Why Financial Risk Management is Important

Mar 16, 2020

What is Financial Risk Management?

All business endeavors come with risks. A risk means an event which, if it occurs, may lead to undesired outcomes and impacts. Risk management offers a set of techniques and tools that allow us to identify, measure, and manage risks. In turn, financial risk management boosts returns from investments and earnings from business activities through:

Risk management strategies

Financial risk management is also about risk management strategies and ways to treat the identified, measured, and prioritized risks within these strategies. We don’t dive deep into such strategies here as these are not the topic of this article. However, it is worth mentioning that the most common strategies are avoidance, reduction, sharing, and retention of risks. Their names say it all. Which type of risk management or risk management strategy to choose depends on the risk weight, severity, the amount of potential and actual losses and gains and many other factors.

After briefly recalling the theory of risk management, we then look at financial risk assessment. In general, assessing financial risk means not only determining the likelihood of the loss of an asset or investment, but also measuring a bank’s attitude and tolerance to the risk, and its capacity for risk within a certain period. Moreover, risk assessment is about quantifying financial risks by applying such methods as value-at-risk analysis, regression analysis, and scenario analysis.

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Global Concerns about Financial Risk

According to Accenture’s 2019 Global Risk Management Study, new risks are emerging faster than ever and are becoming even more complex. Disruptive technology, data breaches, and operational risks are the top three challenges named by risk executives in the study.

The IMF Climate Change and Financial Risk article underlines that policymakers and regulators are increasingly factoring in climate change, which has another implication for the financial sector: damage to property, infrastructure, and land are just few of the possible exposures. In addition, The Green Swan paper published recently by the Bank for International Settlements warns that climate change could simply unleash “potentially extremely financially disruptive events” and the bankers are not capable of saving the world by themselves.

The Global Association of Risk Professionals offers the following overview of the regulatory evolution of financial risk management history:

Types of risk and risk management approaches from the Global Association of Risk Professionals

Today, although the regulatory focus has shifted to climate risk, it still embraces the four major risks: credit risk, market risk, operational risk, and liquidity risk. Investment risks, security, and breaks in business continuity may supplement the list of challenges faced by the capital and financial markets.

How to Manage Financial Risk

Regulators recognize the need for businesses to capture increasing amounts of data and produce progressively more accurate reports to maintain the continuity of financial institutions and banks in the face of financial risk. They stipulate the use of financial risk management software in their recommendations. The benefits are clear: automation, accuracy and relevancy, secure data processing, and real-time recording and updating of information allow businesses to keep pace with changes. In addition, risk management software helps establish proper risk controls: the greater the consequences of the risk, the more stringent the controls that should be applied.

Financial risk management benefits and risk management techniques

Risk and control management software covers many aspects of risk management processes, from identifying a risk through to its assessment, mitigation and monitoring. The features of most risk management software include:

  • Visual representation
  • Evaluation techniques
  • Control activities
  • Analytics
  • Reporting
  • Risk monitoring

As a form of financial risk management, companies should be open to consulting third parties, experts in mitigating exposures.

Risk Management Software: How to Choose a Financial Risk Management Vendor

For companies operating in a highly regulated environment or handling classified and confidential data, or those whose business is spread across multiple locations or exposed to potentially unfavorable market conditions, the smallest negligence or failure to comply or take proper measures may result in the worst consequences. Risk management software helps risk managers identify risks and communicate them to their businesses. Moreover, risk management solutions are important for protecting data, employees, customers, brands, and shareholders.

There are many solutions in the market that are worth exploring. So, how do Heads of Risk Management and Chief Risk Officers (CROs) choose the right solution? Let’s start by answering these questions:

  • What risk management framework applies to the business?
  • Is the existing framework the best one?
  • Should it be a cloud or on-premises deployment?

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  • What are the major features of the solutions offered in the market? And which of these are applicable to our business requirements?
  • Should this solution be integrated with software the company already uses?
  • What are the pricing options?

Once the big picture has been outlined, risk managers can start to evaluate their requirements. The chosen financial risk management solution must also align with business goals and the expectations of stakeholders. With this understanding, Heads of Risk Management and CROs can move to preliminary consultancies with vendors, check their credentials and certificates, and ask them for references.

Tips for CROs when talking with risk management software vendors:

  • Is the solution scalable?
  • What are the payment conditions?
  • Who gets custody of the supplemented data once the company changes vendor?
  • Is there any proof of concept?

At this point, risk managers should already have a clear picture of what they want or need and what a vendor is able to offer! Don’t forget to agree on a detailed roadmap and deliverables, if any, with your software vendor before signing the deal.

At CompatibL, we offer solutions specifically tailored to our clients’ needs. Combining quant and engineering expertise in one team has made CompatibL highly effective at developing risk management software for the financial industry. In particular, our products allow our clients to enhance their risk management infrastructure and framework to improve the performance of their business, improve their risk management culture, and strengthen their risk management techniques.

Focus on Mitigation, Not Elimination

The pace of change does not seem to be getting any slower. And risks are growing even more complex.

The need for a multistakeholder approach to mitigating risks, as stated in the World Economic Forum Global Risks Report 2020, is undoubted: leaders from businesses, governments, and non-profit communities must come together to seek the best solutions.

Meanwhile, firms are supporting incentives to develop new technologies aimed at promoting sustainable finance and mitigating the impact of climate change. Many regulators are urging global coordination and more accurate evaluation of the long-term consequences of climate change.

These are just few of the many global risk management initiatives. They are intended to raise concerns about the current impacts on capital and financial markets and raise awareness of the importance of good financial risk management.

The threats and risks to businesses continue to proliferate, but the combination of new advances and the world of existing technology has the potential to solve them. Manage your risks to protect your financial future.

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