How to Create a Modern Risk Management Framework

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Finance Insights for ProfessionalsThe latest thought leadership for Finance pros

Thursday, February 18, 2021

Creating a clear risk management framework will not only allow an organization to make well-informed decisions, it’ll also help to attract investors.

Article 3 Minutes
How to Create a Modern Risk Management Framework

Risk is a very real part of running a company and while the instinct may be to mitigate it entirely, without risk there’s little or no reward. That means a balance must be sought, allowing finance professionals to accept the right type and amount of risk for their company to flourish without leading to business failure. This is where a comprehensive risk management framework comes in, allowing an organization to grow in a sustainable fashion.

Without such a framework, businesses will find it difficult to attract investors, the cost of borrowing will be high and access to capital will be limited. This is because anyone who has succeeded in business knows that good risk assessment practices are vital when it comes to long-term performance.

Here are the elements that go into an effective modern risk management framework:

1. Identify risks

Identifying all the potential risks to an organization should be a collaborative exercise between team members who can all bring their unique perspective to the table. Once it’s been established what constitutes a risk and a list has been decided upon, each of them must be placed in order of priority so the most significant risks can be dealt with first.

2. Measure the risk

To fully understand the complexities of a specific risk and the impact it might have on the business, it needs to be measured accurately. There’s a wide selection of methods that can be employed for this task, including:

  • Standard deviation - looks at the history of an investment and compares its volatility relative to its rate of return
  • Sharpe ratio - measures performance against risk
  • Beta - pits systematic risk against that associated with the stock market as a whole
  • Value at risk - takes the maximum potential loss over a specific period
  • Conditional value at risk - is similar to value at risk, but is more focused on the tail end of the risk
  • R-squared - uses a fund or security’s percentage of movements within a benchmark index

Teams should decide on a single approach they’re all comfortable with and apply it to all risks to fully understand the potential risk exposure.

3. Accept or mitigate the risk

Once all of the risks have been measured, it’s time to decide whether they need to be tackled or if it’s a risk the company is prepared to take on. The options are:

  • Accept the risk and move forward with all key stakeholders understanding the potential implications
  • Avoid the risk by adjusting funding, scheduling or technical requirements
  • Control the situation and minimize the risk
  • Transfer accountability to someone willing to take the risk
  • Monitor the situation for changes that may affect the risk

4. Risk reporting

Effective reporting is a vital part of the risk management framework and reports should be presented to senior executives for consideration regularly. They should contain both critical risks and emerging risks to represent the full picture and show what actions the organization is taking to control these risks. Finally, a comprehensive report should also show the effect such measures are having, as policies may need to be tweaked throughout the risk management process.

5. Govern the risk

Risk governance should be very clearly structured, with every employee, committee and board aware of their duties in reference to the framework. This will allow for resources to be allocated effectively and decision-making to be both well-informed and achieved through a straightforward process. With an expressly defined hierarchy, risk governance can be effective and provide reassurance to investors.

6. Make decisions

Volatile markets and externally challenged industries can be empowered by a modern risk management framework as it’ll promote debiased strategic decision making. This can lead to a number of definitive decisions being made, such as hedging, the sale of assets or liabilities, purchasing insurance or diversification, leading to long-term success.

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