Unit 1

Principles of Risk
Management
 Risk and Uncertainty
BASIS FOR
RISK UNCERTAINTY
COMPARISON

The probability of winning or losing Uncertainty implies a situation where

Meaning
something worthy is known as risk. the future events are not known.

Ascertainment It can be measured It cannot be measured.

Outcome Chances of outcomes are known. The outcome is unknown.

Control Controllable Uncontrollable

Minimization Yes No
Probabilities Assigned Not assigned 2
Business Risk

● Business risk is any exposure a company or organization factor(s) that

may lower its profits or cause it to go bankrupt.

● The sources of business risk are varied but can range from changes in
consumer taste and demand, the state of the overall economy, and
government rules and regulations.

● While companies may not be able to completely avoid business risk, they
can take steps to mitigate its impact, including the development of a risk
plan.
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Types of risk
Strategic Risk

Reputational Compliance
Risk risk

Operational
Risk
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 Types of Business Risk
Strategic Risk
Risk arises when a business does not operate according to its business model or plan.

Strategic risk refers to the internal and external events that may make it difficult, or
even impossible, for an organization to achieve their objectives and strategic goals.

When a company does not operate according to its business model, its strategy
becomes less effective over time and it may struggle to reach its defined goals.

If, for example, Walmart strategically positions itself as a low-cost provider and
Target decides to undercut Walmart's prices, this becomes a strategic risk for Walmart.

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Compliance Risk

Compliance risk primarily arises in industries and sectors that are highly
regulated.
Compliance risk means the risk of imposition of measures and fines and
the risk of substantial financial loss or loss of reputation to be suffered by
a credit institution due to failure to comply with regulations, standards,
codes and internal bylaws.
Compliance risk is the risk of financial loss, including fines and other
penalties, which arises from non- compliance with laws and regulations of
the state.

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Operational Risk
This risk arises from within the corporation, especially when the day-to-day
operations of a company fail to perform.

Operational risk is the risk of losses caused by flawed or failed processes,

policies, systems or events that disrupt business operations.

Employee errors, criminal activity such as fraud, and physical events are
among the factors that can trigger operational risk.

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Reputational Risk

Reputational damage is the loss to financial capital, social capital and/or market
share resulting from damage to a firm's reputation.

This is often measured in lost revenue, increased operating, capital or regulatory

costs, or destruction of shareholder value.

Any time a company's reputation is ruined, either by an event that was the result
of a previous business risk or by a different occurrence, it runs the risk of losing
customers and its brand loyalty suffering.

The biggest problem with reputational risk is that it can erupt out of nowhere and
without warning. 8
Risk In financial Services

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 External Sources of Risk
● Political Risk
○ Differed view of political parties on wealth creation, it covers economic
policy, tax law, etc,
○ Shifts in government regulations related to taxation, financial reporting
standards, or capital requirements can significantly impact the operations
and profitability of financial institutions.
○ Similarly, political instability or changes in government leadership can lead
to policy uncertainty, affecting investor confidence and the overall stability
of the financial sector.
○ Ex: Demonetization (growth of payment banking in India), USA vs China
(under Trump) Trade war by imposing tariffs on each other's goods. 10
● Economic Risk

○ Interaction between individuals (demand) and firms (supply), and allocation

of their limited resources to maximize their financial position.

○ Ex: Risk that financial firms were exposed to during 2008 on the fall of house
prices following the boom in the housing prices and in turn mortgage backed
securitization.

○ COVID-19 pandemic and its impact on global economies. The pandemic led to
widespread lockdowns, business closures, and disruptions in supply chains,
causing a severe economic downturn. Financial institutions faced challenges such
as increased credit defaults, reduced consumer spending, and heightened market
volatility.
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● Economic Risk

○ During the pandemic, financial services companies, including banks, insurance firms,
and asset management companies, experienced a range of economic risks. For instance:
○ Credit risk: Financial institutions had to manage a surge in non-performing loans and
assess the creditworthiness of their clients more rigorously.
○ Market risk: Stock markets experienced significant volatility as investors reacted to
uncertainties surrounding the pandemic's impact on the economy. Financial institutions
with substantial investments in equities faced potential losses and had to adjust their
investment strategies accordingly.
○ Liquidity risk: The economic downturn led to liquidity constraints, making it challenging
for financial institutions to meet their short-term obligations. They had to carefully
manage their cash flow and access to funding to ensure their operational stability.
○ Interest rate risk: Central banks around the world implemented monetary policy
measures to mitigate the economic impact of the pandemic. These actions, such as
lowering interest rates, had implications for financial institutions' profitability, 12

particularly for those heavily reliant on interest income.

 Risk from the competitive environment,
social and market forces:
Competitive Environment:
• Performance of related companies in the same industry and market
• Increased competition can arise from various sources, including new market
entrants, technological advancements, changing customer preferences, and
regulatory changes.
• Ex: Entry of discount brokerage/ online brokerage firms

This competitive environment poses several risks for financial institutions:

Pricing pressure, Customer churn, Technological disruption, Regulatory changes

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Risk from the social and market forces:
Changing consumer behaviors: growing demand for digital banking services and online
transactions. Failure to adapt to changing consumer expectations can lead to customer attrition
and loss of market share.

Demographic shifts: increased demand for retirement planning services, health insurance, and
wealth management tailored to their specific needs.

Cultural preferences: Cultural factors and social norms there may be a preference for savings
over investment products, impacting the demand for certain financial services.

Market dynamics: economic cycles, interest rate fluctuations, and market volatility,
Economic downturns result in reduced lending activity, increased credit defaults, and
heightened market volatility.
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 Technological and Cyber Security Risk
• Risk of becoming obsolete when firms do not keep up with the
technological advancement
• Ex: Nokia non acceptance of Android OS as an advancement
• Data breaches, Cyberattacks, Technological vulnerabilities

Shocks and Natural Events

• Shocks and Natural Events
• COVID ( growth in online banking, security market participation)
• Rise in insurance policies during natural disaster and health crises
• For example, food exports from Africa were impacted, with farmers being forced
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to dump stocks of fresh food and flowers destined for European markets.
 Risk from stakeholders and Third Parties

• Risk from stakeholders and Third Parties

• Parent Company: Effect of parent company’s global view on subsidiaries
unless carefully managed and freedom is given to Key customers may even have
been consulted as part of the planning process.
• Significant holdings by institutional investors - the competence of certain
board members, then in some cases there may be little that the firm can do to
prevent them pushing for change.
• Large Customers - term, the firm should aim to dilute this risk by increasing its
customer base.
• suppliers, clients, regulators, brokers, advisors and consultant
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Strategic Risk
‘the current or prospective risk to earnings and capital arising from changes in the
business environment and from adverse business decisions, improper implementation of
decisions or lack of responsiveness to changes in the business environment’.

Operational Risk
‘the risk of loss resulting from inadequate or failed internal processes, people and systems
or from external events’

Financial Risk
• Credit risk is the risk of loss caused by the failure of a counterparty or issuer to meet
its obligation

• Market risk is the risk of loss arising from changes in the value of financial
instruments

• Liquidity risk is the risk that a firm has insufficient cash to meet its cash obligations
and will either become insolvent, or will suffer losses from borrowing, selling assets
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below market price, or paying contractual penalties.

Risk Management

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 Risk management
Risk management focuses on identifying what could go wrong,
evaluating which risks should be dealt with and implementing
strategies to address those risks.

Firms that have identified their risks in advance and have formulated a
response plan will be better prepared and have a more cost-effective
way of dealing with them if they do occur.

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• Risk policies and governance - board level

• Risk oversight – often performed by the business unit (ie, the first line of
defence) with results and action plans reported to, and agreed with, the
independent risk management function (ie, the second line of defence), often
organised by risk type and performing the following tasks:
• identify risks
• assess risks
• ensure that risks are appropriately controlled
• monitor and report on the risks and their associated controls.

• Day-to-day risk management – this activity is inseparable from good business

management and must be owned by the business units, not the risk function.
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Risk Management

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Risk Management - Terminologies

Risk Profile

• A firm’s risk profile is made up of the type and intensity of the risk
to which it is exposed.
• It consists of
• the nature of the threat faced by the organization,
• the likelihood of adverse effects of occurring, and
• the level of disruption and costs associated with each type of 23

risk
 Risk Register
• A risk register is a document that is used as a risk management tool
to identify potential setbacks within a project.

• This process aims to collectively identify, analyze, and solve risks

before they become problems.

• While usually centered around projects, other circumstances where

risk management is helpful include product launches and
manufacturing.
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 Risk Appetite

• “amount and type of risk that an

organization is willing to pursue or
retain.”(ISO Guide 73:2009 Risk
Management – Vocabulary)
• Level of risk an organization is
prepared to accept.
• Every organization can tolerate
different levels of risk.
• Organizations should define the
maximum level of risk tolerance in
each area of risk before taking action.
Cont...
Risk appetite can vary based on a number of factors, such
as:
1) industry,
2) company culture,
3) competitors,
4) the nature of the objectives pursued (e.g. how aggressive they
are), and
5) the financial strength and capabilities of the organization (i.e.
the more resources a company has, the more willing it may be to
accept risks and the costs associated to them).
It’s also worth noting that risk appetite can change over
time.
 Risk Culture

❖ Risk culture is a term describing the values, beliefs, knowledge, attitudes and
understanding about risk shared by a group of people with a common
purpose.
❖ This applies to all organisations - including private companies, public
bodies, governments and not-for-profits.
❖ An effective risk culture is one that enables and rewards individuals and
groups for taking the right risks in an informed manner.
❖ “The norms of behavior for individuals and groups within an organization
that. determine the collective ability to identify and understand, openly
discuss and act on the. organization's current and future risks”.
 Conduct Risk
Conduct risk refers to the potential risk that arises from the behavior, actions, or
decisions of individuals within an organization.

It encompasses the risk of misconduct or unethical behavior that may harm the
organization's reputation, financial stability, or relationships with customers and
stakeholders.

Conduct risk can manifest in various forms, such as fraud, conflicts of interest,
market manipulation, insider trading, and non-compliance with regulations.
 Gross/ Inherent Risk
• Inherent risk represents the amount of risk that exists
in the absence of controls.
• An assessment of risk without considering the
beneficial effects of mitigating controls.
• When controls fail, the firm is exposed to the gross
risk.
• The gross risk will not necessarily be the
maximum possible risk; a control can fail but the
efforts of staff, and their honesty, will often tend to
‘keep the show on the road’.
 Residual & Net Risk
• Residual risk is the amount of risk that remains after controls are
accounted for.
• The net risk is the amount of damage caused when preventive measures
are used successfully.
 Risk Mitigation

Depending on the risk type, mitigation techniques may include:

• ensuring that appropriate insurance policies are in place
• upgrading processes and IT systems to control an operational risk better
• hedging against a market risk
• holding collateral against a credit risk

In other words, risk mitigation refers to the efforts made to reduce either the
impact or the likelihood of the risk, or both.

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PESTLE Analysis

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AMAZON PESTEL ANALYSIS

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PESTLE Analysis
1. Apple inc
2. Coca cola
3. Tesla
4. Google
5. Amazon
6. Mc Donald’s Corporation
7. Walmart
8. Microsoft
9. P&G
10. Toyota
11. Unilever
12. Pfizer Inc
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Case Analysis

“Safe Bank” is a large multinational bank offering a wide

range of financial products and services, including retail
and commercial banking, investment management, and
insurance. Given the nature of its business, risk analysis
plays a critical role in ensuring the bank's financial
soundness and regulatory compliance.

Analysis the case with regard to Credit, Market,

Reputational, Operational, Liquidity, Legal and regulatory
risk.
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Credit Risk:

Loan portfolio quality: SafeBank assesses the creditworthiness of its

borrowers and monitors its loan portfolio to mitigate the risk of default and
non-performing loans.

Economic factors: The bank analyzes economic indicators, such as GDP

growth, unemployment rates, and industry-specific trends, to anticipate
potential credit risks stemming from economic downturns or sector-specific
challenges.

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Market Risk:

Interest rate risk: SafeBank evaluates the impact of interest rate fluctuations
on its interest income, net interest margin, and the valuation of fixed-income
securities in its investment portfolio.

Foreign exchange risk: The bank assesses the exposure to foreign currency
fluctuations, especially if it operates in multiple countries, to manage potential
translation and transaction risks.

Market volatility: SafeBank monitors market volatility and assesses the

potential impact on its trading operations, investment portfolios, and hedging
strategies.
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Operational Risk:

Internal controls and processes: SafeBank identifies and mitigates

operational risks associated with inadequate internal controls, fraud, human
errors, and technology failures.

Regulatory compliance: The bank ensures compliance with applicable

regulations and assesses the risk of non-compliance, including legal and
reputational risks.

Business continuity planning: SafeBank develops and tests business

continuity plans to address operational disruptions, natural disasters, or
cybersecurity threats. 38
Liquidity Risk:

Funding sources and liquidity management: SafeBank assesses its funding

sources, including deposits, interbank borrowing, and capital market activities,
to maintain adequate liquidity to meet its financial obligations.

Stress testing: The bank conducts liquidity stress tests to assess its ability to
withstand severe market conditions or unexpected outflows of funds.

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Legal and Regulatory Risk:

Compliance with regulations: SafeBank stays updated on evolving

regulatory requirements and assesses the risk of non-compliance, such as
anti-money laundering regulations, data privacy laws, and consumer
protection rules.

Litigation and legal disputes: The bank analyzes potential legal risks
arising from litigation, regulatory investigations, contractual disputes, and
customer complaints.

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Reputational Risk:

Customer perception and satisfaction: SafeBank monitors customer

feedback and satisfaction levels to identify potential reputational risks
stemming from poor service quality, data breaches, or unethical practices.

Social responsibility: The bank assesses the impact of its business

practices on society and the environment to manage reputational risks
related to sustainability, corporate governance, and social responsibility.

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