5.3 Categorising risk

Question 1

A common approach to risk categorisation is to group organisational risks into which 6 categories?

Answer 1

business risk
credit risk
market risk
liquidity risk
operational risk
reputation risk

Question 2

What is business risk?

Answer 2

Non-financial risk relating to the positive and negative otucomes inherent in an organisation’s operating environment, such as action of competitors and political conditions.

Question 3

Give some examples of business risks.

Answer 3

Actions of competitors
Political conditions
Economic conditions
Changes in consumer demand
Changes in regulation

Question 4

Business risks can be grouped as i________ or e_______.

Answer 4

internal

external

Question 5

How does Blockbuster demonstrate poor management of business risk?

Answer 5

Blockbuster did not adapt to customer demand.

Blockbuster was the leading provider of movie rental during the 1990s. The business refused an offer to buy Netflix for $50M in 2000 and ultimately went bankrupt in 2010 after failing to see the need to move to streaming from physical disk rental.

Question 6

What is credit risk?

Answer 6

The risk that a borrower or counterparty will suffer a real or perceived deterioration of its credit rating, or an outright default, meaning they are unable to meet obligations.

Question 7

In credit risk, exposure if measures as the amount of l____ that would be realized if a borrower or counterparty actually d_______.

Answer 7

loss

defaults

Question 8

What is meant by “concentration” risk in the context of credit risk?

Answer 8

The risk that any single exposure has a potential to result in losses affecting the viability of an organisation - i.e. over-dependency on a single client

Question 9

Credit risk specifically attributable to trading activities is called C________ C____ R___ (CCR), concerned with default on trading obligations such as derivative contracts.

Answer 9

Counterparty Credit Risk

Question 10

Settlement risk is concerned with what?

Answer 10

The risk of a trading transaction not settling as per pre-agreed terms and conditions.

Question 11

What is sovereign risk?

Answer 11

Risk of a sovereign government defaulting on debt obligations.

Question 12

How does the Herstatt example provide a case study in credit risk?

Answer 12

Herstatt was a private bank in Germany, active in foreign exchange, which had a strong position betting against the US dollar. In 1974, the dollar strongly appreciated, leading to the bank’s liquidation. A number of US firms had paid large amounts to the after the liquidation but before they were notified of the liquidation, leading to large losses (and exposure to credit risk).

Question 13

How can credit risk be managed?

Answer 13

Statistical models
Stress testing
Scenario analysis
Risk appetite and limits, including concentration limits
Credit underwriting and diversification standards.

Question 14

What is market risk?

Answer 14

Market risk is the extent of change in the value of an investment due to changes in factors affecting the overall performance of financial markets.

Question 15

Market risk is also known as what?

Answer 15

Systemic risk

Question 16

The four major categories of market risk are:
e\_\_\_\_\_\_\_ risk
i\_\_\_\_\_\_\_ r\_\_\_ risk
f\_\_\_\_\_\_\_\_\_ e\_\_\_\_\_\_\_ risk
c\_\_\_\_\_\_\_\_\_ p\_\_\_\_\_\_\_ risk

Answer 16

equity risk
interest rate risk
foreign exchange risk
commodity price risk

Question 17

V___________ is the key driver of market risk. It represents the degree of dispersion of returns for a given investment.

Answer 17

Volatility

Question 18

How is volatility estimate in statistical terms?

Answer 18

Standard deviation

Question 19

Market risk is primarily calculated using which method?

Answer 19

The value at risk method.

Question 20

How may market risk be managed?

Answer 20

Statistical models
Stress testing
Scenario analysis
Risk appetite and limits
Diversification and hedging
Qualitative assessments

Question 21

There are two types of liquidity risk. What is asset liquidity risk?

Answer 21

An asset’s degree of liquidity, i.e. the inability to easily sell the asset.

Question 22

There are two types of liquidity risk. What is funding liquidity risk?

Answer 22

The risk an organisation is unable to fulfil its payment obligations in a timely manner in normal or stressed market conditions.

Question 23

How did Northern Rock exemplify liquidity risk?

Answer 23

Northern Rock expanded aggressively into residential mortgages, funded by short term overnight borrowing. Following the 2008 financial crisis, banks stopped lending to one another, locking NR out of the borrowing market. This spooked customers who withdrew savings, leading to insolvency and nationalisation of the bank.

Question 24

What is operational risk?

Answer 24

The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

Question 25

Operational risks are generally “pure” risks. What does this mean?

Answer 25

They only result in losses (no positive outcomes).

Question 26

Provide examples of operational risks.

Answer 26

Fraud by staff, customers, or third parties.
Loss due to inadequate risk models
Damage to assets such as fire or flood
Business disruption such as strikes or power cuts
Health and safety issues
Customer service issues
Security breaches such as cyber attacks

Question 27

What is regulatory compliance risk (a type of operational risk)?

Answer 27

The risk of failure to comply with laws and regulations, leading to penalties such as fines.

Question 28

What is data quality risk (a type of operational risk)?

Answer 28

Risk of data used to calculate risk exposure being inaccurate.

Question 29

What is reputation risk?

Answer 29

A strategic risk referring to risk of loss resulting from damages to reputation of an organisation, its brand, and perceived goodwill.

Question 30

Why is reputation important for an organisation?

Answer 30

Good reputation leads to attracting more customers and higher-quality employees. It also contributes to lower marketing and financing costs.

Question 31

How does the Ratner Group case study provide an example of reputational risk?

Answer 31

Ratner Group was a successful budget jeweler. At an IoD dinner at the Albert Hall, CEO Gerald Ratner made rash comments about the poor quality of his organisation’s products. Following this speech, the value of the Group plummeted by £500M.

Question 32

Kaplan & Mikes (2012) developed an alterative risk categorisation framework segregating risks into three categories:

p___________ risks
s________ risks
e________ risks

Answer 32

preventable risks
strategy risks
external risks

Question 33

What is a preventable risk, according to Kaplan and Mikes?

Answer 33

An internal risk faced by an organisation that is controllable.

Question 34

What is a strategy risk, according to Kaplan and Mikes?

Answer 34

A risk assumed by an organisation willingly in pursuit of competitive advantage.

Question 35

What is an external risk, according to Kaplan and Mikes?

Answer 35

A risk outside the organisation beyond the limits of its influence or control. e.g. political changes.

Question 36

What are “internal control” risks?

Answer 36

Risks relating to failure of the processes, systems and controls that an organisation has in place to manage its employees and managers.

Question 37

What were the facts of the LIBOR scandal?

Answer 37

Following the 2008 financial crisis, employees of Barclays Bank plc fraudulently manipulated interest rates reported under the London Interbank Offer Rate (LIBOR), to make the bank appear stronger than it was. This led to an increase in the LIBOR rate, which affected the credit interest rates on mortgages and other loans.

Barclays management were criticised for not having a stronger culture and internal control process to prevent such fraudulent activity. Barclays was fined a total of £390 million and the CEO and Chair resigned.

Question 38

Risk c____________ is important to help organisations understand their risks. Organisations must decide how d_________ to make their subcategories. Too many make it difficult to categorise risks, too few and differences between risks may be missed.

Answer 38

categorisation

detailed