All companies face risk; without risk there is no reward. The flip side of this is that too much risk can lead to business failure. Risk management allows a balance to be struck between taking risks and reducing them. Effective risk management can add value to any organization. In particular, companies operating in the investment industry rely heavily on risk management as the foundation that allows them to withstand market crashes. An effective risk management framework seeks to protect an organization's capital base and earnings without hindering growth. Furthermore, investors are more willing to invest in companies with good risk management practices. This generally results in lower borrowing costs, easier access to capital for the firm and improved long-term performance.
There are six crucial components that must be considered when creating a risk management framework; they are:
- risk identification
- risk measurement
- risk mitigation
- risk reporting & monitoring
- risk governance
The first step in identifying the risks a company faces is to define the risk universe. The risk universe is simply a list of all possible risks. Examples include IT risk, operational risk, regulatory risk, legal risk, political risk, strategic risk and credit risk. After listing all possible risks, the company can then select the risks to which it is exposed and categorize them into core and non-core risks. Core risks are those that the company must take in order to drive performance and long-term growth. Non-core risks are often not essential and can be minimized or eliminated completely. (For a discussion of business risk, see: Identifying and Managing Business Risks.)
Risk measurement provides information on the quantum of either a specific risk exposure or an aggregate risk exposure, and the probability of a loss occurring due to those exposures. When measuring specific risk exposure it is important to consider the effect of that risk on the overall risk profile of the organization. Some risks may provide diversification benefits while others may not. Another important consideration is the ability to measure an exposure. Some risks may be easier to measure than others. For example, market risk can be measured using observed market prices, but measuring operational risk is considered both an art and a science.
Specific risk measures often give the profit and loss ("P/L") impact that can be expected if there is a small change in that risk. They may also provide information on how volatile the P/L can be. For example, the equity risk of a stock investment can be measured as the P/L impact of the stock as a result of a 1 unit change in, say, the S&P500 index or as the standard deviation of the particular stock. Common aggregate risk measures include value-at-risk (VaR), earnings-at-risk (EaR) and economic capital. Techniques such as scenario analysis and stress testing can be used to supplement these measures. (For more, see: Measuring And Managing Investment Risk.)
Having categorized and measured its risks, a company can then decide on which risks to eliminate or minimize, and how much of its core risks to retain. Risk mitigation can be achieved through an outright sale of assets or liabilities, buying insurance, hedging with derivatives or diversification. (To learn more about hedging, see: A Beginner's Guide to Hedging.)
Risk Reporting & Monitoring
It is important to report regularly on specific and aggregate risk measures in order to ensure that risk levels remain at an optimal level. Financial institutions that trade daily will produce daily risk reports. Other institutions may require less frequent reporting. Risk reports must be sent to risk personnel who have that authority to adjust (or instruct others to adjust) risk exposures.
Risk governance is the process that ensures all company employees perform their duties in accordance with the risk management framework. Risk governance involves defining the roles of all employees, segregating duties and assigning authority to individuals, committees and the board for approval of core risks, risk limits, exceptions to limits and risk reports, and also for general oversight.
The Bottom Line
Effective risk management plays a crucial role in any company's pursuit of financial stability and superior performance. The adoption of a risk management framework that embeds best practices into the firm's risk culture can be the cornerstone of an organizations' financial future.