How Do Businesses Manage Financial Risks?

In the financial globe, risk management is the process of identification, acceptance, analysis, and mitigation of uncertainty in investment decisions. Mostly, risk management happens when an investor or fund manager analyzes and tries to quantify the potential for losses in an investment, like moral hazard, and then takes the right action (or inaction), given the fund’s investment purpose and risk tolerance.

Risk is intrinsic in any business operation, and good risk management is vital if you are going to recognize and stop revenue leakage from your business. Financial risk is one of the many types of risks your business might face and has the most immediate effect on your cash flow. You can anticipate these risks and head them off at the pass with a robust financial risk management plan.

What is Financial Risk?

Anything that is linked to money flowing in and out of business is a financial risk. Because the list of potential risks is big, most analysts place them into one of four sections as outlined below:

Market Risk

Just as the name indicates, market risk is any risk that comes out of the marketplace in which your business operates. For instance, if you are a brick-and-mortar clothing store, clients’ increasing tendency to shop online would be a market risk.

Companies that adapt to serve online customers have a better chance of surviving than the businesses that stick to the offline business model.

Generally, whatever sector you are in, every business runs the risk of being outpaced by competitors. If you do not keep up with clients’ trends and the pricing demands, then you will possibly lose market share.

Liquidity Risk

Also called funding risk, this section covers all the risks you encounter when trying to raise funds or sell assets. If something is standing in your way of raising cash fast, it is categorized as liquidity risk. For example, a seasonal business may experience significant cash flow shortages in the off-season. Do you have sufficient cash set apart to meet the potential liquidity risk, and how fast can you dispose of old inventory or assets to get the money you require to keep the light on?

Liquidity risk also incorporates interest rate risk and currency risk. What can happen to your cash flows if the interest rates or exchange rate were to change suddenly?

Credit Risk

In simple words, credit risk is the possibility that you will lose money when someone fails to perform with respect to the terms of a contract. For instance, if you deliver goods to clients on thirty-day payment terms and the client does not pay the invoice on time, or not all, then you have suffered a credit risk. Companies must retain enough cash reserves to cover their accounts payable, or they are going to experience severe cash flow problems.

Operational Risk

This is a catch-all term covering all the other risks a business may face in its daily operations. Poor budgeting, unrealistic financial projections, inaccurate marketing plans, lawsuits, fraud, theft, and staff turnover can pose a risk to your bottom if they are not anticipated and managed well.

What is Financial Risk Management?

Financial risk management is the procedure of understanding and controlling the financial risks that your company might be facing, either currently or in the future. It is not about getting rid of risks since few companies can wrap themselves in cotton wool. Instead, it is all about drawing a line in the sand- understanding what risks you are willing to take, the ones you would rather avoid, and how you will establish a strategy based on financial risk appetite.

The key to any financial risk management plan is the strategy of action. These are the policies, procedures, and practices your business will use to make sure it does not take on more risk than it is prepared for. In simple words, the strategy will make it clear to employees what they can and what they cannot do, the decisions that require escalating, and who has overall responsibility for any risk that might arise.

Procedures and Policies for Risk Management 

For quite some time, fraud threats have been among the main risks to NBFIs and FIs; banks are shielded more than ever before by AML, KYC, and BSA procedures and policies in conjunction with vendor management oversight. One of the criteria for institutions is to know their clients. In this regard, banks should:

  • Vet customer accounts: Organizations are needed to collect and document their customers’ personal information, including date of birth, name, address, and social security number.
  • Vet commercial accounts: Apart from collecting and documenting individuals’ personal information on commercial accounts, organizations are needed to protect business information like articles of incorporation and tax identification numbers.

When gathering consumer information, personal digital data should be retained in networks and the possession of third party vendors. This is most mainly when data collection procedures like account opening and scanning are done online. NBFIs and FIs are required to retain digital for not more than seven years.

Requirements by BSA ( Bank Secrecy Act)

NBIFs and FIs are required to monitor their customer records often to safeguard themselves against criminal activities. Both CTRs (Cash Transaction Reports ) and SARs (Suspicious Activity Reports should be included in BSA documentation. Whereas these documents have customers’ personal information, SAR details should not be shared with the Board of Directors.

How Does NBFIs and FIs Enhance Vendor Monitoring?

To prevent information security risks, NBFIs and FIs must remain agile when assessing third-party vendors. Apart from ensuring the information security of the vendors they associate with, they should also make sure that those vendors remain solvent. To attain this, most NBFIs and FIs integrate SOC 3, SOC 3, and SOC 1 into their vendor monitoring practices.

With most departments requiring more information to promote appropriate compliance, there is a need for a management solution (apart from spreadsheets) that offers the most effective cross-departmental communication.

How NBFIs and FIs Can Benefit from Blockchain?

In their effort to protect transaction information, NBFIs and FIs are using an emerging technology called Blockchain. This is a new technology that assists organizations in building radically better and safer financial systems.

Blockchain utilizes encryption technology that safeguards data while incorporating the transaction’s full history. Thus, systems that adopt this technology are capable of protecting transactions while still being able to retain it. The use of this technology allows NBFIs and FIs to meet OFACs requirements.

How To Implement Finacial Risk Control?

Companies manage their financial risk in different ways. The procedure depends on what the business does, the market it operates in, and the level of risk it is prepared to accept. In this scenario, it is the responsibility of the business owner and directors of the organization to identify and evaluate the risk and decide how the organization is going to manage them. Some of the phases in the financial risk management process include:

  1. Identifying the risk exposures: Risk management begins with identifying the financial risks, and their sources. A company’s balance sheet might be the right place to start. This offers a snapshot of the debt, interest rate, commodity price vulnerability, foreign exchange exposure, and liquidity. You should also assess the income statement and the cash flow statement to check how cash flow and income fluctuate over time, and the effect this has on the company’s risk profile.
  2. Quantifying the exposure: Quantify or put the numerical value on the risks you have recognized. Of course, the risk is uncertain, and putting a number on risk exposure will never be exact. Analysts tend to use statistical models like the standard deviation and regression method to measure a company’s exposure to several risk elements. These tools measure the amount by which your data points differ from the mean or average. For small businesses, computer applications such as Excel can efficiently and accurately assist you in running some simple analysis. The general principle is, the higher the standard deviation, the greater the risk linked with the data point or cash flow you are quantifying.
  3. Making a hedging decision: Once you have analyzed the sources of risk, you have to decide how to act on this data. Are you able to live with the risk exposure? Do you need to mitigate it or hedge against it in some way? This decision depends on multiple factors like the company’s goals and its business environment if the cost of mitigation justifies the reduction in risk and the business appetite for risk.

Typically, you may consider following the steps below:

  • Decreasing cash-flow volatility
  • Managing operating costs
  • Fixing interest loans, so you have more certainty in your funding costs
  • Managing your payments terms
  • Doing away with customers who regularly abuse your credit terms
  • Putting rigorous credit control and billing procedures in place
  • Understanding your commodity price exposure is your susceptibility to variations in the price of raw materials.
  • Make sure the right people are given the right jobs with the right degree of supervisions, to reduce the risk of fraud
  • Performing due diligence on projects, for instance, considering the uncertainties linked with a joint venture or partnership
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