25 - Risk Identification and Classification Flashcards
Risk identification defn.
Recognition of risks that can threaten an organisation’s business plan
Identifying all the risks in an organisation requires a good knowledge of:
- Recognise risks that will threaten the assets & income of the organisation by establishing context:
- > Business objectives
- > Company structures & finances
- > Who are the key stakeholders?
- > What is the area of business?
- > External environment
- Systematic or diversifiable?
- Preliminary identification of possible risk control processes
- Identify exploitable risks to gain competitive advantage
As well as:
- Input from people involved at all levels of the business
Techniques available to ensure all relevant risks have been identified:
- Risk classification to ensure all types of risk have been considered
- Risk checklists as used for regulatory purposes
- Experience of:
o Staff who have joined from similar organisations
o Consultants with broad experience of industry concerned - Project management risk identification methods:
o Preliminary risk analysis
o Brainstorming
o Desktop analysis
o Opinions of experts familiar w details of the project & plans for financing it
o Set out identified risks in a risk register/matrix
-> Cross reference risks where there is correlation
Project management:
Preliminary risk analysis
The initial high-level risk analysis done to confirm that the project does not have a high-risk profile st. it is not worth analysing further - in which case project should terminate
Project management:
Brainstorming
Brainstorming session held with project experts, senior internal & external people who are used to thinking strategically about the long term aimed at:
o Identifying project risks both likely/unlikely and their upsides/downsides o Discussing risk interdependencies o Attempting to place broad evaluation on risks considering both freq./severity of their occurrences o Generate initial mitigation options o Discuss the options briefly
Project management:
Desktop analysis
- Supplements brainstorming results by identifying further risks & mitigation options by researching:
o Further mitigation options
o Similar projects taken up by sponsor or others in the past (including overseas experiences)
What are the different risk categories?
- Credit risk
- Operational risk
- Market risk
- Business risk
- Liquidity risk
- External risk
What are the prerequisites to assessing the significance of each risk?
Why do we need to assess risk significance?
- Understanding of business undertaken by a provider
- Understanding of the organisational structure of the provider
Need to assess risk significance to:
- Determine how the outcome of the risk translates into financial impact on the balance sheet and cashflow requirements
Market risk defn:
Risks related to changes in investment market values or other features correlated with investment markets, such as interest and inflation rates
Market risk components:
- Consequences of changes on asset values (this is the most obvious implication)
- Consequence of investment market value changes on liabilities
- Consequences of a provider not matching asset and liability cashflows
Market risk:
Asset value changes
- Changes in the market values of equities and property
o May be systematic or specific
o Can be reduced by diversification across the mkt. and diff. systems - Changes in interest, inflation rates, currency rates or import tariffs
o Affect value of fixed-interest & index-linked securities
o Also has some effect on equities & property (domestic & overseas)
o Affect value of profits in home currency & prices of imports & exports
Describe the likely effect of an increase in short-term interest rates on the value of: o Fixed-interest bonds o Index-linked bonds o Equities o Property
FI Bonds:
> Increase in short-term int. rate => almost certain fall in short-term bond values
> Impact on long-term FI bonds unknown -> depend on investor views of future inflation & monetary policy
IL bonds:
- Increase in short-term int. rates is a sign of low future inflation => lower demand for IL bonds => lower price
Equities:
o Increase in short-term int. rates might depress economic growth => fall in equity values
Property:
-> Increase in short-term int. rates => lower valuation of future rents => lower value of property
Market risk:
Liability value changes
- These may arise if promises to stakeholders are directly linked to investment market values or interest rates eg. unit-linked or inflation-linked benefits
- Change in interest rates or inflation may affect the amount of capital a provider needs to establish for future liabilities
o Changes the basis used to value liabilities
Market risk:
Why do we need asset-liability matching?
- Market risk can be significantly reduced if the assets matched the liabilities in terms of currency , nature and term.
Market risk:
Why may perfect asset-liability matching be impossible in practice?
- Variety of assets may be insufficient (particularly long-term assets for retirement benefits)
- Cost of maintaining fully-matched portfolio may be prohibitive
- Liabilities may:
o Include discretionary benefits
o Be uncertain in amount and timing
o Include options and hence have uncertain CFs after the option date
Market risk:
What may be the consequences of an unmatched risk portfolio?
- Greater exposure to mkt. risk as assets & liabilities will not move in line with each other
- Higher liquidity risk
- Reinvestment risk -> risk of having to invest asset proceeds on unknown future terms
Market risk:
Credit risk
- Credit risk is the risk of failure of third parties to meet their obligations e.g. counterparties, general debtors
- Also used to describe the risk of a “credit-linked event” such as:
o Downgrade in credit rating
o Bankruptcy
o Defaulted/late interest or capital payments
How to mitigate credit risk?
- If a borrower is required to provide security to the lender, credit risk is mitigated
Decision as to what security is taken is dependent on:
- The nature of the transaction underlying the borrowing
- The creditworthiness of the borrower
- Market circumstances and the comparative negotiating strength of lender and borrower
- What security is available
** It must be within the ability of the lender to realise the security if necessary in a cost-effective manner.
Market risk:
Liquidity risk
- Liquidity risk is the risk that the individual or company, although solvent:
o Does not have available sufficient financial resources to enable it to meet its obligations as they fall due.o They can secure such resources only at excessive cost
What is the nature of liquidity risks faced by:
o Non-financial institutions
o Insurance companies and Pension schemes
o Banks
o Collective investment schemes & insurance funds
Non-financial institutions -:
o Trading companies are likely to have most of their assets in inventory & work in progress.
o Not being able to realise inventory and pay creditors is that largest source of liquidity risk
Insurance companies & pension schemes:
o Face little liquidity risk as assets largely invested in equities & bonds unless in special circumstances eg. catastrophe & bulk transfer out of scheme
Banks:
o Face significant liquidity risk as they lend depositors’ money and funds raised from money mkts for durations longer than they offer to providers of the funds
o Retail banks need sufficient liquid resources to withstand large numbers of customers drawing their money
CIVs & insurance funds:
CIVs & insurance funds may invest in real property, they can protect themselves from liquidity risk by:
o Having the power to defer withdrawals (upto 6mnth)
o Instating lock-in periods
What is market liquidity risk concerned with?
- Can arise where a market does not have the capacity to handle (at least, without a potential adverse impact on the price) the volume of an asset to be bought or sold at the time when the deal is required
- Larger market for an asset => easier it is to trade and the more liquid it will be, because more participants in the market will be trading at any given instant
Marketability vs Liquidity difference:
- Marketability is how easy it is to buy or sell an asset
- Liquidity is a measure of how quickly the asset can be converted into cash AT A PREDICTABLE PRICE
Business risk defn and how is it different to operational risk:
Risks that are specific to the business undertaken
- Operational risk has to do w non-financial risks that have financial consequences
What are the business risks of Financial service providers?
- Underwriting risk: Arises in relation to U/W approach taken
- Financing risk: Arise in relation to financing of projects or other activities
- INsurance risk: Arise from uncertainties related to claim rates & amounts
- Exposure risk: Arise in relation to amt of business sold/retained or to its concentration/lack of diversification
U FINE
Operational Risk defn:
Risk of loss resulting from inadequate or failed internal processes, people and systems or from external event
-> not having measures in place for external events is an operational risk
Operational risk can arise from:
- Inadequate or failed internal processes, people or systems
- Dominance of a single individual over the running of a business, sometimes called dominance risk
- Reliance on third parties to carry out various functions for which the organisation is responsible e.g. if administration or investment work is outsourced
- Failure of plans to recover from an external event.
Examples of common operational risks and the controls put in place to manage them:
- Risk that EXISTING CONTROLS are not operating effectively :- Periodic control reviews with changes made on a timely basis
- Risk of FRAUD (misappropriation of assets and fraudulent financial reporting) :- Segregation of duties; frequent reconciliation procedures for cash and investment balances
- FUNDING/INVESTMENT risk (inappropriate investment strategies) :- Reconciliation procedures; review of investment strategies; independent peer review of funding advice
- COMPLIANCE/REGULATORY risk (failure to comply
with scheme rules and legislation) :- Compliance audits; stewardship and compliance reports from third parties - Non-compliance or MALADMINISTRATION by administration team or third party advisers, eg outsourced administrators (poor record keeping) :- Peer review of key controls by admin team; authorisation procedures; Periodic trustees and provider meetings (when required); service level agreement reviews; performance appraisal of providers; internal quality review procedures by third party administrators
- IT SYSTEMS and database failures :- System recovery plans; data back-up procedures; password controls
External risk defn and give examples:
Risk that arises from external events separate to operational risk however failure to arrange mitigation strategies against such risks is an operational risk
- External risks can arise and spread into other categories of risk eg. COVID pandemic
Examples include:
- Flood, storm, fire, terrorist attack
- Legislative changes, Tax changes Regulatory changes
What details of the identified risks are shown on a risk register?
- Category
- Identifier
- Description
- Size and nature of the risk
- Possible other risks correlated with each risk
- Current status of the risk
- Example scenarios where the risk is likely to occur
- List those responsible for risk handling
- How risk is managed
- Date of last and next assessment
