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What is Risk Management?
Risk management in the financial services industry involves strategic analysis of uncertain investments or decisions. Risk management also includes the identification and analysis of investments in terms of their risk level, strategies for minimizing risks, and planning for potential risks in the future.
Risk management is a process that is evident in all industries and individuals at some level, but financial service industry risk management typically describes the risk of financial loss. Risk managers are tasked with quantifying risk levels to better understand the potential outcome of an investment. In addition, risk managers must also make decisions on whether to accept, mitigate, or transfer risk based on the pre-determined processes and strategies the organization has in place.
In the financial services industry, specifically banks, wealth management, and insurance firms, risk management is essential to avoid the possibility of a financial entity’s cash flows proving insufficient to meet its financial obligations. A failure to avoid risk can lead to not only jeopardy of the financial services industry, but also the economy as a whole.
Risk can be attributed to a variety of macroeconomic, political, or firm-level variables. An investment for one firm may be far less risky than the same investment for another different firm. It is dependent on the individual organization’s risk tolerance, systems in place to manage risk, and the individuals making the final decision. However, decisions on risk will be based on quantitative data gathered and analyzed by a professional risk manager.
Managing or taking on financial risk has advantages and disadvantages. Financial risk management allows for more informed decision-making at every level within the organization. Furthermore, risk management can aid the risk-to-reward ratio for an investment and can be measured and studied with data analytics.
One disadvantage of financial risk management is that risk is often uncontrollable or difficult to overcome. Financial risk can occur from unpredictable outside variables that were not included in the risk management systems. In addition, financial risk in one sector of the financial services industry can spread to other sectors. To compensate for this possibility, the organization can pool risk from two or more sources to achieve a more well-rounded understanding of the risk associated with an investment.
Categories of Risk
Any activity that leads to a loss, whether it be financial or otherwise, has risk associated with it. There are different categorizations of risk in the financial services industry.
On a wider scale, risk can be broken down into three main categories:
- Business Risk – Risks taken by businesses to maximize their shareholder financial profit and value. An example of this would be releasing a new insurance plan because it is a large investment, members may not utilize it, and the company may have to invest more than they make.
- Non-Business Risk – These are risks that are considered to be out of the control of the firm. Non-business risks can arise from political or economic imbalances that make certain investments more or less risk averse.
- Financial Risk – Risk that involves a loss of capital or money. This is the main focus in the financial services industry and generally occurs due to instability in a financial market caused by movements in currency exchange rates, stock prices, interest rates, or another variable involved in risk management.
Financial risk has its own categories to classify investments. There are five major categories of risk in the financial industry:
- Market Risk – Risk associated with the movement in market prices or value. It is typically classified as Directional Risk and Non-Directional Risk. Directional Risks are associated with the movement of stock prices or interest rates. Non-Directional Risks are based on volatility.
- Credit Risk – Risk that arises from a firm being unable to fulfill its obligations to its members or stakeholders.
- Liquidity Risk – This risk occurs when a firm is unable to execute essential transactions due to poor management of liquid investments.
- Operational Risk – Risk associated with the failure of a firm due to mismanagement or technical failures. Operational risk also includes fraud risk and model risk. Fraud risk occurs when a firm lacks control over an investment or employee. Model risk happens when the incorrect model is used to analyze a decision, causing a financial loss.
- Legal Risk – This risk occurs when a firm exits the legal constraints of the law. When a company is faced with financial loss due to a lawsuit or some other legal proceeding it is considered a legal risk.
What are Risk Management Strategies?
Risk management strategies will depend on the risk manager and the position of the organization. Furthermore, risk managers can employ the use of a variety of data analytic techniques to quantify the risk associated with an investment.
Some examples of different methods of quantifying risk include:
- Alpha – The risk that a portfolio or investment strategy will fail to perform at the relative benchmark index such as the NASDAQ.
- Beta – This measures the volatility of returns for a financial decision related to the entire market’s volatility.
- Standard Deviation – The volatility of returns for a financial decision related to the average return over a specified time period.
- Sharpe Ratio – The measure of returns as a single unit of risk for a financial decision over the course of a specified time period. The Sharpe Ratio is intended to quantify the return on an investment relative to the risk associated with the decision.
In the financial services industry, the government has a stake in the risk companies are willing to take on. As previously mentioned, risk can spread throughout an industry and a downturn in the financial services industry can result in a decline in the entire economy. Government monetary policy acts as bumpers for risk management strategies to operate.
Although the government monitors the risk tolerance in the financial services industry, there is still plenty of room for individual firms to take on excessive risk. Moreover, another strategy for risk management is scenario planning. Before making the final decision on an investment, firms should map out all the possible outcomes of the financial action. If the bad outweighs the good, the investment is likely too risky.
Another strategy for managing risk is to employ the use of internal audits. Internal audits will ensure that previous purchases or investments comply with the law and are in good standing. Internal audits can also help identify certain variables that increase or diminish the risk associated with a financial investment or decision.
Additionally, many companies choose to bring on team members that hold the Financial Risk Manager (FRM) Certification. This credential focuses specifically on risk management, bringing new skills and expertise to your business. Before an individual can become FRM certified, they must pass a two-part exam and have at least two years of experience in risk management. Having a team member dedicated to managing risk can help you implement effective strategies.
Risk management is one of the most important aspects of running a successful business. Without the ability to mitigate risk and financial losses, the long-term success and scalability of your organization are at risk.
The financial services industry is relied on by millions of people, known for its security, trustworthiness, and reliability. This means that your bank, wealth management firm, and insurance company needs to be implementing the right controls to minimize risks and maximize returns.
Risk management can be a daunting and, at times, complex task to approach. For this reason, it is important that your financial service business has the expertise and resources to identify and quantify risk within your firm.