- What is Financial Risk Management
- Types of Financial Risk Management
- Financial Risk Management #1: Operational Risk
- Financial Risk Management #2: Foreign Exchange Risk
- Financial Risk Management #3: Credit Risk
- Financial Risk Management #4: Reputational Risk
What is Financial Risk Management?
Financial Risk Management is the process of identifying risks, analysing them and making investment decisions based on either accepting, or mitigating them. These can be quantitative or qualitative risks, and it is the job of a Finance manger to use the available Financial instruments to hedge a business against them. In banking for instance, the Basel Accords are a set of regulations adopted by international banks that help to track, report and expose credit, marketing and operational risks.
Types of Financial Risk Management
There are several different types of Risks that finance mangers need to account for before proposing investment strategies, and this article covers a few of them in detail.
Financial Risk Management #1: Operational Risk
Operational risk – as defined by the Basel II framework – is the risk of indirect or direct loss caused by failed or inadequate internal people, system, processes or external events. It includes other risk types such as security risks, legal risks, fraud, environmental risks and physical risks (major power failures, infrastructure shutdown etc.). Unlike other types of risk, Operational risks are not revenue driven, incurred knowingly or capable of being completely eliminated. As long as people, processes and systems remain imperfect and inefficient, the risk remains.
However, in terms of Financial Risk Management, Operational risks can be managed to within acceptable levels of risk tolerance. This is done by determining the costs of proposed improvements against their benefits.
Financial Risk Management #2: Foreign Exchange Risk
Foreign Exchange Risk is also known as currency risk, FX risk or exchange rate risk. It is incurred when a financial transaction is made in a currency other than the operating currency – which is often the domestic currency – of a business. The risk arises as a result of unfavourable changes in the exchange rate between the transactional currency and operating currency.
An aspect of Foreign Exchange Risk is Economic Risk or Forecast Risk; the degree to which an organisation’s product or market value is affected by unexpected exchange-rate fluctuations. Businesses whose trade heavily relies on the import and export of goods, or who have diversified into foreign markets are more susceptible to Foreign Exchange Risk.
Financial Risk Management #3: Credit Risk
Credit riskis the risk that a borrower or client defaults on their debts or outstanding payments. With borrowed money, in addition to the loss of principal, additional factors such as loss of interest, increasing collection costs etc., must be taken into account when establishing the extent of the Credit Risk. Financial analysts use Yield Spreads as a means to determine Credit Risk levels in a market.
One of the simplest ways of mitigating Credit Risk is to run a credit check on a prospective client or borrower. Other means is to purchase insurance, hold assets as collateral or have the debt guaranteed by a third-party. Some methods corporations use to mitigate Credit Risk arising from non-payment of client dues, is to request for advance payments, payment on delivery before handover of goods or to not provide any lines of credit until a relationship has been established.
Financial Risk Management #4: Reputational Risk
Reputational Risk is also known as Reputation Risk and it is the loss of social capital, market share or financial capital arising from damage to an organisation’s reputation. Reputation Risk is very difficult to predict or realise financially, as Reputation is an intangible asset. It is however intrinsically tied to Corporate Trust and is the reason why Reputation damage can hurt an organisation financially. Criminal investigations into a company or its high-ranking executives, ethics violations, lack of sustainability policies or issues related to safety and security of either product, customer or personnel are all examples of what can damage an entity’s reputation.
The growth of technology and the influence of social media can now amplify minor issues on a global scale. This has led to boycotts as a form of consumer protest. In extreme cases, Reputational Risk can even lead to corporate bankruptcy. For this reason, more organisations are dedicating assets and resources to better manage their reputation.
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