Financial risk management is a function of enterprise risk management (ERM) that deals with the handling, identification and treatment of financial risks. Financial risk management is a particularly sensitive and critical aspect of risk management for many companies as it relates to securing the organization’s finances and preventing losses. Healthy cash flow, diversification and competent financial management all play a role in an effective financial risk management strategy. Good financial risk management leads to cost savings, better decision making and better returns.
By understanding the financial risk landscape and taking a proactive approach to financial risk management (FRM), companies can stay ahead of potential threats to their bottom line and make informed and prudent investments and decisions. FRM best practices offer companies ways to manage the most common financial risks and reduce or eliminate the likelihood or impact of those risks. With a financial risk management approach and regular risk assessment, your organization can manage different types of risk and gain an advantage in a volatile market.
What Are the Six Types of Financial Risk?
In order to understand financial risk management, it is important to understand the different types of financial risks that companies face. Financial risk is the probability that an organization will lose money from a business investment or other decision, including loss of capital. Below are six types of risk that fall into the financial realm, including operational risk, credit risk, market risk, liquidity risk, legal risk, and currency risk. By studying these types of risks and implementing best practices for financial instruments, portfolio management, budgeting and allocation, and asset management, your organization can benefit from better financial decision-making.
Operational Risk
Operational risk in the context of financial risk management includes any unforeseen events in day-to-day operations that could affect a company’s bottom line. For example, a manufacturing plant or data center outage for a few hours could result in a loss of business revenue. These types of risks are realized when systems, processes, people or external events interfere with daily functions. It is difficult to completely eliminate operational risk – because as long as there are processes, people and systems, there will be mistakes. However, by implementing mitigation strategies to reduce operational risk to an acceptable risk tolerance threshold, companies can continue to thrive despite any residual risk. Financial risk management (FRM) and operational risk management (ORM) teams can work together to address and manage potential risks to increase efficiency.
Credit Risk
Credit risk is the risk that a customer or borrower will not meet their financial obligations, such as payments. Companies can take steps to mitigate credit risk through insurance and collateral, however some parties may default regardless. Organizations should understand and compare all historical credit defaults, analyze trends and act accordingly to manage future credit risks, for example by flagging high-risk transactions or preventing buyers with bad credit from accepting loans. Credit checks are another common means used to assess a customer’s or borrower’s eligibility for deferred payments.
Market Risk
Market risks have to do with capital markets and financial markets as a whole, such as risk in a particular sector or geopolitical influences on macroeconomic conditions. High interest rates in the market discourage people from taking out loans and encourage savings, posing a potential risk to lenders and banks’ revenues. The availability of capital can affect the valuation of companies. Market risks are difficult to predict and can appear suddenly, but maintaining a strong FRM program can keep your organization alert and prepared.
Liquidity Risk
Liquidity risk is kind of the opposite of credit risk, where an organization is unable to meet its financial obligations or make payments – due to a lack of cash or funds. Liquidity risk can be an existential threat to an organization and can even lead to business continuity risk. Managing cash flow, liabilities and assets in a balanced manner and maintaining regular FRM procedures and controls can help organizations reduce liquidity risk and keep the company’s cash flow healthy.
Legal Risk
Legal or compliance risks are risks associated with loss due to failure to meet legal, regulatory or compliance requirements that are essential to your organization and your industry. Legal risks can include the risk of financial loss due to litigation, such as in the case of a defective product causing injury, while the risk of non-compliance can lead to fines and lost sales. Integrating FRM with the risk management function of the larger enterprise (or equivalent) organization ensures that risks do not fall through the cracks between silos and supports a proactive, collaborative approach to risk management.
Currency Risk or Currency Risk
Currency or currency risks are realized when unexpected changes in the exchange rate of a foreign currency have an impact on the financial situation of the organization. Fluctuations in exchange rates can have a material impact on the valuation of an organization’s investments, financial position and holdings, particularly when they are sudden and unpredictable. This type of risk is more likely to occur in multinational corporations; companies that invest heavily in imports and exports; and organizations that have significant financial holdings abroad. Management of this economic exposure can be achieved through operational strategies such as diversification of facility locations; the markets where the products are sold; and obtaining materials. Specific currency risk mitigation options are also available, such as currency flows and currency swaps, which allow companies to limit the impact of changes in exchange rates.
What Are the Components of a Financial Risk Assessment Plan?
- Financial risk assessment follows the same methodology as other approaches to risk assessment, with a cycle of risk identification, risk analysis, risk management and risk monitoring, albeit with a focus on financial risks.
- However, before conducting a financial risk assessment, companies and their senior management should establish clearly defined risk tolerance thresholds. These thresholds indicate how much risk an organization is willing to take and should be used to guide decision-making.
Risk Identification
Risk identification is always the first step in any risk assessment process, and this also applies to financial risk assessment. In addition to learning from past experience, published standards, and best practices, organizations should consider several other methods of identifying financial risks. A good starting point for identifying risks is to examine the company’s financial statements, disclosures, balance sheet and other key reports and documentation and note any observations. Appraisers should pay particular attention to debt, expenses and liabilities as well as cash flow. Financial operational risks should also appear, with all identified risks recorded in the risk register. Risk management software can help internal teams manage their centralized risk register and collaborate with teammates to complete treatments.
Risk Analysis
The risk analysis step (sometimes known as risk assessment) follows the risk identification stage and requires assessors to evaluate the likelihood that the risk could materialize and the significance of the impact if the risk were to materialize. By combining the risk probability score and the risk impact score, the risk can be prioritized and categorized for treatment. Although risk analyzes and scoring should have some influence on prioritizing remedial efforts, a company should also consider business goals, objectives, and priorities when deciding which risks to address before others.
Treatment of Risks
- Even as risks are identified and analyzed, assessors consider potential treatments for those risks. The risk treatment phase of a risk assessment involves studying each identified risk and designing a treatment plan that addresses each item. There are four common ways to treat risk: risk acceptance, risk avoidance, risk transfer, and risk mitigation.
- Risk acceptance involves knowingly accepting the risks associated with a decision. Risk avoidance involves choosing not to make a decision that leads to a potential risk. Risk transfer occurs when part or more of the exposed risks are transferred to a third party, service provider or insurance. Risk mitigation requires implementing processes and solutions that limit either the likelihood of a risk occurring or the impact if that risk were to materialize. Ideally, a mitigation plan would reduce the risk score of this risk to a level acceptable to the company.
- Every risk, regardless of treatment method, requires some kind of action plan – even if that action plan is “Go ahead and take the risk.” Action plans for some risks will be more complex than others and some may need to become projects in their own right. Implementing new controls and processes is often a lengthy task that must involve employee training and cross-functional collaboration.
- But by applying the best possible risk solution to financial risks, your organization can protect its revenue, reduce costs and deliver value to stakeholders.
Risk Monitoring
- Risk monitoring is the final component of a sound strategy and approach to financial risk assessment. Financial risk monitoring is continuous and includes regularly reviewing the progress of risk mitigation initiatives, updating the risk register and using lessons learned to improve the organization’s financial risk management process. Financial risk assessments should be scheduled at least annually, and the organization should convene key stakeholders quarterly or more frequently to discuss and manage financial risks. These regular risk assessments can serve as benchmarks for companies to show year-on-year progress.
- By applying risk management principles to financial risks, businesses can better manage their risk position and prepare for different types of financial pitfalls that could threaten the bottom line.
Benefits of Financial Risk Management
Applying a risk management methodology to financial risks brings many benefits to companies that are able to implement FRM well. Financial risk management enables companies and teams to take a cross-functional approach to finance and financial risk, drawing on expertise across the organization and addressing risk management and mitigation challenges. By going through a continuous and regular life cycle of risk identification, analysis, treatment and monitoring, the company will benefit from optimizing financial risk management processes and continue to reduce the likelihood and impact of identified risks. Additionally, with a good FRM program and data protection safeguards in place, businesses can have more confidence in their financial statements and reports.
Extend Your Risk Management Capabilities with Auditboard
Risk management brings together different stakeholders from across the company to come up with innovative solutions to mitigate risks and combat threats. But with so many risks to monitor and resources being pulled in different directions, an effective enterprise risk management function seems unlikely, if not impossible. Managing resources and stakeholders alone would be a task.
Purpose-built risk management software can help you and your team manage overhead, collaborate in a central workspace, and manage risks and controls through dashboards. Keeping up with version control and tracking remediation progress becomes much faster and easier when you have the right technology in place. Schedule your customized RiskOversight AuditBoard solution demo today!
