LESSON 12 IDENTIFICATION, ASSESSMENT, AND MEASUREMENT OF RISK

Systemic Risk

• It is not fully uncontrollable by an organization.

• It is not entirely predictable.

• It is usually of a macro nature.

• It usually affects a large number of organizations operating under a similar stream.

• It cannot be fully assessed and anticipated in advance in terms of timing and gravity.

• The examples of such types of risks are interest rate risk, market risk, and purchasing power risk.

Unsystemic Risk

• It is usually controllable by an organization.

• It is reasonably predictable.

• It is normally micro in nature.

• If not managed, it directly affects the individual organization first.

• It can be assessed well in advance with reasonable efforts and risk mitigation can be planned with proper understanding and risk assessment techniques

• The examples of such risks are compliance risk, credit risk, and operational risk.

Financial Risk

The risk, which has some direct financial impact on the entity, is treated as a financial risk. This risk may be market risk, credit risk, liquidity risk, operational risk, legal risk, and country risk. The following chart depicts some of the various types of risks.

Non-Financial Risk

This type of risk does not usually have a direct and immediate financial impact on the business, but the consequences are very serious and later do have a significant financial impact if these risks are not controlled at the initial stage. This type of risk may include business/industry & service risk, strategic risk, compliance risk, industry fraud risk, reputation risk, transaction risk, and disaster risk.

Market Risk

This type of risk is associated with market ups and downs. It refers to the risk of loss arising from the change/volatility in the market prices or economic values, which are the deciding factors for the pricing of the product/financial assets. This may be absolute risk and relative risk. Hence, this risk may be defined as the risk to a firm due to the adverse changes in interest rates, currency rates, equity prices, and commodity prices.

Interest Rate Risk

The financial assets, which are connected with interest factors such as bonds/debentures, face this risk. For example, this risk adversely affects the value of fixed-income securities. Any increase in interest reduces the price of bonds and debt instruments in debt and the market and vice versa. So it can be said that the changes in the interest rates have an inverse relationship with the price of bonds.

Currency Risk

These risks affect the firms which have international operations of business, and the quantum of the risk depends on the nature and extent of transactions with the external market.

Equity Risk

It means the depreciation in one’s investment due to the change in market index. For example, in the context of securities, the beta of a stock tells us the market risk of that stock, and it is associated with the day-to-day fluctuations in the market.

Commodity Risk

This type of risk is associated with the absolute changes in the price of this. Since these are physical assets, the prices change on account of the demand and supply factors.

Credit Risk

When a counterparty is unable or unwilling to fulfill their contractual obligation, this arises. This type of risk is related to the probability of default and recovery date. Its effect is measured by the cost date of replacing cash flow if the other party defaults. For example, in the case of a loan given by a bank to the borrower and the borrower defaults in making payments of the installments or due interest on the due date, it is termed as this.

Liquidity Risk

Arises due to mismatches in the cash flow or absence of adequate funds. This is altogether different from the word “solvency”. A firm may be in a sound position as per the balance sheet, but if the current assets are not in the form of cash or near assets, the firm may not make payment to the creditors, which adversely affects the reputation of the firm.

• Trading Risk

• Funding Risk

The liquidity risk may be of two types:

Trading Risk

May mean the absence of liquidity or enough products or securities, etc. To actually undertake buy and sell activities. In the context of securities trading, the inability to enter into derivative transactions with counterparties or make sales or purchases of securities.

Funding Risk

Refers to the inability to meet the obligations. Inability to manage funds by either borrowing or the sale of assets/securities. It arises where the balance sheet of a firm contains illiquid financial assets, which cannot be turned into cash within a very short time.

Operational/System/Management Risk

It arises due to inadequate systems, system capacities, system failure, obsolescence risk, management failure on account coordination, faulty control, or human error. Some best practices against operational risk include clear separation of responsibilities with strong internal control and regular contingency planning.

Obsolescence Risk

In the rapidly changing world, this risk is fast emerging, and unless the companies can cope with this timely, the impact will be quite heavy and may lead to closure of the units also. Nokia is the latest example of this.

Legal Risk

This risk arises when a counterparty does not have the legal regulatory authority to engage in the transactions. It also includes the compliance and regulatory risk like insider trading, market manipulations, defaults, mismanagement of legal affairs, etc.

Political/Country Risk

May be on account of the declaration of elections in the territory, area-specific risk, and political uncertainty. Arises where the firm has its business operations abroad. This risk may arise due to an outbreak of war between countries or the imposition of the ban on the business transaction of a particular commodity/product. These can also be existing risks due to a country’s legal or political structure, which drives other institutions like the judiciary, legislature, and general environment for business.

Business/Industry & Services Risk

Implies uncertainty in profits or danger of loss and the events that could pose a risk due to some unforeseen events in future, which causes businesses to fail. Business risk refers to the possibility of inadequate profits or even losses due to uncertainties, changes in tastes, preferences of consumers, strikes, increased competition, change in government policy, obsolescence etc. Every business organization contains various risk elements while doing the business. Such type risk may also arise due to business dynamics, competition risks affecting tariff prices, customer relation risk etc.

Strategic Risk

Business plans which have not been developed properly and comprehensively since inception may lead to this risk. For example, this risk might arise from making poor business decisions, from the substandard execution of decisions, from inadequate resource allocation, or from a failure to respond well to changes in the business environment.

Compliance Risk

This risk arises on account of non-compliance or breaches of laws/regulations that the entity is supposed to adhere to. It may result in deterioration of reputation in the public eye, penalty, and penal provisions.

Fraud Risk

Perpetrated through the abuse of systems, controls, procedures, and working practices. It may be perpetrated by an outsider or insider. It may not be usually detected immediately, and thus the detection should be planned for on a proactive basis rather than on a reactive basis.

Reputation Risk

This type of risk arises from the negative public opinion. This type of risk may arise from the failure to assess and control compliance risk and can result in harm to existing or potential business relationships.

Transaction Risk

Arises due to the failure or inadequacy of internal systems, information channels, employees' integrity, or operating processes.

Disaster Risk

On account of natural calamities like floods, fire, earthquakes, man-made risks due to extensive exploitation of land for mining activity, land escalation, risk of failure of disasters management plans formulated by the company, etc.

Regulatory Risk

On account of changes in government policies and perceptions. Especially this type of risk is associated with the food and beverage and pharmaceutical industries.

Technology Risk

Failure of the system was caused by tampering of data access to critical information, non-availability of data, and lack of controls.

1. Risk Identification

2. Risk Analysis

3. Risk Assessment

4. Handling of Risk

The process of risk management consists of the following logical and sequential steps: