Explore financial risk management strategies, frameworks, and best practices to safeguard your financial services business.
With new regulations, new cybersecurity threats, and new forms of fraud risk constantly arising, banks, credit unions, fintech companies, and other financial services businesses are having to manage an evolving and ever more complicated risk environment. These days, many risks are moving targets.
Risk and fraud professionals in the financial services sector are well aware of these challenges. To protect their organizations in an increasingly volatile landscape, they need financial risk management protocols that incorporate current best practices, including technology solutions that address risks specific to their industry.
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Framework of financial risk management
Best risk mitigation practices
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In the financial services sector, risk management is the process of identifying, evaluating, and taking steps for mitigating potentially dangerous risks that might impact operational or investment decisions. A rigorous risk management framework helps banks and other financial firms anticipate obstacles and reduce their impact, thus facilitating smoother operations, balance sheet stability, strategic decision-making, and long-term profitability.
One of the benefits of an effective financial risk management framework is the ability to provide and combine several different lines of defense.
Risk assessment methods
There are several ways to methodically assess risks. One technique is a risk assessment matrix, a visual tool for evaluating and prioritizing potential risks. A risk assessment matrix can incorporate either quantitative or qualitative assessment methods.
Quantitative matrices rely on mathematical models and numerical data to determine risk likelihood and potential impact. Qualitative assessment methods focus on less measurable factors, including emotion-based decision-making and differences of opinion and motivation among company insiders, customers, and investors.
Other risk assessment methods include Monte Carlo analyses, scenario analyses, and decision trees. Or, even with risk scores, taking account of everything involved can ease decision-making.
Metrics and tools
In addition to these approaches, other financial risk management tools include Value at Risk (VaR), a statistical benchmark in finance and risk management that quantifies potential losses over a specific time period. Another is stress testing, which evaluates the potential impact of adverse events or scenarios.
Common regulatory frameworks
Government regulations and regulatory bodies also offer frameworks that can aid financial services businesses in managing risk. These include the federal Financial Stability Oversight Council (FSOC), which identifies risks and promotes the financial stability of the U.S. banking system. The 1970 Bank Secrecy Act (BSA) and the 2001 USA PATRIOT Act require financial institutions to implement controls to prevent money laundering and terrorist financing. And the Office of Foreign Assets Control (OFAC) push the organizations to conduct sanctions screening. Internationally active banks also should be familiar with the Basel III risk management reforms developed in the wake of the 2007-’08 financial crisis.
A thorough and thoughtfully constructed financial risk management framework can help fraud and risk teams more effectively conduct activities relating to customer due diligence, including KYC and AML onboarding, financial due diligence, and identity verification.
Types of financial risk
In March 2023, California’s Silicon Valley Bank (SVB) made national headlines when this supposedly rock-solid institution suddenly experienced a bank run that would result in the third-largest bank failure in U.S. history. SVB experienced a perfect storm, even a perfect tsunami, of risk events. Interest rates had risen, which weakened the bank’s investment portfolio of long-term, interest-sensitive bonds. The bank also had a high concentration of tech startup customers, which suddenly pulled out deposits to meet their own capital needs.
SVB’s client base and investment portfolio were distinctive. But there are several types of risk that are common among all financial services organizations.
Credit risk
Credit risk can impact lenders’ ability to recover invested capital and maintain cash flow. One example of credit risk is the possibility of borrowers defaulting on loans or credit card payments. Another is trading partners not fulfilling agreements.
Market risk
This is the potential for financial loss due to fluctuations in market variables such as interest rates, foreign exchange rates, commodity prices, or equity prices.
Operational risk
This includes disruptions to internal processes (such as fraud) or from external events (such as market volatility). This category can include valuation risk, which is the potential for loss due to incorrectly estimating a financial asset’s current or future value.
Liquidity risk
What happens if a bank or financial firm can’t meet its cash obligations—or access funds it might need to maintain operations? That’s the risk of insufficient liquidity. The SVB bank run is a prime example. Another is the inability to borrow to cover cash shortfalls.
Reputational risk
This refers to the possibility of negative events or actions that could damage a financial services business’s image in the marketplace. A data breach is an obvious example of such an event. So is bad publicity. SVB, for instance, was hurt by news reports and social media posts that fueled fears of the bank’s failure.
Best risk mitigation practices
Financial services firms can optimize the fundamentals of risk management–identification, assessment, prioritization, response, and ongoing monitoring—by incorporating best practices in three areas:
Prevention
Best risk prevention practices involve establishing internal policies and procedures such as training employees to identify potential risks, diversifying investments, and setting up a risk committee to oversee the organization’s risk management program.
Detection
Best risk detection practices include leveraging technology like data analytics, implementing automated fraud detection systems, monitoring key risk indicators, continuously reviewing transactions, and conducting regular audits.
Investigation
When investigating risk events, financial firms should put in place crisis response strategies–and promptly and thoroughly report suspicious activities to proper authorities.
Again, the fluidity of risk means new potential dangers and challenges are constantly arising. Bond and equities markets have been especially unpredictable. And cyber-criminals continue to “innovate” new techniques—such as AI deepfakes–for stealing sensitive data.
Minimizing risk with technology
That noted, in today’s age of AI, innovative technology can help manage risks as well as generate them. But to fight financial crime, solutions focused on how financial institutions work are crucial.
Financial institutions can enhance their risk management frameworks by integrating digital solutions such as Thomson Reuters Risk & Fraud Solutions platform for financial institutions.
- Efficiently onboard low-risk, legitimate customers and merchant businesses
- Automatically receive notifications when risk emerges
- Investigate suspicious and risky identities
- Risk mitigation and fraud prevention across the financial workflow
CLEAR for Financial Institutions
Financial crime isn’t just about finance. It’s also about knowing your customer.
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