Financial risk management can be very complicated, which can make it hard to know where to begin thinking about it. This Cheat Sheet distinguishes some of the key concepts such as risk versus danger and opportunity, probability, volatility, normality and uncertainty. It discusses how to manage the seven major types of financial risk in financial institutions including asset managers, banks, insurance companies and dealers. These aren’t exclusive; in fact, a common mistake is to fixate only on one type of risk. Most risks cross boundaries and present issues of several, or even all seven, types. The seven types are market risk, credit risk, operational risk, liquidity risk, funding risk, reputational risk and political risk.
7 Types of Financial Risk
Thinking about financial risk tends to induce tunnel vision, especially in the wake of a market downturn or when you fear market uncertainty. However, risk, danger and opportunity are closely aligned aspects of uncertainty, and you need to consider each aspect as you make investment decisions:
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Danger is one-sided uncertainty. Danger produces only bad surprises, and its results aren’t measured in money or anything else that can be aggregated. Dangers should be minimised, subject to constraints.
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Risk is a two-sided uncertainty – both good and bad surprises are possible. Results of risk can be aggregated. Your goal is to optimise risk by choosing the right level for your circumstances. Don’t reflexively choose low risk for predictability or high risk for excitement.
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Opportunity is one-sided again, bringing only good surprises with unquantifiable results. Maximise your opportunities, subject to constraints.
People tend to overestimate the probability of bad events (dangers) and fear dramatic but unlikely ‘movie plot’ scenarios while underestimating the probability of something unprecedented and unexpected happening (risk).
As you make financial decisions, consider the types of risk you may encounter that can affect your strategy:
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Market risk: Uncertainty due to changes in market prices.
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Credit risk: Uncertainty due to a failure of an external entity to keep a promise.
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Operational risk: Institutional uncertainties other than market or credit risk.
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Liquidity risk: Uncertainty about terms and the ability to make a transaction when necessary or desired.
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Funding risk: Uncertainty about whether investors will provide sufficient funds.
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Reputational risk: Uncertainty about how your entity will be perceived.
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Political risk: Uncertainty about government actions.
Make sure you consider the range of risks, and if everyone is thinking about the market risk, take a minute to think about reputational risk or funding risk as well.
Managing Financial Market Risk
When managing financial risk, market risk – the uncertainty about how prices will change in the market – is a constant concern. And a valid one. You should always weigh the risks before making any market decisions.
Prices may move to levels that cause you to lose control of your securities if investors redeem more than you can easily pay out. Alternatively, lenders may demand more cash than you can raise. Dangers can come from several directions.
Volatility, the normal ups and downs of prices, is how you make money in finance, and the main market risk. Too low a level of volatility can mean that you don’t generate enough profits in good times to satisfy investors or survive bad times; too high a level can eat into returns and frighten investors and counterparties.
Sometimes market prices move to a level that allows you to initiate a position you could not do in normal markets. Be prepared to seize such opportunities.
How to Manage Credit Risk in Financial Institutions
In financial risk management, the failure of an external entity to keep a promise is a credit risk you take on every day. This is expected, to a certain point. Managing that risk is the important part.
If a customer doesn’t make a routine payment or a supplier fails to make a promised delivery, you and your organisation may face serious hardship to the point of having your organisation fail. On the other hand, the failure of an entity to perform opens up a profitable market niche for you if you can take advantage of the opportunity.
You must balance your credit risk. If you keep your credit risk too low by dealing only with the most reliable counterparties and forcing them to accept all uncertainty in your business relationship, you may cut yourself off from innovation and knowledge sharing, and pay too much for services. If your credit risk is too high, the accumulation of defaults will likely derail any business plan.
How to Manage Operational Risk in Financial Institutions
As a financial risk manager, one of the risks you need to consider is uncertainty within your own organisation. Institutional or operational risks are many – employee malfeasance, computer errors, attacks (physical or cyber), for example – and too numerous to list.
In managing operational risk, look to see how tight or loose the workplace is. Too loose a workplace leads to errors, inefficiency, bad discipline, frustration for talented employees, and damage from lazy or incompetent ones. Too tight a workplace leads to people hating their jobs, stress, and barriers to innovation; it can attract people who like to boss others around rather than do any work themselves.
To help change operational risk to opportunity, concentrate on business practices that make work fun, build a useful business, meet social needs and contribute to employee career development, personal growth and financial security.
How to Manage Liquidity Risk in Financial Institutions
Liquidity, the ability to convert assets to cash quickly, clearly affects your financial risk management decisions. If you don’t have enough liquidity, you may not be able to get out of untenable positions or be forced to sell assets at losses far beyond hopes and expectations. Too much liquidity makes it difficult to ignore short-term market opinion; too little liquidity insulates decision makers from reality.
A liquidity freeze in one market allows profitable transactions in related markets, however, and excess liquidity allows you to take positions that would be impossible in normal times.
How to Manage Funding Risk in Financial Institutions
Uncertainty about whether investors will provide sufficient funds is a challenge that every financial risk manager faces. Balancing these risks is essential to your success. There are a few things to consider.
If investors withdraw funding, whether by redeeming their stakes for cash or selling their interest to others at low prices, it may lead to a lack of confidence in your organisation and prevent you from raising new funds and encouraging other investors to jump ship.
Investors who are locked in for long terms, with few control rights, allow you to take a long view, but they provide you no pressure to succeed and probably charge a lot for their capital. Investors who can get full value back upon demand keep you on your toes, and charge less for their capital, but are unlikely to be true partners. However, if some investors withdraw, you have an opportunity to restructure your business to run in a better way for remaining investors.
How to Manage Reputational Risk in Financial Institutions
How your organisation is perceived, what its reputation is, is a key component in your financial risk management strategy. The two easiest ways to get a bad reputation are to care only about reputation and to care nothing about reputation. Earning a good reputation requires a careful mix of considering the feelings of others and being willing to stand up against the crowd when necessary.
An embarrassing scandal in a financial entity often leads to regulatory crackdowns, loss of business, lawsuits, employee losses and other bad outcomes. On the other end of the scale is an organisation or people connected with it who are seen to do something admirable – anything from employees pitching in to fund and build a community playground to the business coming up with an innovative and attractive new product.
How to Manage Political Risk in the Financial Field
Political risk is ever-present and uncontrollable. As a financial risk manager, you can only hope to avoid the obvious dangers and benefit from government actions.
The dangers of political risk are many: governments have been known to seize property, outlaw certain types of businesses or business practices, throw business leaders in jail or even kill them. On the less harmful but irritating side, government officials can make your life miserable with red tape, petty injustice, corruption and doubletalk. Sometimes they have good reasons, sometimes not, but such things are rarely predictable.
On the positive side, governments have been known to protect rights, take care of business needs, provide opportunities, create general peace and prosperity, and make you proud to be a citizen. Working with and supporting governments can be very rewarding.
Investors like governments to set clear rules and stick by them, so they can plan things like taxes, legal structure, contracts and so forth. However, they also want government entities to be flexible enough to consider new ideas and to weather changes in the world around them. Ideally, you want government relationships that are close enough that you’re on the same side, but not so close that you become cronies, or capture regulators, or agents of the state.
