A financial institution is only as successful as its ability to manage risk. Take on too many bad loans, and your business model becomes unstable. And if you fail to balance it out, the odds of bankruptcy soar.
We saw this unfold in 2008 when the housing bubble popped. But this wasn't just an organizational problem; it was an industry issue.
While you can't control what others do in the finance sector, you can prevent your institution from substantial financial risk.
Let's review what financial risk management entails and how AI technology can help.
What is financial risk?
Financial risk relates to anything that can negatively impact your economic well-being. It can be an internal or external source that disrupts or drains your finances, leading to financial ruin or bankruptcy.
Here are several examples.
Market risk is when there's a risk in a marketplace, such as the financial sector. For example, Interest rates increasing, causing fewer people to apply for loans. Another example would be digitization, which increases the need for financial institutions to adopt online banking solutions.
Not adapting to the market can cause a loss in current and prospective customers.
Credit risk is the chance that a business may lose money because of a customer not making payments according to the terms of a contract. Banks, insurance companies, and lenders require applicants to undergo credit checks to understand the risk of working with a potential customer.
Accepting or lending money to a client with a history of missing payments or defaulting on loans can be a risk to your business.
Liquidity risk, or funding risk, are risks associated with selling assets or raising funds. Anything standing in the way of increasing cash quickly is considered a liquidity risk.
For instance, a mortgage company may have this issue during an economic downturn. If no one's buying new homes and defaulting (leading to foreclosures), getting rid of the increased stock of homes in your portfolio may be difficult.
Operational risk is any disruption that stops a business's operation. The COVID-19 pandemic is an example of this, as banks and other financial institutions had to limit their operations to prevent crowds and social distancing issues.
Other forms of operational risk include lawsuits, theft, fraud, staff turnover, and poor budgeting.
Interest rate risk
Interest rates do more than determine the payments of a loan. When interest rates increase, it hurts the value of properties. Property owners must reduce selling prices to entice buyers to bite. Otherwise, the price won't match its value, turning it into a poor investment.
Since investors don't want to lose money, they're forced to hold on to inventory until interest rates reduce. This can sometimes take many months or years, causing diminished cash flow.
Stock market risk
The odds of stock prices rising or falling are unpredictable. Volatility, timing, and overconfidence are the primary risks in the stock market:
- Volatility is the rise and fall (fluctuations) of prices caused by various factors, like geopolitical events, inflation, and economic events.
- Timing also affects stock market risks. For example, buying and selling at specific times during the day or week based on past patterns. The goal is to buy low and sell high.
- Overconfidence is an internal risk stemming from an investor taking unnecessary risks. For instance, buying too many assets in one industry or using intuition instead of qualitative data to make decisions.
Currency risk is the risk of investing in foreign markets. The risk increases when one currency is stronger than another, causing you to lose money during the exchange.
For instance, KFC operates in other countries, selling food in domestic currencies. When it converts the domestic dollar to USD, there's a loss. That's because the domestic country's dollar may increase (e.g., from $1USD used to be ¥5 (YEN), but is now ¥8).
If KFC doesn't increase its prices, the exchange to USD decreases because they're still earning the same amount.
Loans for education, houses, and vehicles come with risk. If they don't receive the monthly payments on time, cash flow diminishes. It's common for financial institutions to package assets into asset-backed securities and sell them to institutional investors as mutual funds.
What is financial risk management?
Financial risk management analyzes the internal and external risks that exist now, or that can in the future, and then determines how to prevent or mitigate them. The goal? Set internal boundaries to minimize risks as much as possible.
Those internal boundaries can include things like a lender increasing the credit score needed for approval, or an investment firm creating a diversified portfolio (e.g., 30% single-family, 60% commercial, and 10% rental properties). Reducing high-risk investments is necessary to develop a risk management strategy.
Who manages financial risk?
In small businesses, the owner is responsible for managing financial risk. However, in a larger company, the senior managers are responsible for risk management within their departments. Enterprises hire a dedicated financial risk manager to make recommendations to prevent and mitigate risks as they arise.
How financial risk management works
Risk in the financial industry isn't all bad. In fact, there are certain investments considered "good" risks. Looking at the potential performance of an asset to identify potential risk is imperative.
This is typically done by looking at the deviation from the expected outcome (which can be positive or negative), and agree to accept the risk. If you're looking to reduce risk, volatile assets should at a minimum. However, if you can tolerate the risk, you should identify how many high-risk investments you want in your profile.
The way you manage financial risk depends on several factors. But there are several steps to take no matter what area of the financial industry.
Identify risk exposures
The first step is to identify financial risks and their root cause. Start by looking over your balance sheet. This offers an overview of the company's debt, foreign exchange exposure, interest rate risk, liquidity, etc.
Then look at the income statement and cash flow statement to see how they fluctuate. How do they impact the organization's risk profile?
The way to determine this is to find out:
- The primary sources of revenue
- Customers you're extending credit to
- Credit terms for those customers
- Types of debt the company has
- What would happen if interest rates increase
Estimate the exposure
Next, quantify the value of the risks you found. This won't be exact, but estimating is good enough. Most experts use statistical models to measure exposure (e.g., deviation and regression method). This shows how your data points measure against the average.
Spreadsheets make it easier to calculate and see. The goal is to have a greater standard deviation from the cash flow you're quantifying.
Make mitigation plans
Now that you analyzed the risks, it's time to make a hedging decision. Can the business survive the risk exposure? Or does it need mitigation or hedging?
This comes down to the company's goals, the market, and the company's appetite for risk. Some steps you can take include:
- Minimizing cash-flow volatility
- Adjusting loan interest rates to make financing costs more certain
- Managing operational costs
- Creating rigid procedures for better billing and credit control
- Managing payment terms
- Cutting off customers abusing credit terms
- Reducing risk of fraud by hiring and training staff to use the proper tools and procedures
Financial risk management techniques
Financial risk managers safeguard the company from hardship, but their success relies on the techniques used to analyze and mitigate financial risk.
Here are several methods for financial risk management:
- Regression analysis: Studies the effect on a variable if another one changes. For example, if interest rates increase, how does it affect your cash flow?
- Value at risk (VaR) analysis: Measures potential loss, the chances of losing that amount, and when it may happen. For instance, having an exposed risk to a 5% loss on a $75,000 loan after one year of holding.
- Security analysis: Analyzes debts, equities, and warrants of company.
- Scenario analysis: Quantifies risks using stress tests, "what if" analyses, and sensitivity tests to determine what could happen. For instance, what happens if interest rates increase by 75 basis points? Or what happens if a major client leaves?
The more you analyze, the more answers you'll have to mitigate potential financial risks. Being prepared to put out tame fires is better than allowing them to ravage the company until it exists no more.
Digital financial risk management tools
Processes organize risk management. But without the right tools, these processes will likely be slower and more prone to error. Using digital financial risk management tools enables you to reduce these problems.
Artificial intelligence and machine learning can assist with financial risk management by detecting fraud, underwriting loans, and modeling credit losses. Here's an overview of the tools every financial risk manager should consider.
Enterprise risk management (ERM) software
Having a bird's-eye view of potential risks in the company is key to keeping things under control. ERM software empowers you to analyze a variety of financial risk types. This includes those from traditional and unconventional sources.
ERM software comes with AI and machine learning for:
- Data analytics
- Risk aggregation automation
- Risk assessment and simulation
- Risk reporting
- Natural language processing
Some firms use ERM software alongside specialized software, like Robotic Process Automation (RPA).
Automated credit scoring technology
Getting applications approved faster is possible using automation tools to check credit scores. This is widely used by credit card companies, banks, and buy-now-pay-later (BNPL) agencies.
But this goes beyond just checking the number on the borrower's credit report. It also analyzes the credit history to identify defaults, late payments, and other factors that deem an applicant non-creditworthy.
This allows more informed decision-making for financial institutions.
Governance, risk, and compliance (GRC) software
Staying compliant isn't a choice; it's a legal obligation, and one that's challenging to maintain without proper technologies. Specialized software is necessary for this reason.
For instance, you need tools with natural language processing to help risk departments analyze unclear human communication. This is critical for detecting fraud and insider trading.
Implementing GRC software is complex because it spans across departments. But once you do, you get a high-level view for better analysis.
Cloud computing software
Believe it or not, on-premise software leaves financial institutions prone to data breaches. Going into the cloud offers greater protection against fraud risks and security threats. Plus, it ensures software updates occur on time.
Cloud computing providers offer technical support and maintenance to prevent or assist with system failures and outages.
Going digital may a scary move for the financial sector, but it's necessary. Your customers demand online and mobile access to their accounts. But you need a setup that ensures the security of customers and the company.
Cybersecurity software encrypts data to prevent data breaches, fraud, and damage caused by cyber-attacks. Many use AI and machine learning to detect and remove malware, cybercrimes, and other cyber threats.
Fraud detection and document automation software
Financial risk management is impossible without a means to detect fraud. Now that finance clients expect digital capabilities, it's vital to have software enabling them to submit applications online.
This brings the need for document processing and fraud detection software to mitigate potential crimes. Inscribe’s fraud detection and automation solution uses AI and machine learning.
With this in your tech stack, your customers can submit necessary documents to prove identity, address, and income. The software analyzes each document to determine its authenticity. If it's fake or altered, you're notified to review.
Inscribe also scores applicants based on their bank statement data. It pulls data points to determine the spending habits to see if they're trustworthy.
Improve financial risk management with software
Financial risks are everywhere. And while it's impossible to negate them all, there are ways to reduce the impact once it hits. It requires creating a financial risk management system complete with processes and tools.
With this in place, you can reduce human errors and increase security for your company. Create a tech stack encompassing all aspects of risk, including cybersecurity, fraud, and investment decision-making.