Risk management framework helps financial stability

Almost all companies, with the banking ones in particular, face risk in their business operations. It is said that where there is no risk, there is no reward. Successful risk management ensures rapid progress of a banking organisation as well as other businesses. Hence, the issue of risk management with regard to business organisations in general has been discussed here in this article. The flip side of this, however, is too much risk can lead to business failure. Risk management allows a balance to be struck between taking risks and reducing those.

Effective risk management can add value to any organisation - especially the companies operating in the investment industry rely heavily on risk management as a foundation that allows them to withstand market crashes. An effective risk management framework seeks to protect an organisation's capital base and earnings without hindering growth. Furthermore, investors are more willing to invest in companies with good risk management practices. This generally results in lower borrowing costs, easier access to capital for the firm and improved long-term performance. There are six crucial components, discussed below chronologically, which must be considered when creating a risk management framework:

The first step in identifying the risks a company faces is to define the risk universe, which is simply a list of all possible risks. Examples include information technology (IT) risk, operational risk, regulatory risk, legal risk, political risk, strategic risk and credit risk. After listing all the possible risks, a company can thereafter select the risks to which it is exposed and categorise them into core and non-core risks. Core risks are those that the company must take in order to drive performance and long-term growth. But the non-core risks are often not essential and can be minimised or eliminated completely.

Risk measurement provides information on the quantum of either a specific risk exposure or an aggregate risk exposure, and the probability of a loss occurring due to those exposures. When measuring specific risk exposure, it is important to consider the effect of that risk on the overall risk profile of the organisation. Some risks may provide diversification benefits, while others may not. Another important consideration is the ability to measure an exposure. Some risks may be easier to measure than others. For example, market risk can be measured using observed market prices, but measuring operational risk is considered both an art and a science.

Specific risk measures often present the profit and loss (P/L) impact that can be expected if there is a small change in that risk. They may also provide information on how volatile the P/L can be. Common aggregate risk measures include value-at-risk (VAR), earnings-at-risk (EAR) and economic capital. Techniques such as scenario analysis and stress testing can be used to supplement these measures.

Having categorised and measured its risks, a company can then decide on which risks to eliminate or minimise, and how much of its core risks are retained. Risk mitigation can be achieved through an outright sale of assets or liabilities, buying insurance, hedging with derivatives or diversification. It is important to report regularly on specific and aggregate risk measures in order to ensure that risk levels remain at an optimal level. Financial institutions that trade daily will produce daily risk reports. Other institutions may require less frequent reporting. Risk reports must be sent to risk personnel who have that authority to adjust (or instruct others to adjust) risk exposures.

Risk governance is the process that ensures all company employees perform their duties in accordance with the risk management framework. Risk governance involves defining the roles of all employees, segregating duties and assigning authority to individuals, committees and the board for approval of core risks, risk limits, exceptions to limits and risk reports, and also for general oversight. Effective risk management plays a crucial role in any company's pursuit of financial stability and superior performance. The adoption of a risk management framework that embeds best practices into the firm's risk culture can be the cornerstone of an organisation's financial future.

Sk. Shamim Iqbal is a banker . [email protected]