Financial risk management and risk reporting

Corporate finance theory suggests that the value of an organization can be increased if its risk (the uncertainty of returns) is reduced.

Risk management approach

ISO standard 31000-2009 defines risk as the ‘effect of uncertainty on objectives’. Risk can present opportunities for or threats to objectives. An uncertainly that does not affect objectives cannot be a risk to those objectives.

Key questions to consider – Start the dialog

Management accountants must be aware of the overall approach of the organization to financial risk management, and be able to answer the following questions:

  • Has the organization properly articulated its management approach to threats and opportunities?
  • Hence, is there capacity to take certain risks?
  • If so, is there an appetite?
  • How much of this appetite can be delegated to the treasury function?

Figure 10: Approach to risk management

Approach to risk management
Risk management vs speculation

‘Speculation’ is the act of deliberately taking on risk or hedging a risk that you do not have. Opportunities consistent with the business strategy, commonly within strict limits (such as credit risk or liquidity risk in investing surplus funds) are acceptable. Anything else (inconsistent with the business strategy) is speculation. It should therefore be prohibited in corporate treasury as elsewhere.

Deliberate or inadvertent inaction is also considered speculation when policy would call for action. It too should be prohibited or strictly controlled within limits. For example, treasury operations might be entitled to disregard foreign-exchange positions passed to them if they are accepted as small and not of market size.

This approach does not prohibit the taking of financial risk. For example, increasing levels of debt (leverage) that make the financial structure riskier is a widely accepted approach to increasing shareholder returns. But such leverage should be decreased if either the business or its financing becomes more risky. (We have seen this happen widely since the global financial crisis.)

Risk management framework

Once a budgetary approach to treasury has been established, a risk management framework provides a mechanism to develop an overall approach to financial risks across the entire organization. It does so by creating the means to discuss, compare, evaluate and respond to these risks. It can be seen as a series of successive phases.

Figure 11: Risk management framework

Risk management framework

Figure 12: Enterprise Risk Management (ERM) Process

Enterprise Risk Management (ERM) Process Tool: Enterprise Risk
Risk heat maps

A risk heat map is a tool used to present the results of a risk assessment process visually and in a meaningful and concise way.

The heat map diagram below provides an illustration of how organizations can map probability ranges to common qualitative characterizations of risk event likelihood and a ranking scheme for potential impacts. They can also rank impacts on the basis of what is material in financial terms, or in relation to the achievement of strategic objectives.

Organizations generally map risks on a heat map using a ‘residual risk’ basis that considers the extent to which risks are mitigated or reduced by internal controls or other risk response strategies.

Figure 13: Risk heat map

Risk heat map Tool: Risk Heat Map
Risk reporting

Responsibility for the management of financial risk is often delegated to those responsible for treasury activities. These treasury activities must be included in the organization’s management information as well as, where material, to the market.

For each financial risk, there should be some measure of the risk and risk reduction.

Regular reports should:

  • Inform management of financial exposures outstanding both before and after any hedging
  • Demonstrate that treasury activity is within the policy authorized by the Board
  • Promote the concept of analysis and performance-measurement in treasury
  • Create a feedback mechanism that leads to improvements in efficiency and control.

Best-practice reporting should focus on accuracy, completeness, timeliness and materiality.

Table 6: Financial risk reporting

Financial risk reporting

Dashboard reporting is another tool for reporting the organization’s financial risks. This is a report which summarizes in one page the organization’s key risks/positions, with a brief commentary on any deviations. This is a particularly valuable tool for reporting to senior management. In the treasury domain, items on the dashboard may include:

  • Foreign exchange (FX) exposures (pre- and post-hedging)
  • FX volatilities
  • FX rates
  • Interest rates
  • Borrowing facility headroom
  • Cash positions
  • Credit-default swap prices
  • Funding developments.
Enterprise Risk Management

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