 20% and a return of 20% but averaged out at 7%, these fluctuations will be isolated in the standard deviation analysis. Thus, in certain situations the standard deviation of a model can show its risk proposition.
These are high-level views of the software and tools behind investment banking risk management. To detail all the specific software would be tedious. Instead, let’s focus on other areas of risk outside of the market analysis realm.
Other Tools For Other Risks
While the market analysis tools mentioned above offer direct insight into where changes in the market may affect deals, there are other types of risk mentioned earlier that need to be accounted for. Thus, it’s important for investment bankers to understand the full extent of what IBs need to inculcate them into their risk management strategy.
- Cybersecurity software for the growing threat of cyberattacks. The number of large cyberattacks in all sectors, not just finance, are increasing, and the scale of which the data is stolen is becoming more threatening. According to Statista, the sheer number of data breaches from 2005 to 2018 has nearly multiplied by ten. The same goes for the number of records exposed. With increasing threats, advanced cybersecurity and encryption software is a must to limit the amount of risk exposure your firm has as a whole.
- Blockchain technologies to decentralize ledger authority. Partially attached to security, partially attached to decentralization, blockchain technologies use crowdsourcing efforts to make decisions, keep a standard quo, and offer a more protected and unbreakable form of data communication. Essentially, whereas today a central bank will keep ledger activity on a master ledger, blockchain allows multiple access points to “crowdsource” that data. It creates more security because to pull off a false transaction, you’d have to hack the majority of systems simultaneously (versus targeting one master ledger). With blockchain technology, the risk of false transactions significantly decreases.
- AI and cloud technologies to calculate large risk factors. To physically run the risk engines mentioned above, AI and cloud technologies are needed more and more to operate semi-autonomously and with massive data sources.
Not all risks have equal downfalls attached to them. The risk itself is broken down into two factors: probability and potential.
Probability of Risk and Its Potential Loss
Risk is all part of the decision-making process. That’s why a risk assessment on capital markets is always recommended before you start doing business. By separating risk into the probability of the risky event taking place and its consequential losses, you can better inform yourself whether or not to move forward with a deal. If, for example, the probability of a risky event is high, but the potential loss is insignificant, then moving forward may seem like a safe option. Similarly, with extreme losses at stake but a low probability of occurrence, investment bankers may again choose to move forward with stringent monitoring.
Using SourceScrub To Set Up For Success
By utilizing the right market analysis tools, you can better grasp your risk portfolio and create strategies for risk management. With SourceScrub supporting your deal origination efforts, you can ensure that your M&A deals are as risk-free as possible from the onset.
Target specific firmographic and market data using SourceScrub’s filtered search and gain access to the key players in each field to set up the best deal possible.
If you’re curious how it works, talk to one of our experts today and set up a free demo!
- Deloitte. Strategic risk management in banking. https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/Banking/lu_inside_issue14_strategic_risk_management.pdf
- Statista. Annual number of data breaches and exposed records in the United States from 2005 to 2018. https://www.statista.com/statistics/273550/data-breaches-recorded-in-the-united-states-by-number-of-breaches-and-records-exposed/
- Evestment. ETL: Expected Tail Loss. https://www.evestment.com/resources/investment-statistics-guide/etl-expected-tail-loss/
- McKinsey & Company. The future of bank risk management. https://www.mckinsey.com/~/media/mckinsey/dotcom/client_service/risk/pdfs/the_future_of_bank_risk_management.ashx
- Deloitte. Exploring Strategic Risk. https://www2.deloitte.com/content/dam/Deloitte/global/Documents/Governance-Risk-Compliance/dttl-grc-exploring-strategic-risk.pdf
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