The series of steps undertaken to manage financial risks
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A financial risk management process is a series of steps undertaken to identify potential financial risks, assess their severity, and identify how they can be managed. The overarching process of any risk management process is the following:
- Identifying the risk
- Assessing and quantifying the risk
- Defining strategies to manage the risk
- Implementing a strategy to manage the risk
- Monitoring the effectiveness of the strategy in managing the risk
Key Highlights
- The financial risk process is a series of steps undertaken to effectively manage financial risks.
- The financial risk process includes identifying the risk, assessing and quantifying the risk, defining strategies to manage the risk, implementing a strategy to manage the risk, and lastly, monitoring the effectiveness of the strategy implemented to manage the risk.
What is Financial Risk?
Individuals and corporations face various financial risks. In general, financial risks are events or occurrences with undesirable or unpredictable financial outcomes or impacts.
Individuals face financial risks in many aspects of their lives. These risks come in the form of:
- Employment/Income Risk
- Expense Risk
- Asset/Investment Risk
- Credit/Debt Risk
For corporations, there are additional types of risks faced, such as:
- Market Risk
- Credit Risk
- Liquidity Risk
- Operational Risk
For corporations, there are alternative risks faced:
- Market Risk
- Credit Risk
- Liquidity Risk
- Operational Risk
Financial Risk Management Process
As already mentioned, the following steps are a general process for dealing with any kind of risk:
- Identifying the risk
- Assessing and quantifying the risk
- Defining strategies to manage the risk
- Implementing a strategy to manage the risk
- Monitoring the effectiveness of the strategy in managing the risk
Identifying the risk
Identifying the risk is an important first step in the process. As part of this step, it is critical to consider all possible events or occurrences that can pose a negative monetary impact.
These potential risks can be outlined in a list and are commonly categorized based on financial risk types. For example, all credit-related risks typically will be grouped together.
Tools that can be used to help identify financial risks include:
- Analyzing the current financial situation
- Brainstorming financial risks in a workshop setting
- Using previous financial stress events as reference
- Interviewing internal and external parties and experts
- Using pre-determined financial risk checklists
Assessing and quantifying the risk
When a list of potential financial risks has been compiled, it is important to assess and quantify the risks so that they can be prioritized in an appropriate fashion. This is important as higher urgency risks should be dealt with much quicker than risks that are of a lower severity.
Financial risks can be assessed both qualitatively and quantitatively. In the field of finance, frequently the focus is on quantitative risk assessment, however qualitative risk assessment should never be overlooked.
In general, financial risks can be assessed and prioritized using the following formula:
P x I = E
Where:
- P = Probability of the risk event occurring
- I = Impact of the risk event occurring
- E = Expected loss from risk
For example, if there is a 10% probability that a $500,000 loss may occur, then the expected loss from the risk event is 10% x $500,000 = $50,000.
Defining strategies to manage the risk
Depending on the risk severity, different strategies can be used to manage the risk. The following are potential strategies that are used when faced with financial risks:
- Risk avoidance: includes the elimination of activities which may expose the party to risk.
- Risk reduction: includes mitigating potential losses or the severity of losses.
- Risk transfer: includes transferring risk to a third party.
- Risk retention: includes accepting responsibility for a given risk.
Implementing a strategy to manage the risk
Selecting an appropriate strategy may be challenging. However, in general, the strategy selected should appropriately reflect the nature of the risk, and the individual or corporation’s current situation. Before a decision is made, risks should be fully understood.
Considerations that should be made at this stage include the severity of the risk, whether the risk is tolerable, what other parties have done to manage similar risks in the past and how effective those strategies were.
Monitoring the effectiveness of the strategy in managing the risk
Financial risks should be continuously monitored since new ones may arise, and current ones may change. The effectiveness of strategies must be monitored and reported on to ensure that financial risks have been managed appropriately.
An effective tool for monitoring risks is to utilize an analytics dashboard that presents risks in a consistent manner. This tool allows for the usage of data to drive insights and manage risks more effectively. Processing risk data and continuous stress testing are strong methods to manage risk, especially as technology continues to improve.
Additional Resources
Thank you for reading CFI’s guide to Financial Risk Management Process. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
- Financial Risk Management Strategies
- Tools of Financial Risk Management
- Financial Risk Management Books
- Financial Risk Management Software
- See all risk management resources
