TUTORIAL 3 – PROCESS
Q1.Why is it important to establish the context of the risk management process?
Establishing the context of the risk management process is deemed important as it can better
helps the banking organization to perform the risk assessment in a more adequate and
effective way. Through establishing the context of risk management process, the financial
institutions are allowed to consider both the internal and external factors which should be
considered in the risk assessment phase. Besides, they can also establish the scope of the risk
management process as well as define the risk criteria for analyzing and assessing risks
which better improve their risk assessment process.
Q2.What does “risk criteria” mean?
Risk criteria refers to the terms of reference against which the significance of risk is
evaluated. It is used by financial institutions as a framework to assess the significance of
risks, thus deciding whether to take on the risk exposure or not as well as allowing them to
clearly define the level of risk that they are willing to accept. There are some examples of
risk criteria such as nature and types of causes and consequences that might occur and how
they will be measured, how likelihood will be defined, how the level of risk is to be
determined, the level at which the risk become acceptable or tolerable.
Q3.What is the purpose of the risk identification exercise? What are ‘knock-on effects’ and why
should they be considered?
Risk identification is the process of finding, recognizing and describing risks which involve
identification of risk sources, risk events and their causes as well as the consequences it
brings. The objective of financial institutions to carry out this process is to generate a
comprehensive list of risks based on specific events that might affect the achievement of
objectives. Besides, this process always includes examining the knock-on effects of
particular consequences as well, which there is a large number of risk events and
consequences that happen quickly in a series. It is important for banking organization to
identify the knock-on effects of a risk event as it could bring a severe impact to themselves as
some of the risk event will initially effects only few financial institutions or a particular
geographic region but eventually escalates into a cross-country or cross-company. By
identifying the knock-on effects, those institutions could better identify the possible
outcomes and effects those have a better planning and management on the risk as well as
establishing good strategies to hold the risks when it happens in negative manner.
Q4.Among the risk treatment options is removal of the risk source or the risk transfer strategy
via the use of derivatives or insurance contracts. Discuss how and what type of
derivatives/insurance contracts can help transfer Market risk and Operational risk.
Let’s see how we could use derivatives or insurance contracts to help transfer Market risk
and Operational risk. For market risk, it can be transferred using derivatives such as futures,
options and swaps. These instruments allow investors to hedge against the potential losses
due to market fluctuations. For instance, investor who own a stock could hedge the risk by
purchasing a put option that gives them the right to sell the stock at a predetermined price if
the stock price falls below the exercise price. Through this contract, the investor can protect
themselves from the potential losses caused by the market volatility.
On the other hand, operational risk can be transferred using insurance contracts such as errors
and omissions (E&O) insurance, directors and officers (D&O) insurance, and cyber liability
insurance. These of the policies provide a good coverage for losses arising from operational
risks such as errors and omissions in professional services, wrongful acts caused by
management or decision-making and cyber-attacks.