Businesses today need to be aware of a range of risk factors when operating in fast-changing and volatile markets. A well-devised risk management plan aims to continuously identify and analyse the range of risks a company may face and suggest mitigation strategies.
Risk factors may emerge from both internal and external sources, and successful risk management will allow companies to manage them effectively and support business functions adequately.
Financial institutions are among the most important enterprises in the world today as they have the ability to influence individuals, businesses, market conditions, and the economy at large. To answer the question, “what is risk management in finance?”, we must first discuss prevalent financial risks.
What is financial risk?
Financial risks are among the foremost risks that every business, regardless of the industry they’re operating in, needs to address. Common forms of financial risk include:
- Credit risk: The risk of a client/borrower being unable to hold on to their financial responsibilities.
- Operational risk: The risk of direct or indirect losses due to internal conditions or external events.
- Foreign exchange risk: The risk of losses arising from unfavourable conditions in foreign exchange rates.
- Interest rate risk: The risk of fluctuations in interest rates resulting in adverse financial conditions.
- Liquidity risk: The risk of being unable to raise funds to meet short-term financial obligations.
- Inflation risk: The risk of a rapidly rising inflation rate adversely affecting financial markets.
What is risk management in finance?
The importance of risk management in finance does not need to be elaborated on. The 2008 Global Financial Crisis uncovered many lacking areas of risk management in the financial sector. Effective risk management initiatives will help prevent such crises or at the very least, help manage the consequences of such conditions.
Risk management in finance analyses the finance industry conditions and aims to pre-identify possible risks to financial institutions and suggest mitigation measures.
How is risk management in finance enforced?
Financial institutions face a wide array of risks ranging from internal risks, such as operational malfunctions, to external risks, such as volatile market conditions and cyber threats. The following initiatives must be taken by financial institutions to address these risks:
1. Strengthen regulatory adherence
There are extensive regulations imposed on the financial sector by regulatory bodies, such as FinCen, FATF, FCA, and ESMA. These regulations must be incorporated into the decision-making process to create trust and ensure that the institution is not in violation of the recommended guidelines.
2. Improve data protection
Financial institutions store a large amount of sensitive financial information that should be protected at all costs. Therefore, conducting comprehensive risk assessments, implementing data protection measures, evaluating third-party vendors, and setting up incident response plans are necessary.
3. Enhance operational resilience
Operational risks for financial institutions include data breaches and losses, theft, and fraud. Identifying critical dependencies and addressing them through effective mitigation measures and recovery plans are essential while improving resource allocation strategies.
4. Promote continuous mitigation
Financial institutions are among the most targeted for malicious cyber attacks and data breaches from various threat vectors, including nation-states, cybercriminals, terrorist groups, and insider threats. Continuous mitigation strategies are a necessity to counteract them effectively.
What are the best practices for risk management in finance?
Following the guidelines mentioned below will help in setting up a comprehensive risk management process.
1. Build and nurture a risk-aware culture
Setting up a work culture where employees are made aware of the need for risk management will help in managing internal risks in particular.
2. Conduct regular risk assessments
Conducting regular risk assessments complements continuous mitigation strategies and helps the organisation stay updated with the latest risks.
3. Prioritise risk management
Maintaining a procedure where potential risks are consistently quantified and prioritised will help effectively manage the array of risks.
4. Involve all stakeholders
Involving the entire host of stakeholders in the organisation’s risk management initiatives will ensure that all parties are well informed.
The need for effective risk management in the financial sector is imperative to the smooth operation of the economy
To effectively answer the question, “what is risk management in finance?”, we have to consider what risks are faced by the industry at large, how institutions in the industry engage in risk management, and what best practices are followed to ensure an effective risk management effort.
