Classifying risks by type – standard risk class

The classification of risks is a useful exercise to support their effective management, however it is important to note that some risks could be classified in multiple different categories. Such risks are typically called crossover risks.

The standard risk classification

Risks are commonly classified into three types:

• commercial
• financial
• operational.

Each type is introduced below.

Commercial risk

Commercial risk can be defined as those business risks that flow from the corporate strategy adopted by the company. Investors expect the company to take these commercial risks in the expectation that they will receive a return on their investment. The following are examples of strategic initiatives which result in commercial risk:

• the introduction of new products or services
• the discontinuation of existing products and services
• entry into new markets
• withdrawal from existing markets
• expenditure on research and development
• acquisitions
• introduction of significant new IT systems.

The board should decide which risks will be explicitly accepted by making appropriate strategic business decisions. The role of the treasurer is to support this process. For example, the treasurer could analyse proposals and recommend how initiatives could be financed.

Reputational risk is the risk of adverse consequences arising from a worsening of the reputation of a business, e.g. from adverse publicity that could be a result of business decisions that have been made or financial and/or operational risks that have not been adequately made. Reputational damage can have far reaching negative business and financial consequences.

Financial risk

The management of financial risk is a key area in which the treasurer’s expertise is vital.

Financial risk includes:

• financial market risk, including interest rate risk, currency risk and commodity risk
• liquidity risk
• credit and counterparty risk
• pension risk.

A significant risk that can be classified as either commercial or financial (i.e. a crossover risk) is the risk of not being paid by customers.

Example 1: financial market risk

Interest rate risk

Interest rate changes can have favourable or adverse effects, both on the cost of borrowing and on income from investments. The changes can also affect the market value of both debt and investments.

Changes in interest rates can also affect consumer demand. Demand may fall, for example, if the disposable income of consumers is reduced by increased house mortgage interest payments.

Currency risk

Currency (foreign exchange) risk is the risk that future cashflow, or the value of assets and liabilities, may be adversely affected by exchange rate movements.

Commodity risk

Commodity risk is the risk that future cashflow is adversely affected by changes in commodity prices. Examples of commodities are grain, metals, fuel and electricity. This risk affects most companies.

Operational risk

Operational risk can be defined as all those risks that have not been previously identified as either commercial or financial.

Examples of operational risks include:

• risk of fraudulent activity
• regulatory/legal risk
• external events and catastrophe risk
• processing and systems failures.

Operational risk exists wherever there is a chance that a process, person or system will not produce the expected or required result.

The treasury role often includes highlighting any risk exposure and putting in place appropriate processes and risk mitigation techniques to minimise the probability and impact of operational risks

Example 2: documentation risk

This is the risk that contracts or business relationships may have unforeseen adverse legal consequences as a result of the way in which they are documented. A common example is borrowing documentation.

Stakeholders have a high expectation that operational risks are being effectively managed and eliminated. This should be contrasted to the business risks that stakeholders expect the business to take.