Executive Summary
Risk management is the core function required to address the impending possibilities of a global financial crunch that might occur due to higher volatility in financial and commodity markets. Financial risks like Credit risk, Foreign Exchange risk, Interest Rate risk, etc. are of a prime importance as they result in the direct downswing of the involved business markets in the respective economies. Organizations have developed specific enterprise level risk management frameworks to encounter the business and market risk related contingencies. Financial risk models have already been defined by the BASEL committees in segment like those of expansion strategy, capital allocation, lending norms, interest norms, exposure norms, etc. Similar to the global financial risk regulations given by the BASEL norms, there are many other significant initiatives taken on a global level to counter the market and business risks.
Introduction
Every instance of global financial crunch was a testimonial of unstable market economies due to high market volatility and raised systematic risks in the international business. The risks can be of different types like those of market risks, financial risks, foreign exchange risk, operational risks, commodity value related risks, etc. Out of these, the financial institutions are most seriously affected by the financial risks because of the nature of their business activities and the huge volumes of financial transactions which they incur (Enterprise Risk Management Initiative, 2016).
This report aims at exploring the different types of financial and business related risk and how the organizations develop specific risk management models to tackle them. Further, this report also tends to examine the global initiatives taken so far to maximize the effect of financial risk management.
Major classification of Business Risks
The businesses are susceptible to a wide of risks which often result in affecting the desired profitability standards from the business and some of them even lead to the bankruptcy of business. The global businesses are generally exposed to almost all the major types of these business risks and the organizations require specific risk management departments to evade the possible impact of these business risks (Blackman, 2014). The main types of business risks are those discussed below:
Strategic risk – The firm’s strategy defines the organizational efforts to achieve the strategic goals and objectives which are stated in its mission and vision statements. So, in the case of a strategic risk scenario, the organization’s strategy loses its vitality and effectiveness in leading the organization to its targeted goals of revenue, profit, expansion, global reach, etc.
Compliance risk- The organizations which operate in the international markets are under compliance regulation norms from various national and international agencies. The regulations related to foreign trade operations are mostly prone to situational changes and revisions subjected to market conditions. The organizations are often forced to a tradeoff between their global business goals and those of the regulatory compliance models. Thus, any instance when an organization fails to comply with the standard regulations for its business leads to a Compliance risk scenario for its business (Blackman, 2014).
Operational Risk- The businesses are carried out via their specific business operations which involve sourcing raw material, processing them to finished goods, and then selling them to recognize the desired revenues. The business operations are subjected to change along with the changing business profiles like those of product manufacturing and service oriented agencies. Thus, it can be concluded that the operations are the backbone of any business that ensures the success of its existence and that of the processes related to its executions for generating desired results. Any failure in a company’s day-to-day operations can lead to specific bottleneck situations which can hamper the overall productivity standards of a business. This type of breakdown in the routine operations of the business is classified as the operational risk. Operational risk can be categorized into people related risk, process related risks, and information technology related shifts in performance standards.
Reputational risk – The most established brands in this world are those who have their strong foothold in the markets via their strengthened goodwill. The goodwill is a qualitative factor which is developed from a consistent positive reputation for a business. Any situation of a business failing in committing to its developed quality standard can lead to a loss of its reputation. Such a probability describes the risk of a business being vulnerable to losing its goodwill due to a situational flaw in its service or quality benchmarks (Blackman, 2014). This type of risk is classified as the reputational risk for a business.
Financial risk- The financial risk is a broad category in itself and its sub-classifications will be discussed in detail in the coming section.
Major classification of Financial Risk
Any activity that causes a decline in desired revenues and profitability by raising costs or drop is selling value of the products can be termed as a situation related to financial risk. The financial risk is further classified on the basis of the route through which money flows (into or away from the business) and the capability of it causing a sudden loss (Rangaraju & Kennedy, 2014). The main types of financial risks are discussed below:
Interest rate risk-This refers to a scenario when a financial instrument or investment faces a rise or decline in its value due to a corresponding rise or falls in the interest rates. The association of products and financial instruments with floating rates of interest has a situational dependency on the governing organization’s decisions to revise the rates of interests. This can lead to a scenario of severe negative equity situation in which the rise in the market value of an entity is lesser than that of the financial loan value due to higher interest rates (Rangaraju & Kennedy, 2014). The business needs to enter into a basis swap process for mitigating the possible impact of the interest rate risk.
Foreign exchange risk- With the advent of growing globalization in the business world, the business who expand in international markets develop a linear dependency on that country’s currency and become vulnerable to a relative rise or fall in that currency. This change in the currency exchange rates causes start contrasts in the values of products and services before and after the change in exchange rates and inflicts a subsequent rise in the costs of international operations of the business (Rangaraju & Kennedy, 2014).
Credit risk- The most striking feature of financial risks which estimates the probability of failure of an entity to repay its loan obligations as per the terms and conditions originally affirmed while availing the particular loan facility. Leading instance of failure in paying the debt liabilities to banks involve big institutions like General Motors and even countries like Greece. The BASEL committee is the prime organization that has laid the lending norms for international financial institutions and it explains how the exposures to the borrowers must be regulated to ensure a minimum incidence of the credit risk related failure in repaying the loan obligations (Rangaraju & Kennedy, 2014).
Commodity risk- The commodities are generally classified into the agricultural (wheat, corn, rice, etc.) commodities, industrial (iron ore, copper, aluminum, etc.) commodities, and energy driving (crude oil, natural gas, coal, etc.) commodities. As these commodities are having constant supply and demand in the international markets, their prices are prone to highly varying changes. Hence, any financial institution or a business that has these commodities as a secured investment becomes vulnerable to negative equity scenario due to an adverse change in the prices of these commodities(Rangaraju & Kennedy, 2014).
Equity risk – The stock prices are totally dependent on the growth of a nation’s economy and are driven by the market sentiment over predictions of growth and fall of the stock market as a whole. Thus, the financial institutions and business that depend on equity stocks as security investments are equally exposed to a probable scenario of equity risk along with an adverse change in prices of a stock(Rangaraju & Kennedy, 2014).
How the organizations measure risks?
The organizations are in continuous strive to measure and mitigate the probable risks in their business and financial environments. The business tends to develop a risk management related framework to manage the probable risks which define the foundation of ERM (enterprise level risk management). The preliminary process of risk assessment is divided into following steps for an organization:
Risk identification through a probable mode of affecting business and subsequent mode of collecting adequate data to devise statistical model and risk management framework for a business (QBE European Operations, 2014).
Ownership and responsibility for the data capturing and verification of adequacy of the captured data in defining the accuracy of consequent risk management framework.
Accuracy and consistency estimate of the captured data for developing a corresponding risk management framework for the organization. The data collected assumes the cause and impact of various probable risks on the organizational profitability and costs of operations.
Action planning on the basis of encountered risk and using the data captured in accordance with standardized risk metrics to ensure that the organization’s strategy is apt enough in tackling the risk to which it is exposed (QBE European Operations, 2014).
Ensuring active allocation, implementation, review and update of best practices in managing the risks tackled as an ongoing process. Active tracking for allocation of risk management initiatives to respective departments and functions within the organizational level enterprise risk management processes (QBE European Operations, 2014).
Global initiatives in managing the financial risk management
The effect of Globalization has given added risks of global financial risk crisis to the multinational business and the international business governing agencies have initiated some efforts to mitigate the possible effect of these financial risks on associated businesses (Horcher, 2014). Some of these initiatives are as follows:
Continuous linked financial transactions and settlement-The international level trading in financial instruments is prone to change in exchange rates and interest rates due to the parties belonging to different time zones (Horcher, 2014). More use of electronic transactions which deploy time zone related similarity for the involved parties participating in the financial transaction is an effective initiative in this regard.
Secured investments and trading promoted in new products- This global initiative calls for using products apart from the traditional commodities to avoid the change in commodity prices affecting the business transactions (Horcher, 2014). For example, London Metals Exchange has been using polypropylene and polyethylene plastics for trading.
Improving the payment systems to sustain financial shocks- The players participating in forming the international payment systems are those of policy regulators, financial institutions, central banks, etc. This causes a proper understanding of varying financial market systems in both of the participating parties’ nations and gives a cushion against financial risk related to the regulatory framework or national market changes (Horcher, 2014).
Capital adequacy initiatives for international banks- After the financial crunch of the leading financial institutions to repay their debt obligations, the BASEL norms have developed a minimum capital adequacy standard which acts as an indicator of a bank acting in the possible credit risk related default scenario (Horcher, 2014).
Conclusion
The organizations are still vulnerable to a contingent financial crunch as the business environments are still prone to recurrent changes. These changes in market dynamics have a significant impact on the various aspects of any business and act as the root of an impending risk scenario. Therefore, as a protective measure, the businesses are supposed to keep revising and reassessing their risk management capabilities to ensure that they are flexible enough to accommodate the market dynamics (Enterprise Risk Management Initiative, 2016). The global initiatives in financial risk management discussed in the report above are clear indicators of growing global concerns to reduce the disastrous impact of another financial shock in the future.
References
Blackman, A. (2014). The Main Types of Business Risk. Retrieved online from http://business.tutsplus.com/tutorials/the-main-types-of-business-risk--cms-22693
Enterprise Risk Management Initiative (2016). A Survey of Global Risk Management in a Changing Environment. Retrieved online from https://erm.ncsu.edu/library/article/global-risk-survey7
Horcher, A.K. (2011).Essentials of Financial Risk Management. 6th Ed. John Wiley & Sons : 195-250. Print
Rangaraju, M. S, & Kennedy, H. S. (2012). Innovation in Management Challenges and Opportunities in the next decade
. 1st Ed. Allied Publishers: 183-187. Print.
QBE European Operations (2014). Measuring risk: a key priority for business. Retrieved online from http://www.qbeeurope.com/documents/research/measuring%20risk%20-%20a%20key%20priority%20for%20business.pdf
