Risk is simply the uncertainty that something bad may happen. We, as humans, are exposed to various kinds of risks around us starting from driving a car prone to accidents or marrying a wrong partner; everything holds some quotient of risk. But when this risk enters the premises of economic zone, it becomes the financial risk where it is generally measured in regard to the monetary returns. Fluctuations in the interest rate brining investment values down, defaulting of our biggest counterparty are most common examples of financial risk.
While financial risk management seems to be a comparatively newer concept emerging in last two decade, it actually traces back to 1750 BC where code of Hammurabi records Babylonian maritime loan insurance. The merchants and their lenders shared risk by tying loan repayments to the safe arrival of shipments using maritime loans. Major advancements in this industry took place in 20th century with introduction of various risk models, frameworks and regulations
With every passing financial disaster, the financial risk management evolved and came up with new measures and techniques to identify and manage risk this making things more clearly. These disasters resulted in an everlasting effects to the financial world, most of which are reflected on today’s risk management practices. To name few ,the incident of Baring Bank in 1995 in which a rogue trader made large returns by controlling the back-office accounting and managed reporting through a hidden reconciliation account that resulted in default of 200-year old bank. That one incident led to creation of separate front office and back office with the concept of four eye principle, a phenomenon used in almost all transactions. In 1998, LTCM’s downfall was triggered by devaluation of Russian currency which resulted in depreciation of LTCM’s assets by 40% in a month. In this particular case, there was model risk involved that led to liquidity risk which further strained the company. We consider model risk to be an important factor of risk management today. A giant company Eron filed bankruptcy in 2001 which was once known as America’s Most Innovative Company due to accounting fraud and agency risk). Above all, the downfall of the whole banking system in 2008 financial crisis led to an everlasting change in risk management in the form of Basel III accord.
Financial risk management is the process of limiting or managing this financial risk and a decision between (i) avoiding, (ii) accepting, (ii) mitigating or (iv) transferring risk. Financial risk management protects economic values in firm while measuring and managing different kinds of risks namely credit risk, market risk, operational risk, liquidity risk, reputational risk, business and strategy risk and legal risk through one of the four methods mentioned above.
To streamline and standardize the risk management practice globally, Basel Committee on Bank Supervision (BCBS) was formed in 1974 as a forum for regular cooperation between its member countries on banking supervisory matters. Purpose of BCBS is to provide recommendations on banking regulations. After a combined effort of BCBS and various stakeholders from around the globe, BASEL-I was introduced in 1988, which focused on credit risk, outlined structure of risk weights and capital for banks. As risk management further evolved, a new framework with the name of Basel II was published in 2004, and introduced three pillars namely: Minimum capital Requirement as first pillar, Supervisory review process as second pillar and Market Discipline as third pillar. After the financial crisis 2008 and to address the issues faced during the crisis, BASEL III came in 2010, which is continuity of the three pillars with some additions with a focus on liquidity management and managing economic crisis. It deals with risk management aspects for the banking sector and set global regulatory standard on bank capital adequacy, stress testing and market liquidity risk.
Range of financial risk management practices spreads to all financial institutions including banks, insurance companies, asset management firms, public and corporate clients and governments. Growing financial risk concerns resulted in creation of certain regulatory frameworks that ensures that financial institutions survive from unexpected loses and keep sufficient financial buffers to weather any economic downturn or financial disaster.
Financial risks are mainly divided into quantifiable and non-quantifiable financial risk. Credit, Market and Liquidity risk are consider to be quantifiable while operational risk, reputational risk, business and strategy risk and legal risk are generally non quantifiable risks.
Market risk is the risk that arises due to the movement in the financial instruments largely due to changes in financial markets. It is further classified as directional (occurs due to movement in stock prices or interest rates or etc.) and non-directional risk (volatility risk) and broadly covers fixed income, equity, foreign exchange and commodity portfolios. Credit Risk is the risk that arises when one fails to fulfill the obligations of the counterparty Credit risk is further divided into default risk, bankruptcy risk, downgrade risk and settlement risk… Operational Risk rises due to operational failures. It is further classified as Fraud Risk (occurs due to lack of control) and Model Risk (occurs due to incorrect model application).
Financial risk management is forever evolving field which keep evolving as the world around us keep changing. The recent COVID19 pandemic has highlighted new areas that needs to be focused specially pertaining to business continuity planning, supply chain disruptions, third party risk and customer data protections and we expect to financial risk management to go through another regime shift in the coming years.
Author: Muhammad Owais Atta Siddiqui is a Corporate Trainer and working as a ‘Country Manager and Sovereign Analyst’Islamic International Rating Agency (IIRA)is a strategic institute developed by Islamic Development Bank to promote Islamic Finance globally in Pakistan Liaison office.
Disclaimer: The contents of this article is for information only and is not offered as advice. Readers are encouraged to consult a suitably qualified professional adviser to obtain advice tailored to their specific requirements, FRM