What Is Effective Financial Risk Management?

Gilbert Asamoah, Credit Risk Manager, NiSource Inc.; Doctoral Candidate, Franklin University, Columbus, Ohio

What is the Meaning of ‘Effective?’

The ability of humans to ask probing questions on any phenomenon, including questions about problems that do not yet exist today, is one of our major advantages over machines. One question a friend often asked me years ago was, “You’ve been very busy, but are you effective?” His question begs another question, “What is effective?” On the question “What is effective financial risk management?” the ubiquitous word ‘effective’ appears again. This two-part article explores and attempts to answer that question in a way that would interest practitioners and stakeholders alike.

First, let’s break the clause ‘effective financial risk management’ into different parts, explain each part to see what picture emerges and then reassemble all of them together. Let’s start with the elusive term 'effective.’ Everyone agrees that this word is overused, but what is a good alternative? So, we turn to Peter Drucker, the father of modern management thinking. ‘To be efficient,’ according to Drucker, is doing things right, whereas ‘to be effective’ refers to doing the right things. Drucker further emphasized that no amount of efficiency can compensate for a lack of effectiveness. If you are on a highway, efficiently weaving your way through traffic, you are not effective if you are headed in the wrong direction. Therefore, ‘effective’ financial risk management refers to doing the right things for the reason financial risk management exists in organizations.

Dissecting ‘Financial Risk Management’ by Grouping the Terms

Next up in our definitional journey is splitting the term ‘financial risk management’ into the two-word phrases: ‘financial risk’ and ‘risk management’ for more insights.

‘Financial Risk’ Management

Starting with the phrase ‘financial risk’ allows us to describe financial risk management as the ‘management’ of financial risks. Financial risks are typically readily quantifiable and easily denominated in monetary terms. The International Organization for Standardization’s practical guidelines on risk management (ISO 31000:2018, Appendix B) identifies three risk classes, namely strategic risks, operational risks and financial risks. Our focus here is financial risks of which examples mentioned in that ISO document include credit risk, market risk and inflation risk. Other examples of financial risks identified by the scholarly literature include the potential for monetary loss arising from interest rates, pricing, foreign exchange, accounting, taxation, liquidity, cash flow, currency and financial instrument value risk.

The ability of humans to ask probing questions on any phenomenon, including questions about problems that do not yet exist today, is one of our major advantages over machines

Therefore, the function of managing the risks pertaining to any of the activities on this list defines the scope of financial risk management. I call that a ‘functional domain definition’ of financial risks management. From a practitioners’ perspective, people are involved in financial risk management if the scope of their daily tasks encompasses any of the financial risk classes identified above. They need not have ‘financial risk manager’ in their job title per se.

Financial ‘Risk management’

A second two-phrase grouping is financial ‘risk management.’ This approach emphasizes the ‘risk management’ component as an identifiable class of activities with specific attributes or processes. In this instance of the phrase ‘financial’ risk management, the word ‘financial’ acts as an adjective that qualifies risk management. This definitional approach presents financial risk management as a component of the broader risk management domain and invites us to apply the descriptive properties of risk management to financial risk management. ISO 31000 has described the risk management process into steps depicted in the diagram below. As the figure indicates, the steps appear to move sequentially from the left to the right, but they overlay each other. Furthermore, the giant arow at the bottom shows how these steps loop back to the beginning and continue in an interactive way. Implementing this process from the mother discipline of risk management, calls for applying this systematic and iterative approach to the sub-domain of managing financial risks.

One key observation from my professional career in financial risk management roles is that many astute practitioners have mastered most of the items in the risk management process. However, many often skip the very first step- Understanding the Risk Context, Scope and Criteria. The final part of this article series will describe how skipping over the first step is a serious misstep and a violation of the ‘Peter Drucker Warning’: “no amount of efficiency will compensate for a lack of effectiveness.” Until next time, do not let the ‘Drucker Police’ come after you. Go and do something that really matters.