What Is Financial Risk?
Financial risk is the possibility of losing money on an investment or business venture. Some more common and distinct financial risks include credit risk, liquidity risk, and operational risk.
Financial risk is a type of danger that can result in the loss of capital to interested parties. For governments, this can mean they are unable to control monetary policy and default on bonds or other debt issues. Corporations also face the possibility of default on debt they undertake but may also experience failure in an undertaking the causes a financial burden on the business.
Financial markets face financial risk due to various macroeconomic forces, changes to the market interest rate, and the possibility of default by sectors or large corporations. Individuals face financial risk when they make decisions that may jeopardize their income or ability to pay a debt they have assumed.
Financial risks are everywhere and come in many shapes and sizes, affecting nearly everyone. You should be aware of the presence of financial risks. Knowing the dangers and how to protect yourself will not eliminate the risk, but it can mitigate their harm and reduce the chances of a negative outcome.
What Is Financial Risk Management?
Financial risk management is the practice of protecting the economic value of a company by using financial instruments to manage risks: operational risk, credit risk, and market risk, foreign exchange risk, shape risk, volatility risk, liquidity risk, inflation risk, business risk, legal risk, reputational risk, sector risk, etc.
Similar to general risk management, financial risk management requires identifying its sources, measuring them, and plans to remediate them.
Financial risk management can be qualitative and quantitative. As a risk management specialization, financial risk management focuses on when and how to hedge with financial instruments in order to manage costly risks.
In the global banking sector, the Basel Accords are generally adopted by international banks for tracking, reporting, and disclosing operational, credit, and market risks.
Types of Bank Risk
There are many types of risks that banks face. We’ll look at eight of the most important risks.
- Credit risk
- Market risk
- Operational risk
- Liquidity risk
- Systemic risk
- Business risk
- Reputational risk
- Compliance risk
Out of these eight risks, credit risk, market risk, and operational risk are the three major risks. The other important risks are liquidity risk, business risk, and reputational risk. Systemic risk and Compliance risk are unrelated to routine banking operations, but they do have a big bearing on a bank’s profitability and solvency.
All banks set up dedicated risk management departments to monitor, manage, and measure these risks. The risk management department helps the bank’s management by continuously measuring the risk of its current portfolio of assets, loans, liabilities, deposits, and other exposures.
1. Credit Risk
Credit risk is the risk that a bank borrower, also known as a counterparty, may fail to meet its obligations, pay interest on the loan and repay the amount borrowed in accordance with agreed terms. Credit risk is the largest risk most banks face and arises from the possibility that loans or bonds held by a bank will not be repaid either partially or fully. Credit risk is often synonymous with default risk.
Credit risk affects depositors as well. From the depositors’ perspective, credit risk is the risk that the bank will not be able to repay funds when they ask for them.
The underwriting process aims to assess the credit risk associated with lending to a particular potential borrower. Once a loan is underwritten and the loan is received by the customer, the loan becomes a part of the bank’s banking book.
The banking book is the portfolio of assets (primarily loans) the bank holds, does not actively trade, and expects to hold until maturity when the loan is repaid fully. Nearly all of a bank’s credit risk is contained in the credit risk of the assets in its banking book, although some elements of credit risk can also exist in the trading book.
2. Market Risk
Market risk is the risk that arises from movements in stock prices, interest rates, exchange rates, and commodity prices. Market risk is distinguished from credit risk, which is the risk of loss from the failure of a counterparty to make a promised payment, and also from a number of other risks that organizations face, such as breakdowns in their operational procedures. In essence, market risk is the risk arising from changes in the markets to which an organization has exposure.
The components of market risk are as follows:
- Interest rate risk is the potential loss due to movements in interest rates. This risk arises because bank assets (loans and bonds) usually have a significantly longer maturity than bank liabilities (deposits). This risk can be conceptualized in two ways. First, if interest rates rise, the value of the longer-term assets will tend to fall more than the value of the shorter-term liabilities, reducing the bank’s equity. Second, if interest rates rise, the bank will be forced to pay higher interest rates on its deposits well before its longer-term loans mature and it is able to replace those loans with loans that earn higher interest rates.
- Equity risk is the potential loss due to an adverse change in the price of stock. Stock, also referred to as shares or equity, represents an ownership interest in a company. Banks can purchase ownership stakes in other companies, exposing them to the risk of the changing value of these shares.
- Foreign exchange risk is the risk that the value of the bank’s assets or liabilities changes due to currency exchange rate fluctuations. Banks buy and sell foreign exchange on behalf of their customers (who need foreign currency to pay for their international transactions or receive foreign currency and want to exchange it to their own currency), and they also hold assets and liabilities in different currencies on their own balance sheets.
- Commodity risk is the potential loss due to an adverse change in commodity prices. There are different types of commodities, including agricultural commodities (e.g., wheat, corn, soybeans), industrial commodities (e.g., metals), and energy commodities (e.g., natural gas, crude oil). The value of commodities fluctuates a great deal due to changes in demand and supply.
Market risk tends to focus on a bank’s trading book. The trading book is the portfolio of financial assets such as bonds, equity, foreign exchange, and derivatives held by a bank either to facilitate trading for its customers or for its own account or to hedge against various types of risk. Assets in the trading book are generally made available for sale, as the bank does not intend to keep those assets until they mature.
Assets in the bank’s banking book (held until maturity) and trading book (not held until maturity) collectively contain all the various investments in loans, securities, and other financial assets the bank has made using its deposits, loans, and shareholder equity.
Distinguishing between the trading and banking books is essential to understand how banks operate and how they manage their risks. The value of assets and liabilities in the trading book can change quickly, and the bank has to recognize those changes immediately. In contrast, changes to the value of the banking book generally take longer to happen.
3. Liquidity Risk
Liquidity is the ability of a firm, company, or even an individual to pay its debts without suffering catastrophic losses. Conversely, liquidity risk stems from the lack of marketability of an investment that can’t be bought or sold quickly enough to prevent or minimize a loss. It is typically reflected in unusually wide bid-ask spreads or large price movements.
Common knowledge is that the smaller the size of the security or its issuer, the larger the liquidity risk. Drops in the value of stocks and other securities motivated many investors to sell their holdings at any price in the aftermath of the 9/11 attacks, as well as during the 2007 to 2008 global credit crisis. This rush to the exits caused widening bid-ask spreads and large price declines, which further contributed to market illiquidity.
Liquidity risk occurs when an individual investor, business, or financial institution cannot meet its short-term debt obligations. The investor or entity might be unable to convert an asset into cash without giving up capital and income due to a lack of buyers or an inefficient market.
4. Operational Risk
Operational risk is the risk of loss resulting from ineffective or failed internal processes, people, systems, or external events that can disrupt the flow of business operations. The losses can be directly or indirectly financial.
For example, a poorly trained employee may lose a sales opportunity, or indirectly a company’s reputation can suffer from poor customer service. Operational risk can refer to both the risk in operating an organization and the processes management uses when implementing, training, and enforcing policies.
Operational risk can be viewed as part of a chain reaction: overlooked issues and control failures whether small or large lead to greater risk materialization, which may result in an organizational failure that can harm a company’s bottom line and reputation. While operational risk management is considered a subset of enterprise risk management, it excludes strategic, reputational, and financial risk.
5. Systemic Risk
Systemic risk refers to the risk of a breakdown of an entire system rather than simply the failure of individual parts. In a financial context, it denotes the risk of a cascading failure in the financial sector, caused by linkages within the financial system, resulting in a severe economic downturn.
A key question for policymakers is how to limit the build-up of systemic risk and contain economic crises events when they do happen.
Reducing the likelihood and severity of future financial crises can be ensured by a coordinated global effort to monitor market trends and bubbles, and to end government bailouts for failing financial institutions.
Other Risks That Banks Face
6. Business Risk
Business risk is the exposure a company or organization has to factor(s) that will lower its profits or lead it to fail. Anything that threatens a company’s ability to achieve its financial goals is considered a business risk. There are many factors that can converge to create business risk. Sometimes it is a company’s top leadership or management that creates situations where a business may be exposed to a greater degree of risk.
However, sometimes the cause of risk is external to a company. Because of this, it is impossible for a company to completely shelter itself from risk. However, there are ways to mitigate the overall risks associated with operating a business; most companies accomplish this through adopting a risk management strategy.
7. Reputational risk
Reputational risk is the damage that can occur to a business when it fails to meet the expectations of its stakeholders and is thus negatively perceived. It can affect any business, regardless of size or industry.
Reputational risk happens when the expectations of stakeholders – such as your customers, employees, third-party suppliers, investors, and regulatory bodies – are higher than the reality of what your business delivers. But what can cause this disparity? And what types of reputational risk are there? Key areas to be aware of are:
- Poor workplace operations and conduct – The actions of employees, including upper management, and any third-parties you work with can affect your reputation. Poor behavior of your CEO – or even a single employee – could lead to your business receiving negative media coverage and other harmful consequences.
- Inadequate quality of services and products – Shortcomings in your systems, processes, and products can contribute to a damaged reputation. For example, in manufacturing, a faulty product that must be recalled could lose you the trust of your stakeholders. In financial services, a mishandling or breach of sensitive customer data could also lead to a loss of confidence in your business.
- Failing to adapt – According to Harvard Business Review, reputational risk can occur when businesses don’t keep up with the changing beliefs of their stakeholders. Expectations can change over the years, and they can vary in different regions and countries. You must be able to understand your stakeholders at all times. It is also important to stay up to date with regulatory and industry expectations, so that you can quickly and effectively adapt to any changes.
Another way of looking at reputational risk is that it can stem from other risks faced by your organization. To properly protect your reputation, you must ensure you have all areas of risk management covered.
8. Compliance Risk
Compliance risk is an organization’s potential exposure to legal penalties, financial forfeiture, and material loss, resulting from its failure to act in accordance with industry laws and regulations, internal policies, or prescribed best practices. Compliance risk is also known as integrity risk.
Organizations of all types and sizes are exposed to compliance risk, whether they are public or private entities, for-profit or nonprofit, state or federal. An organization’s failure to comply with applicable laws and regulations can affect its revenue, which can lead to loss of reputation, business opportunities, and valuation.
How Do You Implement Financial Risk Control?
Organizations manage their financial risk in different ways. This process depends on what the company is doing, what market it is in, and the level of risk it is willing to accept. With this in mind, it is up to the business owner and directors of the company to identify and assess the risk and decide how the company will handle it.
Some of the stages in the financial risk management process are:
1. Identifying the risk exposures
Risk management begins with identifying the financial risks and their sources or causes. A good starting point is the company’s balance sheet. This provides a snapshot of the debt, liquidity, currency risk, interest rate risk, and commodity price vulnerability that the company is facing.
You should also examine the income statement and cash flow statement to see how income and cash flows fluctuate over time and what effect this has on the organization’s risk profile.
Questions to ask here include:
- What are the main sources of revenue of the business?
- Which customers does the company extend credit to?
- What are the credit terms for those customers?
- What type of debt does the company have? Short-term or long-term?
- What would happen if interests rates were to rise?
2. Quantifying the exposure
The second step is to quantify the risks you have identified or to set a numerical value. Of course, the risk is uncertain and the number of risk exposures will never be accurate. Analysts tend to use statistical models such as the standard deviation and regression method to measure a company’s exposure to various risk factors. These tools measure the amount by which your data points differ from the average or mean.
For small businesses, computer software like Excel can help perform a simple analysis efficiently and accurately. As a general rule, the larger the standard deviation, the greater the risk associated with the data point or cash flow being quantified.
3. Making a “hedging” decision
Now that you’ve analyzed the sources of risk, you need to decide how to respond to this information. Can you live with the risk exposure? Do you need to mitigate it in any way or hedge against it? This decision is based on several factors such as the company’s objectives, its business environment, its risk appetite, and whether the cost of risk reduction justifies the risk reduction.
Generally, you might consider the following action steps:
- Reducing cash-flow volatility.
- Fixing interest rates on loans so you have more certainty in your financing costs.
- Managing operating costs.
- Managing your payment terms.
- Putting rigorous billing and credit control procedures in place.
- Saying farewell to customers who regularly abuse your credit terms.
- Understanding your commodity price exposure, that is, your susceptibility to variations in the price of raw materials. If you work in the haulage industry, for example, a rise in oil prices can increase costs and reduce profits.
- Understand your commodity price risk, which is your vulnerability to commodity price fluctuations. For example, if you work in a haulage industry, an increase in the price of oil can increase costs and reduce profits.
- Ensure the right people are getting the right jobs with the right level of oversight to reduce the risk of fraud.
- Carrying out due diligence on projects, for example taking into account the uncertainties associated with a partnership or a joint venture.
Who Manages Financial Risk?
The business owner and management are responsible for risk management. Only when the company grows into several departments and activities, you may want to employ a dedicated financial risk manager who controls the risk and gives recommendations for action on behalf of the company.
Financial risk management is the practice of protecting economic value in a firm by using financial instruments to manage exposure to risk: operational risk, credit risk, and market risk, foreign exchange risk, shape risk, volatility risk, liquidity risk, inflation risk, business risk, legal risk, reputational risk.
Financial risk is the possibility of losing money on an investment or business venture. Financial risk is a type of danger that can result in the loss of capital to interested parties. For governments, this can mean they are unable to control monetary policy and default on bonds or other debt issues.
Risk is defined in financial terms as the chance that an outcome or investment’s actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of the original investment.
There are many ways to categorize a company’s financial risks. One approach for this is provided by separating financial risk into four broad categories: market risk, credit risk, liquidity risk, and operational risk.