In the world of finance, risk management refers to the practice of identifying potential risks in advance, analyzing them and taking precautionary steps to reduce/curb the risk.
When an entity makes an investment decision, it exposes itself to a number of financial risks. The quantum of such risks depends on the type of financial instrument. These financial risks might be in the form of high inflation, volatility in capital markets, recession, bankruptcy, etc.
So, in order to minimize and control the exposure of investment to such risks, fund managers and investors practice risk management. Not giving due importance to risk management while making investment decisions might wreak havoc on investment in times of financial turmoil in an economy.
Why is Risk Management Important?
These threats, or risks, dealt with risk management practices could stem from a wide variety of sources, including financial uncertainty, legal liabilities, strategic management errors, accidents and natural disasters. If an unforeseen event catches an organization unaware, the impact could be minor, such as a small impact on your overhead costs. In a worst-case scenario, though, it could be catastrophic and have serious ramifications, such as a significant financial burden or even the closure.
To reduce risk, an organization needs to apply resources to minimize, monitor and control the impact of negative events while maximizing positive events. A consistent, systemic and integrated approach to risk management can help determine how best to identify, manage and mitigate significant risks.
The risk management process
At the broadest level, risk management is a system of people, processes and technology that enables an organization to establish objectives in line with values and risks. A successful risk assessment program must meet legal, contractual, internal, social and ethical goals, as well as monitor new technology-related regulations. By focusing attention on risk and committing the necessary resources to control and mitigate risk, a business will protect itself from uncertainty, reduce costs and increase the likelihood of business continuity and success. It is vital to set standarised processes and protocol in order to recognise threats, act effectively and learn from them. That is why risk management firms always take the following 5 risk management steps.
Risk Management Steps
Numerous bodies of knowledge describe the five steps of risk management that businesses must take to manage risk. The ISO 31000 standard, Risk Management Guidelines, created by the International Organization for Standardization (ISO), is one well-known example.
Any entity can apply ISO’s five-step risk management approach, which consists of the following steps:
- Risk identification
- Risk analysis
- Risk evaluation/prioritization
- Rick’s treatment/mitigation
- Risk monitoring/review
1) Risk Identification
It is the identification of existing and potential risks. For example, businesses might have operational, financial, or cybersecurity risks. For this step, you’ll need to use your imagination and envision worst-case scenarios, from natural disasters to economic ones.
What if a fire broke out in your building? What if someone stole your proprietary secrets? What if the economy crashed? What if ransomware locked your systems? What if a competitor undercuts your prices? And so on. Common risks include the following:
- Financial risk
- Compliance risk
- Reputational risk
- Cybersecurity risk
- Competitive risk
- Legal risk
- Economic risk
- Operational risk
- Physical and environmental risk
- Quality risk
During risk identification, remember that we cannot see into the future. You might miss something, or new risks could emerge for which you haven’t yet formed a plan. Hence it’s important to keep your risk management process and program flexible; plan to review this list regularly and establish contingency plans for new and unforeseen risks.
2) Risk Analysis
After you identify relevant risks, you must analyze their potential harm. In this analysis phase, you’ll examine each identified risk and assign it a score based on four factors:
- Likelihood. What’s the chance that the risk will materialize?
- Impact. How much disruption would your project, function, or enterprise suffer if the event occurred?
- Velocity. How quickly would your project, function, or enterprise feel the impact?
- Materialization. What’s the potential severity of the impact? (To arrive at this score, add the impact and velocity scores and divide by 2). Scores for impact and velocity (and, therefore, materialization) can be reduced with risk mitigation or controls.
3) Risk Prioritization
Some risks are more potentially damaging than others, and so deserve more of your attention. Others may pose little danger and can be accepted. An effective risk management strategy requires risk prioritization according to levels of risk. Prioritizing risk can help you avoid wasting time and expenses. Prioritizing risks can be a relatively straightforward exercise. Look at your risk analysis, and the materialization scores assigned to each identified risk. The ones with the higher scores should receive your attention – and your efforts to introduce controls to reduce the potential harm – first.
4) Risk Mitigation
Mitigation is the set of controls you’ll introduce to reduce the harm of a risk. Typically, risk treatment has four options:
- Risk acceptance. The potential harm is so low that you simply live with the possible damage.
- Risk avoidance. The potential harm is high enough that you avoid those actions that might trigger it. For example, if a certain technology vendor’s security is extremely poor, you choose another vendor or don’t outsource that technology process at all.
- Risk transfer. Typically this involves buying an insurance policy to cover the financial costs of the potential harm. You might also strike partnerships with third parties so that they assume the risk rather than you.
- Risk reduction. You implement a set of controls (extra management approvals to award a contract, for example; or using multi-factor authentication to access confidential data) that work to reduce the unwanted outcome you’re trying to avoid.
5) Risk Monitoring
Circumstances change over time. Regulations and industry standards get updated; cyber criminals adopt new techniques for breaching systems. As a result, staying on top of risk is a constant process and can be challenging. Risk management experts resort to a myriad of different tools to be able to follow up on events, consider multiple outcomes from global events and strategise action plans for all the possible situations.
Why Are the Five Steps of Risk Management Critical?
An organization will become more robust and resilient as it formalizes its risk management procedure and creates a risk culture. Making better judgments will also lead to more robust performance over the long term by thoroughly understanding the organization’s operational environment.
The Future Of Risk Management
In the future, risk management will no longer be something separate from proper business management. All organizations have goals and objectives they pursue. Whether incorporating market share, the cost of borrowing, market preference studies, or any other business intelligence, our forward decision-making improves when the data provided is professional, insightful, and designed to help us. Risk management conducted in this manner will thus transform into a cornerstone of corporate governance and business strategy. It will become fully integrated into executive deccisions, organizational structures, and corporate cultures.