Chapter 26: Risk identification and classification Flashcards
What techniques can be used as part of the risk identification process?
- risk classification (to ensure full coverage)
- risk checklists, e.g. as used for setting
regulatory capital requirements - experience of staff joining from similar
organisations, consultants, experts - project management risk identification
techniques:
-> high-level preliminary analysis
-> brainstorming
-> desktop analysis
-> risk register/ risk matrix
Outline the techniques that can be used to identify the risks associated with a project.
-. High level preliminary analysis to confirm
that there are no big risks that mean it is
not worth continuing.
- Brainstorming with project experts and
senior internal/external people to:
-> identify likely/unlikely, upside/downside
risks
-> discuss these risks and their
interdependency
-> broadly evaluate the frequency and
severity of each risk
-> generate and discuss initial mitigation
options - Desktop analysis to supplement
brainstorming, which involves looking at
similar projects undertaken by the
sponsor and others. - Consult with experts who are familiar with
the details of the project and the plans for
financing it. - Risk register or risk matrix setting out
risks and their interdependencies
List the 6 major types of risk categories faced by an organisation.
- market risk
- credit risk
- liquidity risk
- business risk
- operational risk
- external risk
Suggest 7 categories of risks that could be used in a risk matrix for a typical project.
PNEFCPB
- Political - opposition to project, war,
terrorism, etc - Natural - earthquakes, hurricanes
- Economic - interest rate or exchange rate
movements - Financial - sponsor default, incorrect
cashflow estimates - Crime - fraud, theft
- Project - time delays, budget overruns,
bad design - Business - competition/lack of demand,
operational problems
Market risk
The risk related to changes in investment market values or other features correlated with investment markets such as interest rates/inflation.
Credit risk
The risk of failure of third parties to meet their obligations.
Liquidity risk
Liquidity risk is the risk that an individual or company, although solvent, does not have available sufficient financial resources to enable it to meet its obligations as they fall due, or can secure such resources only at excessive cost.
The risk for an insurer is usually low since investments usually include a large proportion of cash, bonds and stock market assets
Liquidity risk arises when the market does not have the capacity to handle that volume of transacted asset without a potential adverse price impact.
Business risk
Risk specific to the business undertaken.
Operational risk
The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
External risk
External risk arises from external events.
In general, external risk is systematic (i.e. non-diversifiable) risk.
Outline 3 subdivisions of market risk.
- changes in asset values - due to changes
in the market value of assets or changes
in interest rate, inflation rate, exchange
rate or market crashes. - investment market value changes on
liabilities - where liabilities are directly
related to investment market values,
interest rates or inflation rates. - mismatching asset and liability
cashflows.
Market risk could be removed through holding an asset portfolio that perfectly matches the liability portfolio.
Give reasons why a perfect match may not be possible in practice
- There may not be a wide enough range of
assets available; in particular it may may
not be possible to find assets in
sufficiently long duration. - Liabilities may be uncertain in amount
and timing. - Liabilities may include options and hence
have uncertain cashflows after the option
date. - Liabilities may include discretionary
benefits. - The cost of maintaining a full-matched
portfolio is likely to be prohibitive.
Credit rating
A credit rating is a rating given to a company’s debt by a credit-rating agency as an indication of the likelihood of default.
List examples of credit risk.
- borrowers defaulting on interest and
capital payments (including credit
concentration risk and possibly also credit
spread changes), e.g. issuers of
government or corporate bonds. - counterparties to a transaction failing to
meet their obligations (including
settlement risk), e.g. banks, reinsurers,
external investment fund managers - debtors failing to pay for purchased
goods/ services, e.g. policyholders,
brokers
How can credit risk be reduced when lending money?
Security (or collateral) may be required from the borrower as a way of reducing credit risk when lending money.
Outline the considerations when determining what security should be taken from the borrower.
- nature of transaction underlying the
security - covenant (credit worthiness) of the
borrower - what security is available
- comparative negotiating strength between
lender and borrower - market circumstances
What is a liquid asset and how does this differ from a marketable asset?
A liquid asset is one that either:
- is close to cash in nature, or
- can be converted to cash quickly and the
amount of cash it would become is almost
certain
A marketable asset is one that can be converted to cash quickly, but the amount of cash received is uncertain.
What makes a market liquid?
A liquid market is likely to be a large market with lots of ready participants.
Why are banks exposed to significant liquidity risk?
Banks lend depositors’ funds and funds raised from the money markets to other organizations for potentially long periods. Customers may want instant access to their deposits, creating a need for liquidity. There is a risk that more customers than expected demand cash.
Outline 4 examples of business risks to a financial provider.
- Inadequate underwriting standards
leading to the mis-pricing of risks
(underwriting risk). - More claims than anticipated (insurance
risk). - Investment in a business or project that
fails to be successful (financing risk). - Greater exposure than planned to a
particular risk event (exposure risk).
Outline 5 examples of operational risk.
- Inadequate or failed internal processes,
people or systems e.g. fraud,
mismanagement, system failure. - The dominance of a single individual over
the running of a business (dominance
risk). - Poor conduct towards customers / the
market (conduct risk). - Reliance on third parties to carry out
various functions for which the
organization is responsible, e.g.
outsourcing - The failure of plans to recover from
external events.
List examples of external risks.
- Natural disasters such as storm, fire, flood
- Terrorist attacks
- Regulatory, legislative and tax changes
How are operational risks likely to be identified and analyzed?
A model could be used but such models are only as good as the parameters input.
Identification and analysis of operational risks typically requires considerable input from the owners of a business, senior management and other individuals with a good working knowledge of the business.
Outline 3 risks to a financial company, that may be generated by climate change.
- physical – arising from the first-order
effects of environmental changes, e.g.
extreme weather - transition – arising from economic,
political and market changes, e.g.
reduced fossil fuel consumption - liability – relating to compensation claims
due to the impacts of climate change, e.g.
claims arising from professional
indemnity or public liability insurance
