Chapter 26 - Risk Identification & Classification Flashcards
Risk Identification
Risk identification is the recognition of the risks that can threaten an organisation’s business plan.
It is also important to identify opportunities to exploit risks and gain a competitive advantage over other providers. Taking on risk is a potential source of profit if the risk is priced correctly.
Identifying all the risks in an organisation is a difficult task and requires good knowledge of:
- the circumstances of the organisation concerned
- the features of the business environment in which it operates
- the general business and regulatory environment.
Initial Risk Identification & Analysis
- High-level preliminary risk analysis to confirm that the project does not have such a high-risk profile that it is not worth analysing further
- Brainstorming session of project experts and senior internal and external people who are used to thinking strategically about the long term
The aim will be to:
- identify project risks, both likely and unlikely, and their upsides and downsides
- discuss these risks and their interdependency
- attempt to place a broad initial evaluation on each risk, considering both frequency of occurrence and probable consequences if it does occur
- generate initial mitigation options
- discuss these options briefly
- Desktop analysis to supplement the results from the brainstorming session, by identifying further risks and mitigation options
- Considered opinions of experts who are familiar with the details of the project and the outline plans for financing it
- Carefully set out all the identified risks in a risk register or a risk matrix, with cross-references to other risks where there is interdependency
Market Risk
Risks related to changes in investment market values or other features correlated with investment markets, such as interest and inflation rates
The risk can be divided into:
- consequences of changes on asset values
- consequence of investment market value changes on liabilities
- consequences of a provider not matching asset and liability cashflows
In practice, a perfect match may be impossible because:
- may not be a wide enough range of assets available , in particular it is unusual to find assets of long enough 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
- cost of maintaining a fully-matched portfolio is likely to be prohibitive
Credit Risk
Credit risk is the risk of failure of third parties to meet their obligations
Particular examples are:
- a borrower defaulting on interest or capital payments
- There may be credit concentration risk, where lending is heavily weighted towards individual borrowers, industrial sectors or countries. This is a particular risk for banks, in terms of their loan portfolios.
- The term ‘credit risk’ is sometimes also used to describe the risk associated with any kind of credit-linked event. This could include changes to credit quality (up or down) or variations in credit spreads in the market as well as the default events described above
- counterparty risk, where one party to a transaction fails to meet their side of the bargain. An example of counterparty risk is settlement risk, which arises when a party pays away cash or delivers assets before the counterparty is known to have performed their part of the deal
- general debtors – the purchaser of goods and services fails to pay for them.
- in banking, credit risk is the potential that a borrower or counterparty will fail to meet its obligations in accordance with agreed terms. Retail credit risk refers to the risk of loss due to a customer’s failure to repay on a consumer credit product. Products may include: mortgage loan, personal loan, credit card or overdraft facility
Liquidity Risk
Liquidity risk is the risk that the individual or company, although solvent, does not have available sufficient financial resources to enable it to meet its obligations as they fall due
In the context of financial markets, liquidity risk 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.
In general, the larger a market is, the easier it is to trade and the more liquid it will be, because more participants in the market will be trading at any one time. Thus, when any member of the market wishes to complete a trade, it is likely that the market will be able to find a counterparty willing to accept the trade.
The market is sensitive to factors such as changes in interest rates and the economic outlook, which means that the price of the assets can vary significantly over time, so there is a risk that the asset holder may make a loss if they are required to make a sudden sale at a time the price is depressed.
Business Risk
Business risks are risks that are specific to the business undertaken. Business risk differs from operational risk in that the latter are non-financial events that have financial consequences.
The business risks of financial product providers can be further divided into the following subcategories:
underwriting risk – arising in relation to the underwriting approach taken insurance risk – arising from the uncertainties relating to claim rates and amounts financing risk – arising in relation to the financing of projects or other activities
exposure risk – arising in relation to the amount of business sold or retained, or to its concentration or lack of diversification.
Operational Risk
Operational risk refers to the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
Operational risks can be controlled or mitigated by an organisation. For individuals, operational risks arise in carrying out their normal lifestyle.
Operational risk can arise from:
- inadequate or failed internal processes, people or systems
- conduct risk, for example mis-selling, interest rate manipulation and money laundering
- the 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
- the failure of plans to recover from an external event
External Risk
External risk is a form of non-financial risk but is separate to operational risk
External risk arises from external events, such as storm, fire, flood, or terrorist attack. However, the failure to arrange mitigation against such risks is an operational risk
In general, these are systematic risks. Only for the largest entities is it economically efficient to diversify these by carrying out the same operation on different sites
Climate Change
Climate risks are risks arising from adverse changes in the physical environment and secondary impacts on the economy at a regional or a global level. Climate risks for financial companies are categorised into physical, transition and liability risks.
Physical climate risks are the first-order effects of environmental changes such as greenhouse gas emissions, pollution and land use. The effects may be chronic, such as global warming and sea level rise, or they may be acute events, such as instances of extreme weather
Transition risks refer to economic, political and market changes as a result of efforts to mitigate climate change. For example, changes in consumer preferences towards greener products, or changes in government policy towards reducing fossil fuel consumption.
Climate liability risks can arise from injured parties seeking compensation for the impacts of climate change. These impacts may be the first-order physical impacts related to climate change, or the second-order transition impacts. For example, a new link established between air pollution and adverse health conditions, resulting in a new class of latent insurance claims
