Financial and non-financial risks, and how they interact

Before a risk can be measured or modified it has to be named. The curriculum splits sources of risk by where the loss starts: in the financial markets, or somewhere else.

Which risks are financial?

Memorize

Most risks end in money, but only those that arise from events in the financial markets are called financial. There are three.

Risk	Where the loss comes from
Market risk	Movements in interest rates, exchange rates, share prices and commodity prices. The underlying causes are economic risk drivers, which come back in the next lesson
Credit risk	A borrower or counterparty fails to pay in full and on time. Also called default risk or counterparty risk. It can run both ways in forwards and swaps
Liquidity risk	A significant price concession needed to sell an asset, because the market has thinned or the position is large relative to normal trading volume

Two points about liquidity risk catch candidates. First, a bid-ask spread is a known transaction cost, not a risk. The risk is that the cost rises sharply, which is why liquidity risk is also called transaction cost risk. Second, an illiquid asset is not itself the risk, because its lower price is paid on purchase. Uncertainty about what it will fetch when sold is the risk.

Which risks are non-financial?

Memorize

Non-financial risks arise from actions inside the organization, or from the environment and from relationships with counterparties, regulators, governments, suppliers and customers.

Sources of risknamed by where the loss originates

• Financial Memorize arise in the financial markets
  • Market risk Memorize interest rates, exchange rates, share and commodity prices
  • Credit risk Memorize a counterparty fails to pay what it owes
  • Liquidity risk Memorize price concession needed to sell an asset
• Non-financial Memorize arise inside the organization or from outside the markets
  • Settlement risk Memorize you pay, the other side does not deliver
  • Legal risk Memorize being sued, or a contract not upheld
  • Compliance risk Memorize conforming to rules and laws
    • Regulatory risk Use it new or changed regulation
    • Accounting risk Use it changed standards, restatements
    • Tax risk Use it changed tax law, back taxes
  • Model risk Memorize valuation error from the wrong model, or the right one misused
  • Tail risk Memorize more extreme events than the model expects
  • Operational risk Memorize failed people, systems, processes; external events
    • Employees Use it errors, fraud, rogue traders
    • Disasters and terrorism Use it business interruption
    • Cyber risk Use it hacking, data breaches, programming errors
  • Solvency risk Memorize runs out of cash to meet obligations
• Individuals Use it in addition to many of the above
  • Health risk care costs, lost income
  • Mortality risk Use it dying young
  • Longevity risk Use it outliving financial resources
  • Property and casualty risk fire, disaster, liability

Risk	What it is
Settlement risk	One party pays or delivers and the other does not. The loss is driven by the timing of payments, often across time zones. Also called Herstatt risk
Legal risk	Being sued over what an organization does or fails to do. In finance the main worry is that a contract’s terms will not be upheld, so a losing party escapes the loss
Compliance risk	Failing to conform to laws, rules and policies. It covers regulatory risk , accounting risk and tax risk . Rules change more slowly than products, producing unexpected costs, back taxes, restatements and penalties
Model risk	A valuation error from using the wrong model, or the right model incorrectly. Example: valuing mortgage bonds with a prepayment model fitted only to years when rates were falling
Tail risk	More events in the tails of a distribution than a probability model expects. It is a facet of market risk, but ignoring it is a form of model risk
Operational risk	Inadequate or failed people, systems, policies and processes, and external events beyond the organization’s control that disrupt operations
Solvency risk	The organization fails to survive or succeed because it runs out of cash, even though it might otherwise be solvent

Tail risk in numbers

A normal model is easy to overuse. Suppose a fund’s monthly returns have averaged 0.8% with a standard deviation of 4.0%.

Operational risk has four main sources

• Employees. Honest errors (a transfer of 1,000 keyed in as 10,000) and dishonest acts, from theft to accounting fraud. The rogue trader takes large, speculative positions outside the firm’s limits and can imperil the whole capital base.
• Business interruption. Floods, storms and earthquakes cannot be controlled, but the response can: generators, backup sites, remote working.
• Systems and cyber. Cyber risk is the disruption or failure of information technology: hacking, data theft and breaches, which bring reputational and compliance consequences. For example, the EU’s data protection rules require notice of a breach within 72 hours, with large fines for failure. Programming errors and bugs in secure systems are a risk too.
• Terrorism. Organizations in obvious targets keep backup operations far away.

Some operational risks can be insured, but most firms prefer to prevent them.

Solvency risk

Solvency here means having the funding to keep operating without liquidating, and to meet obligations as they fall due. A firm can have assets worth more than its liabilities and still fail because funding dries up and counterparties will no longer lend. Solvency risk was the most underappreciated risk before 2008. Bank runs are the simplest example: a solvent bank is ruined when depositors withdraw faster than it can pay. It is also the clearest case for the enterprise view: a charity’s reserve portfolio may look prudent on its own, but in a recession donations dry up just as the portfolio falls and the charity’s cash needs rise.

Solvency risk can be reduced, never eliminated, and every safeguard costs something: less leverage, more stable financing, more cash and liquid assets, and better modeling.

Go deeper Why the curriculum separates solvency risk from liquidity risk

In practice the cash position of an organization is often called liquidity risk, and the curriculum notes this. It still reserves the label for the price concession on a sale, so that two different problems have two different names. The first is a valuation shock when selling an asset. The second is the organization running out of cash. They are linked, because forced selling of illiquid assets to find cash is how one leads to the other. On the exam, use the curriculum’s wording: a cash crunch that threatens survival is solvency risk.

Risks facing individuals

Individuals meet many of the same risks, such as market and credit risk in their investments and operational risk such as identity theft, burglary or a hacked computer. Their distinctive non-financial risks concern life and health.

• Health risk: care costs, lost income through disability, shorter life or lower quality of life.
• Mortality risk : dying relatively young, which ends an income stream and leaves dependants short.
• Longevity risk : outliving one’s financial resources. Insurers and pension plans can rely on group averages, but an individual cannot know the date, so someone in a defined contribution plan must make assets last.
• Property and casualty risk: fire, natural disaster, or liability for harm to others. These are generally insured.

Go deeper Human capital: the individual's biggest asset

Most people’s largest asset is the income they will earn over a career. A financial portfolio should be judged together with it. A software engineer who also holds technology shares has a double concentration: a downturn can cost both the job and the savings. The same logic is behind the warning against holding too much of one’s employer, treated below under interactions.

How do risks interact?

Use it

Risks seldom arrive alone, and one category is often hard to separate from the next. The risk interactions can be traced along a chain: a market move creates credit risk, and credit risk brings settlement, operational and legal risk with it.

• A large market move means one party owes another a lot of money (market risk).
• The debtor may fail to pay (credit risk).
• Wherever there is credit risk there is settlement risk, because both parties must run processes to pay and collect, and this takes time.
• Parties that lose have long searched contracts for loopholes, so legal risk follows market and credit risk.

Wrong-way risk

Wrong-way risk is the extent to which exposure to a counterparty rises as that counterparty’s credit quality falls. A fund holds a currency forward with a bank. A sharp currency move makes the forward very valuable to the fund, but the same shock weakens the bank, so the credit exposure peaks just as the bank is most likely to fail.

A numerical case shows the cost of ignoring the link.

$$V = \sum_{s} p_s \times X_s \times (1 - d_s)$$

Here $p_s$ is the probability of a scenario, $X_s$ the payoff in it and $d_s$ the chance the counterparty fails in that scenario.

Leverage, liquidity and solvency

Leverage turns market risk into larger losses. If funding is also fragile, the combination is toxic: margin calls force sales into thin markets (liquidity risk), the sales deepen the losses, and the cash runs out (solvency risk). The effect is non-linear, as this illustration of a fund with 2× leverage and a baseline loss on its unlevered twin shows.

Loss on the unlevered twin	Loss at 2× leverage	With funding trouble as well
5%	10%	10%
15%	30%	36%
25%	50%	fails: cannot meet margin calls

Many banks and funds in 2008, and Long-Term Capital Management in 1998, suffered from this mix.

A personal case

An engineer is paid partly in shares of the chip maker she works for and never sells them, because the company has done well for years. If the company or its industry stumbles she can lose her job and her savings together: market risk interacting with human capital risk.

Systemic risk is the ultimate case of interaction: stress in one sector spreads to others and can reach the whole economy. Regulators worry about it most. Most risk models do not capture interactions directly, which makes the damage worse, so scenario planning matters.

Exam tip When a question describes one event with two effects, look for the interaction. The usual pattern: a market move changes what is owed, and the same move weakens the party who owes it.