Module 3: Introduction to risk taxonomy Flashcards
Definition of risk
There is no single definition of risk that is applicable to all circumstances.
However, most definitions encompass:
- the UNCERTAINTY of possible future random events
- the nature and degree of harm associated with each such event, eg failure to meet objectives, specified financial loss etc.
A common, basic risk categorisation is made up of 4 risk types:
- Market risk
- Credit risk (default / counterparty)
- Operational risk
- Underwriting / Insurance risk
Market risk
Risk arising from changes in investment market values, or other features correlated with investment markets, such as interest and inflation rates.
Includes the consequence of investment market value changes on liabilities, and may also include the consequence of mismatching asset and liability cashflows.
Underwriting / insurance risk
The risk of accepting risks which turn out to be inappropriate or pricing accepted risks inappropriately.
4 Financial risks
- Market risks
- Credit risks
- Business risks
- Liquidity risks
Financial risks:
—- 4 Business risks
- Underwriting
- Insurance
- Financing
- Exposure
2 Non-financial risks
- Operational risks
- External risks
3 Types of market risk
- Trading risk
- Asset / Liability mismatch
- Liquidity risk
Causes of trading risk
- changes in prices (equity, commodity) or rates (interest, exchange)
- other market driven risks
- basis risk
2 Characteristics of trading risk
- short-term
- able to close-out or hedge in a few days
4 Parties exposed to trading risk
- investment banks
- dealers
- market-making energy firms
- non-financials with trading book
3 Causes of Asset / Liability mismatch risk
- unmatched interest rate sensitivity of assets and liabilities
- foreign exchange risk
- basis risk
2 Characteristics of Asset / Liability mismatch risk
- takes longer to close out than for interest rate trading risk
- can be hedged more frequently than other types of risk.
4 Parties exposed to Asset / Liability mismatch risk
- commercial and retail banks
- investment banks
- insurance companies
- energy firms (input / output price mismatches)
2 Causes of liquidity risk
- inability to fund financial obligations without sizeable losses
- insufficient market capacity leading to adverse impact on market price when a deal is required
Economic risk
Refers to risks arising from the impact of microeconomic factors on an organisation and/or its customers.
Examples are inflation risks and changes in demand.
Factors include:
- aggregate supply and demand
- own and foreign governments’ policies
- employment levels
- inflation, interest and exchange rates
- accommodation costs
Interest rate risk
Risks arising from changes in interest rates, which could include impact on customer behaviour as well as the financial impact.
Can be considered a subset of market risk and economic risk.
Foreign exchange risk
Risk arising due to exposure to movement in foreign exchange rates.
Can be considered a subset of market risk and economic risk.
Basis risk
The risk arising from differences in the movements of two comparable indices, e.g. different stock market indices, so that offsetting investments in a hedging strategy will not experience exactly offsetting movements.
Credit risk
The risk that a counterparty to an agreement will be unable or unwilling to make the payments required.
Some definitions define credit risk more narrowly as the risk that a borrower will partially or wholly default on repayment of debt.
Counterparty risk
The risk that another party to a transaction or agreement fails to perform its contractual obligations, including failure to perform them in a timely manner.
2 Components of credit risk
- the probability of default
- the loss (or recovery) on default
Liquidity risk
Can refer to:
- the risk of money markets not being able to supply funding to businesses when required (funding liquidity risk)
- or more broadly to the management of short-term cashflow requirements
Alternatively it may refer to:
the insufficient capacity in the market to handle asset transactions at the time when the deal is required (market liquidity risk).
Insurance risk
Arises from fluctuations in the timing, frequency and severity of insured events, relative to the expectations of the firm at the time of underwriting and pricing.
This will include:
- mortality
- morbidity
- property
- casualty risks
Insurance risks may be broken down into various components, such as:
DEMOGRAPHIC RISKS
- mortality and longevity risks
- morbidity risks
- proportions married and age differences of partners
NON-LIFE INSURANCE RISKS
- property risks, eg loss or damage due to fire
- casualty risks, eg worker’s compensation due to injury on the job
OTHER INSURANCE RISKS
- persistency risk, eg uncertainty in number of policies renewing
- expense risk, ie expenses not being as expected.
Demographic and non-life insurance risks can be further sub-divided into
LEVEL (OR UNDERWRITING) RISKS
- the risk that underlying claims incidence (and intensity) is not as expected
RESERVING RISK
- Volatility risk - uncertainty due to only having a finite pool of policies
- Catastrophe risk - e.g. the occurrence of a natural disaster
- Trend or cycle risk - the risk of future changes in claims incidence and intensity
Operational risk
The risk of losses resulting from inadequate or failed internal processes, people and systems, or from failure to recover from external events.
Basel accords:
This definition includes legal risk, but excludes strategic and reputational risk.
6 Possible components of operational risk
- PROCESS risk
- PEOPLE risk
- EVENT risk
- BUSINESS risk (including reputational risk)
- CRIME risk
- SYSTEM / TECHNOLOGY risk, which gives rise to risk because it requires significant investment, complex project management to introduce or change and effective oversight / governance.
Environmental risk
Covers risks relating to the natural environment and human interactions with it.
It therefore includes a wide range of drivers, from natural disasters and climate change to pollution and the impact of declining natural resources.
Legal risk
Risk arising from the understanding of and adherence to legislation, including changes in accepted interpretation.
Legal risk can arise due to (2)
- breaching the law, eg due to:
- — lack of awareness
- — lack of understanding
- — changes in interpretation by courts
- — deliberate intent
- inability to demonstrate compliance with the law.
3 Areas of legal risk
- NEW LEGISLATION
There may be new legislation in response to political or social pressures, which could impact on an organisation. - PROVISIONS IN IMPORTANT CONTRACTS
- COURT JUDGEMENTS AGAINST AN ORGANISATION
Regulatory risk
The risk of losses arising from changes in legislation or regulation.
It may also cover compliance risk.
(Regulatory risk is classified as an operational risk)
Compliance risk
Risk of losses due to failing to comply with existing legislation or rules.
Political risk
Encompasses a wide range of risks, including those related to political decisions (both social and fiscal) or indecision, changes in government, or events related to political instability including terrorism and wars.
3 Levels at which political risk might arise
MICRO LEVEL
- affecting specific firms, industry sectors, geographic regions
MACRO (NATIONAL) LEVEL
- eg nationalisation of an industry
MACRO (INTERNATIONAL) LEVEL
- eg the potentially conflicting actions of different governments on an organisation operating across many countries, perhaps involving a complex system of tariffs and quotas.
Agency risk
The risk resulting from the misalignment of interests between different stakeholders.
Used to refer to the specific risk that the management of an organisation will not act in the best interests of other stakeholders.
Reputational risk
The risk that events or circumstances could have an adverse impact on an organisation’s reputation or brand value.
Project risk
Risk of failure relating to a specific project undertaken by an organisation.
(classified as operational risk)
Strategic risk
Strategic risk relates to the achievement of an organisation’s overall strategic business plans and objectives.
Covers all those operational risks that might prevent an organisation meeting its objectives.
Demographic risk
Arises from demographic changes such as mortality rates, impacting both customers and employment.
It can also be a component of insurance risk.
Moral hazard
Refers to the action of a party who behaves differently from the way they would behave if they were fully exposed to the consequences of that action.
The party behaves inappropriately or less carefully than they would otherwise, leaving the organisation to bear some of the consequences of the action.
Moral hazard is related to information asymmetry, with the party causing the action generally having more information than the organisation that bears the consequences.
Conduct risk
Used to encompass those risks that relate directly to the relationship between a company and its customers.
It can therefore encompass elements such as
- operational failures
- information asymmetries
- keeping pace with regulatory requirements
- keeping pace with customer needs
- product development activities
- strategic objectives
Social risk
Arises due to uncertainty over the future characteristics of a population, such as:
- age profile
- educational standards
- health standards
- economic wealth
- attitudes and lifestyles
Pension risk
Risk of losses to the sponsoring company resulting from an unexpected increase in the shortfall of the value of the pension scheme’s assets when compared to the value of its liabilities.
Systematic risk
Risk that is not diversifiable, or which cannot be fully diversified because it affects a large number of quantities of interest.
Non-systemic risk
Risk factors that are uncorrelated with or possibly independent from other sources of risk.
Such risks are largely diversifiable.
Concentration of risk: possible causes
Concentration of risk may be the result of
- not being able to diversify risk (i.e. constraints, either self- or externally imposed)
- a deliberate decision, e.g. based on high expected returns for a specific asset or product.
- poor management
Financial contagion
Refers to situations where financial losses in one company or sector or country lead to losses in another.
Contagion in the area of credit risk modelling
The default of one organisation can cause its creditors and suppliers to experience financial difficulties, which can generate further defaults.
A chain reaction can result.
Credit contagion in banking
Can arise where the failure of one bank leads to losses at others.
Imperfect information about the scale and location of these losses causes banks and other financial market participants to reduce the amount of credit available in the system, in turn increasing the likelihood of further bank failure.
Advantages of outsourcing
- increased capacity
- reduced costs
- reduced time to market
- better quality
- transfer of operational and other risks to the 3rd party
Disadvantages of outsourcing
- legal risks arising from the outsourcing contract
- loss of direct control over the risks now being experienced and managed in the outsourcer.
4 Examples of process risks
- efficiency (cost) versus effectiveness (meeting objectives)
- processing errors result in costs: financial, customer turnover, loss of reputation, legal / compliance breaches
- inadequate documentation results in costs, eg miscommunication
- model and data risks
9 Examples of people risk
- key positions remaining unfilled
- wrong people are employed / promoted / retained
- absenteeism, eg sickness, industrial action,
- lack of risk awareness
- incompetence
- dishonesty
- agency risks
- moral hazard risks
- risk of adverse selection
6 Examples of system / technology risks
- out-of-date functionality
- lack of sufficient access or capacity
- unauthorised use or access to data
- failure of technology
- inadequate backup systems or disaster plans
- software errors
3 Examples of event risk
- business continuity risk, eg due to inadequate contingency plans
- ineffective internal-change management, eg in effecting a merger
- ineffective external-change management, eg failures to adapt to changes in regulations
5 Examples of business risk
- inappropriate business strategy
- inadequate business plans
- changes in the (external) business environment
- business results do not meet stakeholder expectations
- damage to reputation or brand value (reputational risk)
4 Situations where financial losses in one sector or organisation may lead to losses in another
- financial infrastructure - the failure of a commonly-used system
- funding liquidity risk
- common market positions - where a change in share price results in further changes.
- exposure to a common counterparty - where a failure in one organisation causes another organisation to fail or creates a lack of confidence in the sector.
List of risk mentioned in the ST9 syllabus
- Market risk
- Liquidity risk
- Credit risk
- Operational risk
- Insurance risk
- Economic risk
- Interest rate risk
- Foreign exchange risk
- Basis risk
- Counterparty risk
- Environmental risk
- Legal risk
- Regulatory risk
- Political risk
- Agency risk
- Reputational risk
- Project risk
- Strategic risk
- Demographic risk
- Moral hazard
