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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:
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:
For corporations, there are additional types of risks faced, such as:
For corporations, there are alternative risks faced:
As already mentioned, the following steps are a general process for dealing with any kind of 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:
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
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.
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:
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.
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.
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