Types of financial risks: which financial risks should companies keep in mind

Types of financial risks: which financial risks should companies keep in mind

Finances are one of the most integral parts for businesses to operate properly. That’s why companies must be aware of all the financial risks they can potentially encounter.

Let Genome explain what you need to look out for! Find out the primer financial risks for businesses and how to deal with them!

What is a financial risk? 

As the name suggests, it is a type of risk associated with certain financial operations, as well as internal and external changes that can result in money and capital loss. 

Financial risks are something that experienced companies know all too well about. Some can occur because of a company’s faults, such as the potential inability to return loaned funds in time. On the other hand, external risks, such as political situations, natural disasters, etc., can be even more detrimental and unpredictable. 

To better understand what companies have to deal with, we need to review some common types of financial risks. 

Types of financial risks

Generally, the risks can be divided into two categories: systematic and unsystematic risk. 

  • Systematic risks usually occur due to unplanned global events, such as wars, natural disasters, geopolitical changes, etc. Unfortunately, systematic financial risks are unavoidable in most cases and influence the financial market entirely.
  • Unsystematic risks are on a minor scale compared to systematic ones, meaning they usually influence a particular company, not the market or industry as a whole. Such financial risks can be external and internal and are much easier to mitigate than systematic ones. 

Among the most common types of financial risks are credit risk, operational risk, market risk, and liquidity risk, as well as some other ones we will cover below. 

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Credit risks

This kind of financial risk can come to mind first when talking about banking and finances. Traditionally, it refers to the possibility of losing the lender’s money due to the borrower not paying back a loan.

A company’s credit risk depends on credit history and the ability to pay back. Meaning the higher the risk – the higher interest that the business will end up paying. Banks thoroughly research the company’s history before giving loans as a part of their credit risk management strategy. 

As you can imagine, giving loans to companies than to individuals is much trickier for banks, as business loans are much heftier. That’s why, during credit risk management, banks assess the following:

  1. The company itself, its operations, structure, management, credit score, and strategies;
  2. The field in which the company works;
  3. The industry as a whole as well as current developments in it.

And, of course, financial institutions implement different credit risk mitigation strategies to make sure that they won’t lose the funds they loaned to companies. 

Even if your business is doing fine, but your industry suffers from bad conjuncture, it will affect your potential credit ratio in the worst way.

When it comes to credit risk management on the companies’ part, one of the best ways to manage this type of financial risk is transparency and cooperation – the more the bank knows about the company, the more sparing it will be. 

Issuing credits is a long-term story that’s why lenders prefer working with trusted clients and often provide much better conditions if they are secure in the company’s competence.

Operational risks

Operational risks represent a summary of all hazards and unforeseen circumstances that can take down your cash flow or even the business itself.

The human factor represents a crucial part of operational risks – mistakes are a part of human nature, and even the best of us are not immune from this. The daily tasks and actions performed by employees determine the company’s efficiency.

That’s why KRI (key risk indicators) exist. Companies collect, analyze data and operate relying on this metric, trying to minimize operational risks as a part of their operational risk management. 

Still, the more employees you have, the more risks you will face. That is why big companies’ operations nowadays are entirely based on financial risk management. You can say it made decision-making a bit clunky but reliable.

Market risks

Market risks are defined by price movement in the specific market and demand volatility, exchange rate, and stock price. 

The fundamental difference between market risks and other risk types is that you can’t avoid them through diversification or other actions that work in other cases.

Price volatility can be predicted, but economic recession, wars, and political instability can be detrimental to the operations of any company, and it is much harder to adapt to such monumental changes. 

On the other hand, such global market risks will impact all companies on the market, so you and others are on an equal footing.

Some pinpoint four types of market risk, this is how they differ:

Types of market risksEquity price riskExchange rate (currency) riskInterest rate riskCommodity price risk
Market risk exampleThis type of market risk is attributed to stock prices and issues with their volatility. For instance, a business bought stocks of a promising tech company, planning to sell them later for a higher price. But turns out the tech company had a major data breach, resulting in their stock dropping in value, which, in turn, caused losses for a business that bought the said stocks.Here, the problem for companies arises due to currency prices fluctuating. Imagine a business with its headquarters located in country “A” while one of its branches is on the other side of the world, in country “B,” which has another domestic currency. Due to exchange and currency fluctuations, the company can lose a lot of money during transactions between them.This type of market risk is all about interest rate fluctuations and their impact on asset prices. Imagine this scenario: a business purchases a 1200 euros bond which has a 2% interest rate. But then, the interest rate for new bonds increases to 5%. It means that it will be more difficult for the company to sell its bonds because the latest market offerings are better.Commodities are raw materials that can be used for trade. The most common commodities are metals, energy sources, and agricultural production. In turn, commodity price risks are attributed to the changing prices of said commodities. For instance, the global wheat harvest was poor due to extreme weather conditions, resulting in a surge in wheat prices.

As you can see, there are many problems companies can face in this risk category. Thus implementing a substantial market risk management strategy is a must. 

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Liquidity risks

Liquidity risk occurs when a business may not have enough money to pay its debts on time. It also means that investors might be unable to convert an asset into cash or other exchange without financial losses. It usually happens when the cash flow management is poor.

Investors and creditors use liquidity measurement ratios in their work as a tool when they need to describe the level of risk within an organization.

The most common thing is to compare short-term liabilities to the liquid assets listed on a company’s financial statements.

When the liquidity risk is too high, it usually leads to selling assets and searching for ways to increase revenue and delay payday.

But such risks can be handled with the right actions. Yes, good old risk management will be a suitable tool.

Banks work in a liquidity risk environment and can show us a perfect example of liquidity risk management.

Because the financial industry works with all sorts of currencies and often with stocks, having access to liquidity assets is essential. You definitely wouldn’t like it if your bank ran out of currencies of your choice.

Commonly, a bank’s treasury is mandated to manage the overall liquidity risk in banks as a keystone of its risk management.

They implement and provide key liquidity metrics for both internal and market indicators that, in turn, determine limits and thresholds for banks to work with clients.

In Europe, banks must maintain a liquidity coverage ratio at a minimum threshold of 100%. That means bank liquidity must have a high number of relevant, highly liquid assets to pay out all deposits at the same time if necessary.

Legal risks

This type of financial risk applies to companies that ignore the legal regulations applied to their business or don’t know all the aspects of the law to follow it correctly. But, as you know, ignorance is no excuse, and a company can suffer financial and reputational losses due to legal risks. 

Legal risk management is crucial to ensure the stable work of your company, as you don’t want to deal with lawsuits or clear your brand name during your day-to-day operations. This is why many businesses now have considerable legal teams.

Legal risk management is commonly used to deal with three main types of legal risks:

  • Litigation risks. These risks derive from damages caused as a result of the company’s decisions or inaction;
  • Contract risks. They occur when one or multiple parties that signed a contract violate the obligations stated in it;
  • Regulatory and compliance risks. Such risks are frequent, as businesses need to constantly adapt to ever-changing compliance policies. 

Speculative risk

Although this one is not as discussed as other types of financial risks, it still affects some businesses. So, what is speculative risk meaning? It primarily applies to investments and how they will affect the investor. 

For instance, a business wants to buy the stocks of a manufacturing company. From here, the speculative risks start to show as the business analyzes the manufacturing company’s operations and other aspects of its work environment and strategies to better understand if the investment will pay off. 

In the end, the business decides in favor of buying the stocks, as the information they gathered regarding the manufacturing company allows them to assume that this will be the right investment. However, it is still not a 100% guarantee, as other factors may influence the value of stocks. As a result, the business can lose capital or, on the contrary, earn more thanks to its investment.  

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Are financial risks and bank risks the same? Types of bank risks

First of all, financial risks and bank risks are not the same. While the term financial risks can be used regarding businesses from any industry, bank risks refer specifically to losses banks can face due to certain occurrences and issues.

Financial institutions implement bank risk management to mitigate the risks associated with their field of work. This way, banks can ensure that they predict and track all the potential risks in due time and have the tools necessary to avoid or minimize them.

Risk management and financial institutions go hand in hand nowadays, as it is important not only for banks’ stable operations but to ensure a trustworthy, secure reputation among their clients. 

As for the types of bank risks, they correlate with the main financial ones, which are: market risk, liquidity risk, operational risk, and credit risk. Because we have already described these, our team will provide examples of such risks specifically for the banking industry.  

Types of bank risksOperational riskCredit riskMarket riskLiquidity risk
ExamplesA bank announces a new feature that is of high interest to clients. But its implementation was rushed and didn’t undergo proper tests, resulting in poor feature performance and the loss of some clients.The credit risk in banks is self-explanatory: a company takes a substantial loan and cannot pay it back, creating problems for its financial institution.A bank bought shares of a company that deals with microchip manufacturing. But, the global microchip prices dropped, resulting in money loss for the said bank.Here’s a liquidity risk example: a bank wasn’t able to comply with all its financial obligations and couldn’t pay off its debts because it didn’t plan out the costs of its daily operations.

What can companies do about financial risks?

The first and most important step – acknowledge that these risks are real and, unfortunately, you are very likely to face at least some of them in the course of your company’s operation. 

It especially applies to start-up companies. All the potential financial risks need to be assessed carefully and thoroughly before you even start a business.

It is where financial risk management comes into place, a complex of analytical tools and personnel that can pinpoint and evaluate all types of risks a business can encounter and work out strategies and instruments to reduce and eliminate potential threats to a company. 

Yes, financial risk assessment is a complex and ongoing procedure, but it can really pay off in the long run. Not to mention that many companies on the market provide financial risk management services, and their experience in the field can aid any business greatly.

Also, you can avoid some risks in other ways, for instance, using a secure and trusted financial provider, such as Genome

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Genome is an Electronic Money Institution licensed and supervised by the Bank of Lithuania. We are PCI DSS, GDPR, and PSD2 compliant and provide services for individuals, businesses, and merchants. 

Here, you can start personal and business wallets and have multiple accounts inside them – in euros, British pounds, and US dollars. All the main money transfer options, such as SEPA, SWIFT*, and Faster Payments*, are included. Genome provides virtual and physical cards for both personal and corporate clients. 

With Genome’s merchant accounts, companies can accept payments worldwide, with customers paying them in over 20 currencies.

Genome is secure: all the log-ins and outgoing payments are protected with two-factor authentication. Not only that, but business wallet users can get a special Genome token for another layer of security when it comes to each outgoing transaction!

*Please note that SWIFT transfers and Faster Payments are temporarily unavailable.

 FAQ

How is financial risk defined?

It is a risk that can result in loss of capital for businesses and people because of a number of external and internal factors.

What are the financial risks in a business?

Companies can face many types of financial risks. Some depend on their activity and decisions they make, some on their financial operations, and others – on external events that influence the market in general. 

What are the main types of financial risks?

There are four main types of financial risks: credit risk, market risk, operational risk, and liquidity risk. We described all of them in this article. 

What are business risks and financial risks?

There is a difference between these two terms. Financial risks refer to the possibility of a business losing capital due to a number of external and internal factors. Meanwhile, business risks are associated with the company’s ability to cover its daily operational expenses and generate enough revenue.

What are financial risk examples?

We provided some examples of different types of bank risks and financial risks in the article. For instance, natural disasters, such as floods and earthquakes, entail global financial risks. As they, unfortunately, lead to the destruction of businesses and manufacturing factories, which can have a negative effect on multiple industries simultaneously. 

How many financial risks are there?

Unfortunately, there are many risks, as multiple factors can cause the downfall of any company. In this article, we described some of them, for instance, operational risks, liquidity risks, legal risks, market risks, speculative risks, and credit risks. 

What are the 4 types of financial risk?

These are the most common types of financial risks: liquidity risk, credit risk, market risk, and operational risk.

What are examples of financial and non-financial risk?

Most financial risk examples were listed in this article, but basically, it is a type of risk that causes a company to lose capital. As for non-financial risk, one such example is compliance risk, when a business struggles to meet all the major requirements and regulations, resulting in its termination. 

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