What is risk?

We face risk whenever we cannot be certain of the outcome of our actions. When we step out of our home each morning, we never know what the day will bring. If your firm launches a new product, you cannot be certain that the product will be a success and that it will generate profits. In financial markets, whenever we make an investment, we could make a profit. But we could also make losses. We can form a view of what the most likely outcomes are likely to be, but in general, we cannot be sure that our investment will be a success. And large losses, in particular, could have very severe consequences. They could even force our company to go bust.

It is important, therefore, to think of strategies which help us reduce the possibility of large losses.

A traditional view of finance is that it serves as a bridge between savers and investors. Through financial instruments and institutions, resources are transferred from those sectors of the economy which save part of their income and are in surplus - and many households would fall into this category - to those sectors of the economy which are in deficit, for instance, private corporations and governments. A modern view of finance is that, in an addition to acting as an intermediary between savers and investors, finance also helps manage risk by making it possible to transfer that risk across market participants. Financial institutions can pool together the risks of individual investors, or they can diversify away the risks that individual investors would otherwise face.

The first step in risk management is the identification of the sources of risk that then can affect institutions, and the analysis of how risk can affect their profits. In general, it is important to distinguish between financial and non-financial institutions, since there could be important differences in the way they relate to risk. Financial institutions often act as intermediaries between investors with a different risk exposure. Their role is therefore to offer opportunity for diversification and hedging of risks. Or they may be asked to act so as to increase the risk profile faced by investors, if these investors want to speculate. By contrast, non-financial institutions face risks in the course of their normal business activity.

And these could be related to uncertainties in output markets or exchange rate fluctuations, for example. Non-financial institutions may therefore seek to limit the effects of risks on their profits.

We can classify the risks faced by financial institutions in several ways. Firstly, market risk. This is due to changes in prices and rates of interest in financial markets. Then, credit risk. This risk consists of changes in the credit quality of the counterparties. How likely are they to be able to repay their loan? Liquidity risk is a risk associated with the institution’s ability to raise the necessary funds to carry out its desired financial transactions. And then, operational risk. This is the risk associated with the ordinary activities of the institutions, and can be associated, for instance, with a breakdown in software systems, management failures, or fraud, or human error.

Legal and regulatory risk is associated with the possibility of changes in the regulatory framework or in the tax laws, or could involve the difficulty of enforcing a financial contract in a court of law. And finally, systemic risk. This risk could be associated with a systemic collapse of the banking industry at regional, national, or international level - the so-called “domino effect” - where the effects of bank failures can rapidly spread throughout the economy and generate a systemic crisis in the banking system.

The risks faced by non-financial institutions can be classified as follows. First, business risk. This is a risk associated with the ordinary operations of the institutions, such as fluctuations in demand and supply, price changes, pressure from competition. Operational risk. This includes the risk associated with the need to replace production processes due to obsolescence. Market risk includes the risk to the firm’s profits due to changes in inflation, interest rates, fluctuations in exchange rates, among other things. And then there is credit risk. And this includes changes in the institution’s own credit rating or in the credit rating of its clients, which would affect the cost to the firm of obtaining funds for its investment projects.

Of course. For instance, both financial and non-financial institutions increasingly face reputation risk. Awareness of reputation risk is becoming more widespread following a number of recent accounting and financial scandals involving large corporations. Also, the increasing complexity and use of structured financial products have led some to even question the legality of these transactions. In the end, reputation risk is not easy to measure nor to assess.