What is risk? What are the methods of identification of risk?
What is Risk?
Risk refers to uncertainties that lead to adverse outcomes. These outcomes deviate from planned objectives or expectations.
Financial risk is the uncertainty that results in adverse variation of profitability or outright losses. Profits depend on cash inflows and outflows. Any uncertainty in these creates financial risk.
There are three levels of risk based on variability:
- Low risk means low variability in net cash flow.
- High risk means high variability — both upside and downside.
- Zero risk means no variation at all, but gives a very low return.
Methods of Risk Identification
Risk identification is the starting point of risk management. Banks must identify risks in both existing activities and new business initiatives.
Review the Banking Book
This identifies credit risk, interest rate risk, liquidity risk, and operational risk arising from day-to-day banking activities.
Review the Trading Book
This identifies market and liquidation risk for tradable assets such as bonds, equities, and derivatives.
Review Off-Balance Sheet Exposures
This identifies risks in guarantees, letters of credit, and derivative contracts that do not appear on the balance sheet.
Internal Audits and Risk Assessments
Conducting audits and structured assessments across all business units helps uncover hidden risks.
SWOT and PESTLE Analysis
SWOT analysis identifies internal strengths, weaknesses, opportunities, and threats. PESTLE analysis identifies external political, economic, social, technological, legal, and environmental risks.
Historical Data and Interviews
Studying historical loss data, incident reports, and interviewing business line managers also helps identify risks that may not be visible through other methods.
Banks must use adequate tools and techniques so that no risk is missed. Risks not identified at this stage will not be included in further analysis. [5th BPE Q1(a); 98th BPE Q1(c)]
