Managing financial risks across businesses has become more and more complex in the era of globalization. However, successful financial risk management is important because it helps safeguard a company’s current and future financial health.
It also provides companies with a risk framework through which they can judge whether taking advantage of an opportunity is likely to be safe or not in an uncertain and often changing environment.
In this article, we cover:
- What financial risk management is
- The 12 main types of financial risk to protect yourself against
- Four methodologies risk professionals use to model risk
- Six popular financial risk management tools
- How to build effective financial risk management into your company
What Is Financial Risk Management?
The financial risk management (FRM) process aims to identify which money-related issues your business may face now or in the future and how big each risk might be.
The goal is not to eliminate risk from running your business. Instead, it’s about deciding on a level of risk you're happy to be exposed to.
You assess each risk you identify according to a set of rules primarily based on your organizational risk appetite. The result of a risk assessment is to judge whether a proposed course of action or strategy has an acceptable level of risk or not.
The 12 Main Types of Financial Risk
For decision-making related to financial risks, there are two main groups. The first is macroeconomic — risks that affect the economy as a whole and that are largely out of your control. The second is microeconomic — risks that affect your business only because of how you run it.
The types of financial risks companies mitigate against are:
- Credit risk: Potential losses if a customer doesn't pay their invoices — for example, if a borrower fails to pay back a loan to a financial institution
- Cyber risk: Losses and disruptions caused by cyber threats, like hacking and a data breach
- Environmental risk: Loss of money or harm to reputation from natural disasters, climate change, and pollution
- Legal risk: Legal disputes, fines, or penalties that cause financial loss or reputational harm — for example, working with politically exposed persons
- Liquidity risk: Difficulties in repaying debts or maintaining cash flow because of challenges in converting assets (like property or investments in other companies) into cash
- Market risk: Effects on profitability, asset valuation, and financial performance caused by fluctuations in financial markets like interest rate rises, domestic currency appreciation and stock price falls
- Model risk: Costs associated with poor outcomes caused by mistakes made because of poor data or incorrect assumptions
- Operational risk: Financial and reputational losses caused by internal issues like technology or system failures, inadequate KYC verification, loss of key staff, legal problems, and fraud
- Political risk: Financial consequences of exposure to political decisions at home or abroad, particularly to overseas operations or investments
- Regulatory risk: Potential impacts on finances, operations, or competitiveness as a result of changes in legislation
- Reputational risk: Costs incurred as a result of non-compliance, PR crises, or public perception of your company's ethical stance on an issue
- Strategic risk: Losses and delays caused by previous decisions not delivering the forecasted outcomes
The penalties for getting FRM wrong can be severe, as Citibank found out when it was fined $400 million by the Office of the Comptroller of the Currency for “serious and longstanding deficiencies and unsafe or unsound practices.”
The 4 Main Financial Risk Management Strategies
The four main risk management strategies used by companies are as follows.
1. Risk Avoidance
Through risk analysis, you identify the issues you’re exposed to and the level of risk they present. You then use this analysis to decide whether or not an issue meets your risk appetite threshold.
For example, you might choose not to invest or open operations in a country because political and currency risks are too high. For the same reasons, you may not wish to work with persons of political interest.
2. Risk Reduction
With a clear understanding of the level and cost of each issue, you create mitigation strategies for each identified risk to limit potential losses if things go wrong.
- Interest rate risks: You might want to hedge against market fluctuations by investing in derivative products like interest rate options or swaps.
- Risk modeling: Many risk professionals, like CFA charterholders, use value at risk (VaR) models when managing the balance sheet and deciding on which assets to invest in. VaR is a way of estimating the loss of value across an investment portfolio under market conditions over a specific period of time.
3. Risk Transfer
When you insure your car, this is a form of risk transfer. Sometimes it works out for the insurer and other times for you, particularly if your car is involved in an accident and the repairs cost thousands of dollars or more.
Risk transfer is a part of FRM. Companies use products like insurance and credit default swaps to transfer part of the risk to a third party. The benefit of risk transfer is that your expenditures remain essentially the same no matter what happens.
4. Risk Retention
Risk retention is the opposite of risk transfer. This is a strategy employed by businesses when they decide that the cost of transferring risk is too high.
Companies set aside cash to cover potential losses if a risk does come to pass. This requires careful financial planning to make sure that contingency reserves will cover the actual costs incurred if the worst happens.
6 Popular Financial Risk Management Tools
Financial management teams often use one of the six following tools when assessing risk.
1. SWOT Analysis
SWOT stands for strengths, weaknesses, opportunities, and threats. With a SWOT analysis, you can identify internal and external factors that might impact your company's financial performance.
For example, you might see foreign exchange rates as a threat to your cash flow. That’s because an appreciating dollar would mean that your exports become more expensive to overseas buyers.
2. Risk Register
Risk registers are documents that keep track of the following for each identified risk:
- How likely it is to occur
- The impact it would have on your business
- Your current mitigation strategy
An everyday example of this is using a credit-scoring agency to monitor how likely a client is to pay you on time and in full. If the risk attached to a particular customer rises, you may choose to reduce their credit limit to reflect the fact that they may be in financial distress.
3. Risk Matrix
Here’s how to create a risk matrix. Draw a table. Create five rows on the likelihood of a threat coming to pass ranging from 1 (or very unlikely) to 5 (or very likely). Create five columns measuring the severity of these risks on your finances ranging from 1 (or negligible) to 5 (or severe).
For each financial risk you've identified, place it in the appropriate cell that reflects its likelihood and its severity. This approach helps you determine the priority of these risks within your organization.
4. Monte Carlo Simulation
Used in many different risk exercises, the Monte Carlo simulation is an attempt to determine multiple outcomes based on a variety of fluctuating metrics.
Companies may use this approach to estimate the potential return on investment (ROI) on a complex project. Another use case is when businesses are making investment decisions, particularly in relation to asset allocation across their portfolio.
5. Scenario Analysis
Essentially a macroeconomic exercise, scenario analyses are an attempt to discover the financial effects of different economic, political, or market situations.
You could use scenario analysis, for example, to predict the likely impacts of a financial crisis on your asset management strategy.
6. Key Risk Indicators (KRIs)
In the way companies use key performance indicators (KPIs) to quantify internal performance, they use key risk indicators to quantify risk exposure. Businesses regularly monitor their KRIs to help them reduce potential losses in case a risk becomes a reality that you need to deal with.
For example, many private equity firms monitor the growth at a reasonable price (GARP) metric to help them uncover potential issues with a business's valuation. They may change or withdraw an investment offer as a result.
Create a Financial Risk Management Framework for Your Business in 8 Steps
Take the following eight steps to create and implement robust FRM across your business:
- Decide on your risk appetite: Accept that all business decisions involve risk and determine the level of risk you’re happy to be exposed to across the 12 risk vectors listed earlier in this article.
- Identify potential financial risks: Now that you’re clear on risk appetite, identify the different financial risks you are exposed to and their inherent volatility. Given swings in stock prices, you might want a policy that triggers the sale of a particular stock if its price moves out of a predetermined band.
- Analyze and quantify risks: Next, use risk assessment and risk measurement tools to understand each risk and the threat it poses.
- Prioritize risks: Order risks based on how likely they are to turn into threats and the impact that would have on you financially. You can use the risk matrix we described earlier. By doing this, you can direct resources to protect against the most significant risks first.
- Develop risk management strategies: Develop specific mitigation strategies to defend against each risk. For example, to protect yourself against unfavorable interest rates or currency changes, you could choose to hedge your position by investing in financial instruments like options and futures.
- Implement and monitor risk management strategies: Pay close attention to external issues like the state of the financial system, regulatory changes, and general market conditions as well as internal risks like cybersecurity. This will give you a real-time picture of your overall risk exposure that you can periodically stress test.
- Communicate and educate: Gaining buy-in from investors, shareholders, and other stakeholders like regulators will help safeguard their continued confidence in you.
- Create a risk-aware culture: The importance of financial risk management should percolate down into the business as a whole. Employees need to be aware of financial risk and how they should act when they perceive a threat. Training staff on the financial risks of their particular roles will help create a risk-aware culture. So will rewarding those who perform well and offering backup training for those who take longer to reflect their training in their actions.