Module Guide Risk Management Cep - 2021

College of Business and Economics
School of Management
Department of Business Management
Continuing Education Programmes

(CEP’S)
Learner Guide
RISK MANAGEMENT
HC1RSKM
Ashley Gandanhamo
2021
Copyright © University of Johannesburg, South Africa

Printed and published by the University of Johannesburg
© All rights reserved.

Apart from any fair dealing for the purpose of research, criticism or review as permitted under the Copyright Act 98 of 1978, no part of
this material may be reproduced, stored in a retrieval system, transmitted or used in any form or be published, redistributed or screened
by any means electronic, photocopying, recording or otherwise without the prior written permission of the University of Johannesburg.
1|P a g e
Contents
MODULE GUIDE ............................................................................................................................................ 6
Section A: ADMINISTRATIVE INFORMATION ..................................................................................................... 7
Department of Business Management: Strategic viewpoint statement ........................................................... 7
Equality clause ................................................................................................................................................... 7
Contact information ...................................................................................................................................... 8
Guidelines for student behaviour.................................................................................................................. 8
Please always refer to the Student Guide to Academic Administration for information on the Department
of Business Management’s Qualification Rules and Regulations, University and qualification-specific rules
and regulations .............................................................................................................................................. 9
Policies and procedures............................................................................................................................... 10
Section B: Programme and module information............................................................................................. 12
Composition of the qualification ................................................................................................................. 12
Section C: SUBJECT INFORMATION ................................................................................................................. 13
FACILITATION OF LEARNING AND ASSESSMENT ......................................................................................... 13
Action words lecturers often use ........................................................................................................... 13
Module name .............................................................................................................................................. 15
Module NQF level ........................................................................................................................................ 15
CALCULATION OF ASSESSMENTS................................................................................................................. 15
Assessment schedule/opportunities ............................................................................................................... 16
Purpose of this module ............................................................................................................................... 16
Module outcomes ....................................................................................................................................... 17
STUDY MATERIAL ...................................................................................................................................... 18
LEARNING UNIT 1: AN INTRODUCTION TO RISK MANAGEMENT ........................................... 19
INTRODUCTION TO RISK MANAGEMENT ........................................................................................... 20
1.1 RISK PERCEPTIONS ...................................................................................................................... 20
1.2 DEFINITION OF RISK ..................................................................................................................... 20
1.3 UNCERTAINTY AND RISK ............................................................................................................ 22
2
1.4 DIFFERENT RISKS ......................................................................................................................... 24
1.4.1 End-economic risks ................................................................................................................... 24
1.4.2 Financial risks ............................................................................................................................. 24
1.4.3 Pure risks ...................................................................................................................................... 25
1.5 NATURE OF PURE RISKS ............................................................................................................... 28
1.6 CLASSES OF PURE RISK ................................................................................................................ 31
1.7 THE DIFFERENCE BETWEEN FINANCIAL AND NON-FINANCIAL RISKS ....................... 32
1.7.1 Financial Risks .......................................................................................................................... 32
1.7.2 Types of Financial Risks .......................................................................................................... 33
1.7.3 Non-Financial Risks (also known as pure risk) .................................................................... 34
1.8 RISK MANAGEMENT OF PURE RISKS ........................................................................................ 35
1.9 COSTS ASSOCIATED WITH RISK MANAGEMENT ................................................................... 37
1.10 THE INFLUENCE OF RISK PREFERENCES ............................................................................. 38
1.11 THE RELATIONSHIP BETWEEN RISK AND TIME .................................................................. 38
1.12 PURE RISK MANAGEMENT PROCESS...................................................................................... 39
Step 1: Risk Identification ........................................................................................................................ 39
Step 2: Risk Evaluation ............................................................................................................................ 40
Step 3: Risk Control.................................................................................................................................. 41
Step 4: Risk Financing ............................................................................................................................. 42
1.13 MEASUREMENT OF RISK............................................................................................................. 43
LEARNING UNIT 2: THE ROLE OF THE FINANCIAL SYSTEM IN THE ECONOMY .............. 46
2.1 BASIC NATURE OF FINANCIAL SYSTEM ................................................................................ 47
2.2 THE ROLE OF MARKETS IN THE ECONOMIC SYSTEM ....................................................... 48
2.2.1 Flow of funds in the financial system ............................................................................... 49
2.3 THE FINANCIAL MARKETS AND THE FINANCIAL SYSTEM ............................................... 51
2.4 TYPES OF FINANCIAL MARKETS WITHIN THE FINANCIAL SYSTEM.............................. 52
2.5 EFFICIENCY OF FINANCIAL MARKETS .................................................................................. 54
2.6 MAINTAINING A FAIR PRICE ...................................................................................................... 55
2.7 ROLE OF CENTRAL BANKS IN FINANCIAL MARKETS ....................................................... 55
3
2.8 STRUCTURE OF FINANCIAL SYSTEMS IN SOUTH AFRICA ............................................... 56
LEARNING UNIT 3: DIFFERENT KINDS OF FINANCIAL RISK .................................................... 59
3.1.1 Credit risk ................................................................................................................................. 60
3.1.2 Liquidity risk ............................................................................................................................ 61
3.1.3 Market risk ................................................................................................................................ 62
3.1.4 Operational risk ....................................................................................................................... 64
3.1.5 Legal and reputation risk ...................................................................................................... 65
3.1.6 Capital or solvency risk ........................................................................................................ 65
3.1.7 Purchasing power risk .......................................................................................................... 67
LEARNING UNIT 4: FACTORS INFLUENCING RISK MANAGEMENT ........................................ 69
4.1 INTRODUCTION .............................................................................................................................. 70
4.2 THE INTERNAL ENVIRONMENT ................................................................................................. 70
4.2.1 The Credit Policy of the Bank .............................................................................................. 70
4.2.2 Credit Management and Control Systems ....................................................................... 70
4.2.3 Employees of the Bank ......................................................................................................... 71
4.2.4 Products and Markets ........................................................................................................... 71
4.3 THE EXTERNAL ENVIRONMENT ................................................................................................ 71
4.3.1 The Marketing Environment................................................................................................. 72
4.3.2 The Economic Environment ................................................................................................ 73
4.3.3 The Physical Environment ................................................................................................... 75
4.3.4 The International Environment............................................................................................ 75
4.3.5 Legislative and Institutional Environment ....................................................................... 77
4.3.6 The Social Environment ........................................................................................................ 79
4.3.7 The Technical Environment ................................................................................................. 80
4.3.8 The Political Environment .................................................................................................... 80
LEARNING UNIT 5: RISK MANAGEMENT ENTERPRISE RISK MANAGEMENT AND THE

RISK MANAGEMENT PROCESSES ACCORDING to ISO 31000 ................................................. 82
5.3.1 Simple Risk Management Process .................................................................................... 86
5.3.2 RISK MANAGEMENT PROCESS ACCORDING TO ISO 31000 .................................... 89
4
ASSIGNMENT .............................................................................................................................................. 90
5
MODULE GUIDE
6
Section A: ADMINISTRATIVE INFORMATION
Welcome
The Department of Business Management welcomes students to module Risk

Management. We trust that information contained in this module guide will assist in your
preparation for lectures, guide your studies and assessments, and contribute to your
successful completion of this module.
Department of Business Management: Strategic viewpoint statement

What do we want to be?
We aspire to be a department that:
• creates impactful knowledge; and
• prepares the mind-sets of business innovators.
Who are we?

We are a dynamic, diverse team of academic business experts.
What guides us?

We are driven by the ambition to challenge mainstream thinking in an ethical, open, and
collaborative manner.
What do we do? (And how, and for whom, do we do it?)

We develop graduates by means of market-related programmes that are informed by quality
knowledge creation, and teaching based on challenging current paradigms to transform the
society of the betterment of all.
Equality clause
All students will receive the same amount of time to hand in assignments and to prepare for tests
and exams; will be measured against the same standards when exams, tests, and assignments
are marked; and will be held to the same course rules. Justification: Every student has the same
right to equal treatment as every other student, which is in line with the Bill of Rights in our country’s
Constitution. This is why no exceptions to the course rules will be made at any stage of the course
or under any circumstances. Students with disabilities may apply for special considerations.
General information
7
Every registered student must please familiarise themselves with the content of the
Student Guide to Academic Administration booklet. This is available on

the Blackboard system.
Whenever you have a query or you are unsure of what the required procedures are to follow,
please always refer to this booklet first.
This booklet was compiled specifically to assist you, the student, with relevant information
and contains contact information, information, and advice on administrative issues, forms
and documents, etc.
Please do not expect the lecturer to answer ANY of these queries.
Contact information
Our contact details are as follows:

The Department of Business Management
Continuing Education Programmes
Library Block, 1st Floor, Office L13.
For contact details on the Programme Co-ordinator, please refer to the Student Guide to Academic
Administration.
Guidelines for student behavior
• Class attendance is compulsory.

• Check your registration documents to ensure that you are registered for the qualification and
subjects for which you attend lectures. If you are not registered correctly, please rectify this
immediately by completing and submitting the “Addition/Cancellation of Subject” form to UJ.
• Make sure you update your details whenever changes take place. Changes in postal/physical
address, telephone numbers, and next of kin can be done by the students themselves. This
information needs to be accurate as we may have to contact you telephonically or by email in
the course of your studies.
8
• Should you decide to discontinue your studies for any reason, do not just stop attending lectures
and assume that UJ knows that you have canceled your studies, you are required to complete
a “Cancellation of Qualification” form.
• Students must be punctual. By being late for lectures, you are being disruptive to other students
and the lecturer.
• Be prepared for every lecture you attend by bringing with you the correct stationery and course
material.
• If you find difficulty understanding something in class, ask questions, and/or discuss it with your
subject lecturer.
• The noise level in lectures – no talking unless invited to do so.
• Cell phones must be switched off while in class.
• Students must be in the exam venues no later than 15 minutes before the start of the exam.
Latecomers (30 minutes or later) will not be admitted.
• No borrowing of stationery is allowed in exams or tests.
• After completion of tests/exams, students must leave the venue quietly and must not stand
outside of the venues as it disrupts those that are writing.
• Be familiar with the program and UJ rules and regulations. Do not request UJ staff to break the
rules.
• Read your Student Guide to Academic Administration regularly as well as the relevant subject
guide to familiarise yourself with the subject content, dates, and deadlines. It is the responsibility
of the student to keep abreast of updated information. This is done on the Blackboard system.
• Adhere to deadlines, for example, registration dates, handing in of assessments, etc.
• Be familiar with your lecturer’s details, for example, his or her name, consulting hours, office
number.
• Make use of Student counseling services, for example, time management, study skills,
emotional and personal issues. For this, you can contact PsyCaD directly on 011 559 1318.
• The University of Johannesburg offers an education service. In service delivery, there are roles
performed by the lecturers and those performed by the student. In this case, you are the client
and you are expected to perform accordingly by attending all lectures, participating in all
assessments, not misbehaving, and following the rules and regulations of UJ.
Please always refer to the Student Guide to Academic Administration for

information on the Department of Business Management’s Qualification Rules and
Regulations, University and qualification-specific rules and regulations
This Student Guide is intended to assist a student in understanding the scope of the subject and his/
her commitments required to pass the subject.
9
The Student Guide is a contract between the University and the student with the University being
represented by the lecturer.
You will be regarded as adult students and treated as such. Your lecturer will perform the role of
facilitator, to enable you to achieve the learning outcomes of this subject.
You will be required to work individually and/or together in groups. The theory will serve to provide
you with background principles and understanding. To enable you to evaluate and apply these
principles in an experiential mode you will be expected to conduct practical assignments or projects.
This means that if you do not prepare the theory beforehand you will be seriously disadvantaged
regarding achieving the learning outcomes. You will be assessed on both theory and application, in
tests and examinations, with a stronger emphasis on theory, as the approach is academic-oriented.
It is compulsory to attend all the classes because you can be expected to perform several
assessments and practical tasks during classes.
Ensure that Administration has your correct contact details (cell number and email address) as the
University will not take responsibility if you cannot be contacted to inform you of any changes that
might affect you. Please ensure that you are correctly registered.
Policies and procedures
All applicable UJ Policies and Procedures apply. The Student Guide to Academic Administration will
contain some of the relevant Academic Regulations and Qualification Rules.
Plagiarism
Dishonesty and plagiarism are not tolerated and will be punished.
• Plagiarism is the verbatim (word-for-word) use of another’s work and presenting it as if it were
one’s own.
It is important to acknowledge any thoughts, ideas, and information that are not your own. It is also
important to use a standard form of referencing to provide all relevant information that will help any
person who may be interested to read further about the information. As a result, you need to keep
an accurate record of collecting your data.
• You will be required to cite your source(s), especially when referring to an item within your text.
You are also required to indicate the reference where the citation can be found at the end of
your work.
10
• The different departments within the University may require you to use a particular (or different)
way of citation. It is therefore important for you to enquire and adhere to the requirements set
by your departments.
• The proper procedures are laid down by the University and the Faculty is responsible for
strategies that address means of preventing, monitoring, and handling acts of plagiarism.
Copyright issues are handled following DALRO principles and procedures.
Lecturer’s details:
For subject-specific information (academic-related questions only):
Lecturer’s: Ashley Gandanhamo

Campus: Soweto Campus
Contact details: ashleyg@uj.ac.za
The lecturer for this module is available by appointment and via email.
11
Section B: Programme and module information
Composition of the qualification

HIGHER CERTIFICATE ADVANCED CERTIFICATE ADV. DIPL. BRIDGING
MODULES MODULES MODULES
Environment of Strategy
HC1ENOB AC1STIM ADBE01A
Business Implementation Economics 1A
International
Strategic Management HC1STRM AC1NTM Economics 1B ADBE01B
Management
Human Resource Change

HC1HRMT AC1CHMT Mercantile Law ADBL01A
Management Management
Business Writing and Economic

HC1BWCN AC1ECPR Mercantile Law ADBL01B
Communication Principles
Management
Accounting Aspects HC1ACAS AC1MACC Management 3A ADBM03A
Accounting
Financial Management HC1FINM Risk Management HC1RSKM

Management 3B ADBM03B
Business Decision Operations Quantitative

HC1BDMG AC1OPSM ADBQ01A
Making Management Techniques A
Services Quantitative
Labour Relations HC1LREL AC1SERV ADBQ01B
Management Techniques B
Applied
Marketing Logistics
HC1MKTM AC1LOGM Accountancy ADBA01A
Management Management
Skills 1A
Applied
Business Continuity
Project Management HC1PJMN AC1BCOM Accountancy ADBA01B
Management
Skills 1B
Information
Introduction to
HC1ANAT Technology AC1ITMT
Analytical Techniques
Management
Managing Risk
Risk Management HC1RSKM AC1MARM
Management
Corporate Govern.
Compliance HC1CGCM Risk Financing AC1RFIN
Management
Financial Risk HC1FINR Risk Assessment AC1RIAS
Project Integration
Operational Risk HC1OPSR AC1PIMT
Management
Project Identification Nature of

HC1PJIS AC1NPLC
and Scoping projects/Life cycle
Project Procurement Project Integration

HC1PPCM AC1PIMT
and Communication Management
Project Change
Project Control HC1PJCL AC1PCMT
Management
Project
Communication AC1PCOM
Management
Project
Management AC1PMCL
Control
12 | P a g e
Page | 13
Section C: SUBJECT INFORMATION
FACILITATION OF LEARNING AND ASSESSMENT
Action words lecturers often use
The action verbs below are often used in required activities, assignments
and/or tests/exams; here you can find out exactly what is expected of
you.
Apply Put to practical use or make use of a relevant equation or law.
Calculate Determine the value, using formulae or specific calculation methods.
Group concepts or subjects together based on certain characteristics or
Classify
commonalities.
Point out the similarities and differences between objects or points of
Compare
view. The word contrast can also be used.
Transform a quantity expressed in one unit to a quantity expressed in
Convert
another unit.
Define Give a short and clear description of a term or concept.
Demonstrate Show clearly/prove/make clear by reasoning or evidence/illustrate and
explain, especially with many examples.
Derive Deduce or infer something from the given information.
Tell in detail how a process works or how a subject appears. You need
Describe not
comment on the process or the subject or give your own point of view.
Differentiate Find differences between objects or statements.
Explain terms or concepts in your own words. Give comments or give
Discuss your
own point of view.
Distinguish Write down the differences between subjects or concepts.
Draw Create a drawing, diagram or representation of a subject or concept.
Write about the subject in your own words. Clarify or give reasons – use
Explain examples or illustrations. You must prove that you understand the
content.
Formulate Express in a concise, systematic way.
Identify Establish the identity or recognise a process.
Illustrate Explain by means of detailed descriptions and drawings.
Interpret Explain or clarify the meaning of a concept/value.
List/Name Briefly write down the facts or main points.
Motivate Give reason(s) for your answer.
Name Nominate or specify a site or process.
Organise Arrange data according to certain criteria.
Predict Use the facts available to derive an outcome.
Relate Show the relation/connection of entities, how the concepts can be linked.
Solve Find an answer by using critical thinking and/or calculations.
Summarise Briefly state/list/write down only the most important detail/facts.
13
Page | 14
LECTURING DATES AND TIMES

Please refer to your Academic Calendar as it differs from group to group.
Ensure that you know which group you are registered with.
ASSIGNMENT
Submit to Blackboard on or before the Assignment due date as scheduled on the Academic Calendar
Examination: ALL UNITS & ADDITIONAL NOTES
Supplementary Exam: ALL UNITS & ADDITIONAL NOTES
Materials used
• Study material
• Slides
• Any additional articles or notes uploaded onto Blackboard or discussed in class
14
Page | 15
Module name
Module name: Risk Management

Module code: HC1RSKM
Module NQF level
NQF level 5
NQF credits 12
CALCULATION OF ASSESSMENTS
THREE summative assessment opportunities have been scheduled for this module as follows:
The semester result which consists of: 10% for class attendance
15% for in-class assessment/activities
75% Blackboard assignment
A written exam which counts 100%
It is compulsory for students to complete all these assessment opportunities.
15
Page | 16
A MINIMUM SEMESTER MARK OF 40% IS REQUIRED TO HAVE ACCESS TO THE

FINAL ASSESSMENT (EXAMINATION) OPPORTUNITY.
• A subminimum of 40% in the final summative assessment opportunity (examination)

will be required to pass the module.
• A final mark of 50% will be required to pass the module.
• A student will pass with distinction if the final mark is 75% or more.
The ratio between the semester mark and the final summative assessment mark is 1:1. The
calculation of the final mark is shown in the table below:
Description Contribution to final mark

(%)
Class attendance 10%
Class assessment(s)/activities 15%
Blackboard assignment 75%
Total semester mark (SM) 100%
Final summative assessment 100%

(examination) (EM)
FINAL MARK (SM+EM/2) 100%
Assessment schedule/opportunities
Please refer to the Academic Calendar OF YOUR SPECIFIC QUALIFICATION for due
dates.
Purpose of this module
Modern day organisations are very dependent on understanding the importance of risk
management in order to achieve success. The purpose of this module is to give students
with an overall knowledge, insight and skills that are needed to understand the introductory
aspects relating to Risk and Risk Management. The sources of risks are identified, described
and classified as controlled and uncontrolled sources and/or types of risk in terms of micro
16
Page | 17
(internal) organisational influences vs. external influences. This module is mostly theoretical.
It identifies and explains the need for Risk Management (overview) and introduces the
student to ISO 31000 Risk Management Framework to assist them in managing risk in an
organisation.
Module outcomes
Outcomes Assessment criteria

At the end of this module you should be You will be assessed as competent if
able to do the following: you can OR
The student should be able to….
• Identify and define an evaluate Risk and • Define and explain the different risk
the Risk concepts concepts
• Discuss the role of the Financial System • Define, explain and discuss the
in the economy elements of the Financial System and
how it affects the economy
• Identify define and understand the • List and explain the different kinds of
different kinds of financial risk financial risk
• Describe the factors influencing risk • Explain and discuss the market and
management external factors affecting risk
• Distinguish and discuss and Risk • Explain and discuss each element in
Management and Enterprise Risk the risk management process
Management and the risk management according to the ISO 31000
processes according to ISO 31000
17
Page | 18
STUDY MATERIAL
References
Crouhy M, Galani D, Mark R, (2001) Risk Management McGraw-Hill Inc
Chapman RJ, (2006) Simple tools and Techniques for Enterprise risk Management Wiley
Finance
Falkena BH, Kok WJ, Meijer JH, (1956) Financial Risk Management in South Africa, The
Macmillan Press Ltd
Pamapallis A, Notes
Shore B, (1973) Operations Management McGraw-Hill Inc
18
Page | 19
LEARNING UNIT 1: AN INTRODUCTION TO RISK MANAGEMENT
PURPOSE AND INTRODUCTION
The purpose of this Learning Unit is to introduce you to the term of risk and types of risk and
what is included in the risk management process. Communicating risk is an important part of
the organisation. Risk is one key element that determines the success or failure of company
because it enables its members to coordinate their activities and reach the organisation’s
business goals.
OUTCOMES AND ASSESSMENT CRITERIA
At the end of this unit you should be You will be assessed as competent if you can
able to do the following:
• Define the basic concepts applicable • Describe risk perceptions

to enterprise risk management. • Define Risk
• Define Risk and Uncertainty
• Define the various risks. • Explain End-Economic risk
• Explain and list Financial risk
• Define Pure risk
• Define and explain credit risk
• Define the nature and classes of pure • Define the nature of pure risk
risk. • Know the differences between Perils and Hazards
and to be able to define these terms
• Explain and list the classes of pure risk
• Explain and list the financial and non-financial Risks
• Explain the risk management of pure risks
• Discuss the measurement of risk and • Explain the costs associated with risk management
the costs associated with risk • Explain the influence of risk perceptions
management. • Explain the relationship between risk and time
• Understand and discuss pure risk • Discuss and list the different steps of the pure
management process. management process
• Discuss and list the techniques of risk control for pure
management
• Understand the mesurement of risk • Discuss the measurement of risk and explain the
different approaches to solve the problems
19
Page | 20
INTRODUCTION TO RISK MANAGEMENT
1.1 RISK PERCEPTIONS
Individuals, companies, financial institutions and other participants in the economy perceive
risk differently and therefore risk cannot be universally defined. From the way people describe
it, it is evident that risk is perceived differently by economic entities partly due to different
backgrounds, attitudes and different perceptions of the word risk. For example, in life
insurance the insured person is often referred to as the risk, whereas an investor perceives a
possible fall in share prices as a risk. When starting a new business the possibility of failure
or bankruptcy is perceived as a risk from the entrepreneur’s point of view. On a personal level,
people face the risk of death or the risk that their home may be destroyed by fire.
Different financial institutions and organisations also have different views and attitudes
towards risk. Taking two banks as an example Bank A, might take on more risk than Bank B
because the former is less risk averse. Bank B, on the contrary, is more risk averse and
therefore it has a less comfortable attitude towards entering into riskier investments.
Risk attitudes are also closely knitted to psychological perceptions and it translates into the
communication of ideas and thoughts related to risk. Different entities understand risk
differently because of different environments and past experiences imposed on perceptions
related to risk.
Factor X might be perceived as a high risk for Bank A whereas Bank B might consider it as a
non-event. Bank A and Bank B therefore will react differently in terms of their analysis and
risk management of factor X.
If we do not have a particular context in mind when asking people about risk, they will most
probably formulate their own idea based on their own experiences, beliefs and habits. Other
dimensions such as fairness, comprehensibility and the degree to which the situation appears
to be controllable will also be added to the risk equation.
1.2 DEFINITION OF RISK
There are two key aspects related to risk, variability and expectation. For example, Bank X
20
Page | 21
expects profits to be R100 million, but the actual profit figure is only R80 million. Risk in this
context therefore refers to the possibility that events may turn out differently from what is
expected. Bank X’s actual profit deviated by R20 million from the expected profit. Risk (mostly
financial) is unavoidable for financial institutions, including banks. Banks have to take risk
because the business of banking is based on taking calculated risks. The consequences of
risk can on the contrary, be controlled and managed by means of effective risk management
systems and procedures.
Risk can be defined as the deviation or variability of actual results from desired or expected
results. It could be said that longer future time periods could result in a higher level of
deviation from expected results. Time horizons therefore impact on risk because of a higher
degree of uncertainty associated with longer time periods.
Risks can therefore be managed more effectively the shorter the time period.
The principle that usually applies in the business world is that if risk increases, the possible
desired return also increases. The investor wants to be compensated for the increased risk
brought about by uncertainty so that there has to be some degree of correlation between risk
and return.
Risk and uncertainty are integral, fundamental and constituent elements of the process of
decision making within banks and enterprises. Uncertainty may be seen as being critically
important. The mere fact that the future is uncertain should not be a barrier for future planning.
If all variables that affect a financial institution’s and the different enterprises, financial position
were known, risk management would fall away.
Banks and enterprises, for example, operate and compete in an economic environment that
is not constant and changes continuously which creates uncertainties. These economic
changes could be the result of say globalization (refers to the gradual opening of markets such
that geographic boundaries do not restrict financial transactions), so that an event in other
parts of the world has a bearing on local banking and enterprise operations. Uncertainties
cannot always be correctly forecasted and therefore poses a potential risk that will alter
expectations and results.
The Argentinean financial crisis in 2000 and developments in South East-Asia during 1997 -
98 had a dramatic impact on South African economic variables which affected banking
21
Page | 22
operations in the country. Interest rates, for example, increased from about 12% in 1998 to
about 25% later on in the same year.
In the business world, all businesses operate in an environment which constantly changes.
Changes in factors such as the prices of resources or interest rates influence the environment
and give rise to uncertainty about the future course of events. In general, the planning of
commercial activities one month into the future is less uncertain than planning activities that
will only take place in five years’ time. A key element of risk management is time. The strategy
has to outline time intervals to measure and manage different risks. Segmented time frames
should be established to measure risks.
Uncertainty about the future manifests itself as the risk that the realised results will deviate
from what is anticipated. The greater the uncertainty is, the greater the chance of actual
results deviating from expected ones and therefore, the greater the risk.
1.3 UNCERTAINTY AND RISK
Although risk and uncertainty are often seen as being the same thing, there is a substantial
difference. Uncertainty implies that all possible results or outcomes of an event cannot be
identified or foreseen. If a rugby player runs out on the field to play a match, it is impossible
to know if he is going to be hurt or not during the course of the match. Risk on the other hand
implies that it is possible to determine the probability that some expected result or outcome
can materialise. The use of weather forecasts is a good example of attaching a probability to
the expected risk that my planned picnic for tomorrow could be ruined by rain. If there is a
75% probability of rain being forecast, it is highly possible that it could in fact rain tomorrow
and I can therefore take it into consideration to make alternative plans for the day.
Therefore Risk and Uncertainty are not the same. These terms are interrelated, but should
not be used interchangeably. Certainty is the opposite of uncertainty where certainty is
doubtless, so that a particular consequence can be unambiguously predicted to follow a given
event. Examples of certainty are predictions and outcomes from physical laws, such as the
law of gravity or laws of motion in physics. The predictions of these laws correspond to the
actual outcomes.
Uncertainty arises from an imperfect state of knowledge and information about future events
22
Page | 23
and their outcomes. There is uncertainty when decisions have to be made where the decision
maker lacks complete knowledge, information or understanding of the decision and its
possible consequences.
The perceived level of uncertainty depends on information that can be used to evaluate the
likelihood of an outcome and the ability to evaluate information. In other words, uncertainty is
present in different levels or degrees, which then impacts on risk and the approach to manage
risk.
Banks and enterprises are interest rate sensitive institutions and they are not always 100%
certain when interest rates will change, and if they do, in which direction and to what extent.
Uncertainty regarding this event embraces whether the event (interest rates) will occur, and if
it does occur, what the outcome, the effect on the financial position will be. Enterprises have
to accept uncertainties that influence their operations, but certain actions can be put into place
to limit the negative consequences of uncertain future developments - this is where risk
management comes in.
The degree of uncertainty is also linked to the knowledge and understanding of the source of
the risk event and the actions needed to counteract the possible negative consequences if the
event occurs. In this regard experience plays an important role to predict future outcomes.
The historic occurrence of events that negatively impact on performance can also be used to
facilitate actions to counteract the negative consequences of a risk event.
A high degree of uncertainty reflects a significant lack of understanding and knowledge of the
situation resulting in a low level of confidence. Where there is complete uncertainty, it is
impossible to predict possible outcomes. Probability is therefore also a key variable related
to risk management.
Uncertainty influences decisions made and could therefore impact on the outcome of events.
The decision maker is uncertain about the outcome and the actual outcome may therefore
deviate from the expected outcome. If the outcome was certain and only one outcome was
possible, there would be no uncertainty and no deviation from expected results so that risk is
eliminated.
The degree of uncertainty surrounding the event determines the level of risk. The more
uncertain the decision maker is, firstly, about whether the event will take place, and secondly,
23
Page | 24
of what the outcome will be, the greater the possible deviation of the actual from the expected
result. The degree of risk can therefore be interpreted in terms of the frequency with which
an event will occur and the probability that it will have a particular outcome.
To analyse risk it is therefore important to incorporate a probability theory, which includes

uncertainty about the occurrence of an event and the possible outcome as well as the
frequency with which an event occurs.
1.4 DIFFERENT RISKS
There are different types of risks in the business world. It could be said that some risks can
be managed, and others not. The identification of risk and the origin or source of the risk is of
paramount importance to the risk manager in order to formulate an effective risk management
strategy.
Risk in a corporate environment can be sub-divided into three categories, namely end-
economic risks, financial risks and pure risks.
1.4.1 End-economic risks
End-economic risks are broad-based and include all activities, decisions and events, which
impact on the main business of an organisation. End-economic risks consist of two elements:
1. Specific or unsystematic risks. These risks are specific to the company without being
affected by the external environment. An example could be the mechanic failure of a
machine that produces a product.
2. Systemic or market risk is brought about externally and impacts on the operations of a
business.
1.4.2 Financial risks
Financial risks arise naturally from the type of activities and operations of a business. A key
function of a commercial bank, for example, is to lend money to deficit economic units (the
24
Page | 25
unit’s spending is more than its income). The borrowing party should adhere to the loan
agreement, and if not, the bank is exposed and credit (non-payment) risk therefore comes into
the risk equation.
From a bank’s point of view, there are several financial risks that should be managed and it
includes:
1. interest rate risk

2. liquidity risk
3. investment risk
4. credit risk
5. currency risk
6. capital risk
However, these risks might be very important to financial institutions but they are equally
important to the different enterprises depending on some of their functionality. For example if
a company has debt, it could have interest rate risk or if it is in the process of importing an
asset from overseas it could be facing currency risk. So even though we speak of the different
financial risks pertaining to the financial institutions these also apply to the different
enterprises. These financial risks will be covered in detail in the Financial Risk Management
module.
1.4.3 Pure risks
Pure risks originate from sources that are not controllable by business. Pure risks include the
possibility of loss or no-loss situations. A typical example of a pure risk event is the destruction
of a fire or flood to the physical premises of say an enterprise. The result of the fire is a loss
or a cost to the enterprise. Had there been no fire, there would have been no loss or additional
costs. Pure risks are usually insurable (taking out cover which is done at a price) to limit the
negative impact of an event on the financial standing of a business.
1.4.4 The Relationship between Risk and Return
25
Page | 26
Return is what I gain or lose on an initial investment over a specific period of time, expressed
as a percentage. If my initial investment amount of R 1 000 increased by R 200 over a period
of one year, the return would be as follows:
R 200 100
R 1 000 X 1 = 20 %
1.4.5 The Meaning of Risk-return Trade-off
Whenever a financial decision is made, it will always involve the weighing up of expected risk
against expected return. It is an accepted financial principle that the higher the risk involved,
the higher the return the investor will require.
This is so because the investor wants to be rewarded for the higher risk involved in the
investment. The other side of this principle is that lower risks mean lower returns.
1.4.6 Credit and Credit Risk
In general terms credit can be defined as the facility to obtain goods and/or services now
against the promise to pay in the future. This implies a relationship of trust between the two
parties involved. From a Bank’s perspective, this would mean that credit implies any
transaction entered into with a person or organisation / business concern, which results in
funds being lent. Whenever credit is granted, it always implies that there is risk involved.
Credit risk from a banking perspective can be defined as the possibility that a person or
business concern to whom funds are lent, may or may not honour the contractual
commitments entered into with the bank lending the funds, and that the bank itself did not
make adequate provision for potential loss control.
26
Page | 27
 Question time
1. Define risk.
2. Explain how uncertainty and risk is related.
3. List the different categories of risks.
27
Page | 28
1.5 NATURE OF PURE RISKS
Pure risks represent the downside to or no change to outcomes of possible future negative
events which imply the possibility of a loss or no loss situation.
The origin or cause of pure risks is multi-fold. In some cases pure risk has its origin from man-
made errors or from Godly acts. The source of any pure risk event results in loss-causing
sufferings. The loss-causing impact of pure risk events varies according to the severity of the
event.
Pure risks originate from sources that are therefore not planned for and could therefore be
seen as uncontrollable events. A typical example of a pure risk event is the destruction of a
flood or fire to the physical premises of the enterprise. The result of the flood or fire is a loss
or a cost to the enterprise. Had there been no fire, there would have been no loss or additional
costs to the enterprise. It is not possible to prevent loss-causing events such as a flood,
because the source of the event is not controllable by man. It is controlled by a higher power.
Unfortunately, as the risk definition implies, the loss-causing effect of pure risks is not only the
particular effect of the theoretical deviation from the expected value. In practice, the impact
of a pure risk event could be immeasurable in terms of the great sufferings and even the loss
of life. Furthermore, its loss causing impact could cripple economies and communities with far
reaching consequences.
Pure risks may be further categorised by distinguishing between fundamental and particular
risks. Fundamental risks arise from losses that are impersonal in origin and in consequence
and stem from economic, political or social interdependency of society although they might
also arise from purely physical occurrences. Particular risks are losses that have their origin
in discrete events which have an essentially personal cause. Such risks would, for example,
be fire damage to a building.
The reason for the distinction between particular and fundamental risks is to establish whether
commercial insurance may be appropriate or available as a means of financing the
consequences of such a risk. A hurricane in the area in which an enterprise is situated can be
classified as a fundamental risk while an explosion or fire at the enterprise can be categorised
as a particular pure risk for the enterprise.
28
Page | 29
Losses arising from fundamental risks cannot be prevented, particularly by an individual.
Frequently such losses are of a catastrophic nature and economic insurance cannot be made
available to mitigate their effects. Some pure risks are more insidious and impact on society
and the environment unnoticed.
Certain pure risks only resemble after the exposure incident occurred so that the loss causing
impact of the event is only evidenced at a later stage.
It is also important to identify and explain the concepts of peril and hazard before identifying
the different types of pure risks. These concepts are important in order to understand the
management of pure risks.
Peril is the cause or source of loss or the loss event. Some examples of perils are fire, theft
and accidents. Insurance policies usually refer to specified perils, which mean that cover is
provided whenever the loss is caused by the specified peril.
The term hazard relates to the environment surrounding the cause of loss. A container of a
flammable product, for example, could negatively impact on the environment because it may
give rise to a fire.
Hazards can be classified into four broad categories:
1. physical
2. moral
3. morale
4. legal hazards
Physical hazards consist of those physical properties that increase the chance of loss from
various perils. Examples of physical hazards that increase the possibility of loss from, say the
peril of fire, are the soundness and fire insulated type of building construction, the location of
the building and the occupancy of the building. Driving a vehicle with worn tyres could be one
of the physical hazards in a motor vehicle. Any mechanical fault on a vehicle can be listed as
a physical hazard for a motor fleet company.
Moral hazards refer to an increase in the probability of loss which results from destructive or
evil tendencies in human character. An organisation or bank faces losses due to the ability of
29
Page | 30
its staff to be dishonest that could lead to theft. Many financial institutions face insolvency due
to fraud. The fall of Barings Bank in 1995, the oldest British merchant bank, resulted from
inadequate risk management systems and procedures not detecting the fraudulent operations
of a single dealer, Nick Leeson.
Moral hazard is very common in the insurance industry where dishonest insureds provide the
insurer with false or illegitimate claims.
A dishonest individual or business, in the hope of collecting from the insurance company, may
intentionally cause a loss or may exaggerate the loss amount in an attempt to receive more
than the actual loss amount from the insurance company.
Moral hazard could have far-reaching implications for the entire economy of a country. Inflated
insurance claims, for example, decrease the profit margins of the insurance company. This in
turn motivates the insurance company to increase premiums across the board affecting the
honest category of claimants as well.
Morale hazards are different to moral hazards and the two concepts should not be confused.
Morale hazard is more focussed on attitude. The attitude of the insured in moral hazard
towards the occurrence of the event. The fact that insurance is available could imply that the
insured person or financial institution becomes more reckless, since the insurance company
will bear the loss if a loss causing event occurs.
Legal hazards refer to the increase in the frequency and severity of loss that arises from legal
doctrines enacted by legislatures and enforced by law. A legal hazard is common in the field
of legal public liability, but is also present in other domains. For example, in a jurisdiction where
the law imposes obligations on property owners to remove debris from a property after say a
fire, the exposure to loss is increased.
30
Page | 31
1.6 CLASSES OF PURE RISK
Pure risks that individuals and businesses face can be classified as:
1. personal risks
2. property risks
3. liability risks
4. risks arising from actions of other individuals or entities\
Personal risks focus on an individual’s ability to work and to generate an income.
If individuals fail to work, no income can be generated unless compensated by the government
or for example insurance that was bought for protection against not being able to work.
Personal risks embrace the possibility of loss of income or assets as a direct result of the loss
of ability to earn income.
There are various factors that affect an individual’s ability to generate income, such as
retrenchments in times of restructuring of businesses, lack of skills, disability and of course
death.
In general, the ability of an individual to generate income is subject to four perils – death,
sickness, disability and unemployment.
The second class of pure risks is property risks, which also includes other assets besides
say residential property. Anyone possessing property is exposed to this risk because of the
fact that the property can be destroyed or stolen. Direct loss is simple to understand and an
example could be the destruction of a home by a huge fire. There are also other consequences
for the owner after the destruction of the home. The loss causing fire implies that the owner
also loses the use of the home during the reconstruction period. The owner of a house
therefore loses a place to stay, and a business firm will also lose income that would have been
earned through the use of the building.
The third type of pure risk is known as liability risk. The most prominent peril associated with
liability risk is unintentional injury of other person/s or damage to their property due to
negligence or carelessness.
31
Page | 32
There are situations in which the liability risk is caused intentionally. The legal system provides
for legal risks and individuals can insure themselves against the unintended harm caused to
other entities or their possessions. The law provides for compensation to those harmed by
others due to intent or unintentionally. Furthermore, a legal system of a country also decrees
that an employer or other principal is responsible for the acts or omissions of agents or
employees.
The failure of other parties could also be classified as a pure risk. The non-performance of a
verbal or written contract/commitment by a builder to complete your home in seven months
can be classified as a pure risk.
It could be said that the builder did not meet a specified clause in the contract thereby not
meeting expectations and possible financial loss implications for the owner.
1.7 THE DIFFERENCE BETWEEN FINANCIAL AND NON-FINANCIAL RISKS
1.7.1 Financial Risks
Financial risks result from the fluctuations of rates and prices in the extremely volatile financial
markets of our time.
Daily, business organisations are faced with changing foreign exchange rates, prices of
commodities, which are never constant and interest rates, which change regularly.
Many large enterprises have suffered severely from an economic viewpoint because of poor
assessment of, or inadequate cover for financial risks.
For example in 1979 Rolls Royce recorded an enormous loss because they had taken major
contracts in United States dollars and did not adequately hedge against exchange rate
fluctuations. Also, in the 1980’s, 1990’s and 2000’s a number of South African private and
public enterprises wrote off millions of Rands because they did not cover forward their
currency exposures resulting from cross-border contracts.
32
Page | 33
Financial institutions and particularly banks, are participants in the dynamic financial system
of the country, and they are exposed to the risks of the ever-changing economic environment
in which they operate.
The risks to which corporates including banks are exposed can be categorised into financial
risk and non-financial risk.
By way of reiteration it is important to note that management of financial risks, as a result of

exposure to volatile market conditions, especially fluctuations in prices and rates, is a major
role of a bank’s treasury or other organisations who have treasury departments.
Each day corporate treasurers are faced with changes in the market environment that bring
about fluctuations in interest rates, exchange rates and commodity prices. Often these
fluctuations swing ‘violently’ from day to day, sometimes from moment to moment or situation
to situation. There are many factors that can influence these fluctuations and a major function
of a corporate treasurer is to assess risks which affect transactions now, and by forecasting
rates, to endeavour to foresee possible risks that could influence future dated transactions.
This means that the treasurer would need information resources, which could inform him of
the multitude of assumed factors, financial, political, and otherwise, which could produce risks
to his environment.
Banks and corporations which fail to take action against financial risks could well suffer
collapse, if not entirely, at least in the maximisation of returns and in value.
1.7.2 Types of Financial Risks
• Exchange risk (Currency risk)

• Interest rate risk
• Liquidity risk
• Capital or Solvency risk
• Price risk
• Credit risk
These risks will be discussed in more detail in later chapters.

33
Page | 34
1.7.3 Non-Financial Risks (also known as pure risk)
Non-financial risks encompass a vast range of risk factors (as mentioned before) any one of
which could cause heavy losses if not assessed and managed proficiently. Non-financial risks
are also known as business risks or pure risk depending if associated with businesses’ or
individuals.
Some of these are listed below;
• Natural disasters
• Operational risk
o Fraud
o System failure
o Errors
o Dealing and Trading risks
o Documentation
• E-commerce liability risks such as
o Tax liabilities
o Breach of privacy
o Defamation
o False advertising
o Financial losses incurred by third parties because of network problems and
transmission of viruses
• Employment risks
o Wrongful termination
o Discrimination
o Class action
o Environmental claims
o Litigation related to mergers and acquisitions
• Other risks influencing profitability
o Crime (costs the country over R30 billion annually)
o Environmental exposures
o Risks related to human capital (stress and violence in the work place, HIV Aids,
alcohol and drug abuse)
These many risks mentioned and that have been listed indicate the urgent necessity for
corporations to adopt a holistic approach to risk management, integrating the risks of all
departments of the firm into one forum of risk management by a risk management team which
is responsible for management of the total scope of the enterprise’s risk exposure.
34
Page | 35
1.8 RISK MANAGEMENT OF PURE RISKS
The ability to define what may happen in the future and to choose among alternatives lies at
the heart of modern contemporary societies. Risk management guides individuals and
organisations over a vast range of decision making, from allocating wealth to safeguarding
public health, from paying insurance premiums to wearing a seatbelt. The process of
identifying and managing risk is old in its traditional insurance form and very new in its financial
price risk form.
Risk management has two common meanings in the business world. In many corporations,
the person looking after the traditional insurance coverage is called the risk manager.
Increasingly in financial business, the risk manager looks after risks that arise in the business’
financial statements due to movement in prices.
Although risk is always present, it must be actively managed and controlled in order to reduce
or eliminate adverse consequences as far as possible and to exploit profitable opportunities.
The management of exposure to misfortune and adversity and methods to cope with risks
have been central to human existence. All economic units, ranging from individuals to financial
institutions and manufacturing firms, are exposed to pure risks. Some economic units are more
risk averse than others meaning that they are more serious about managing pure and financial
risks.
Financial institutions invest in effective risk management systems and procedures. There are
costs associated with the implementation of risk management systems.
As a management function, the risk management function consists of various processes in

order to plan, direct and coordinate activities in the pure risk area in order to develop a
comprehensive strategy for dealing with risks.
Risk management can be defined as the objective to protect people and assets (and profits
if a business) by eliminating or minimising the potential for loss from pure and financial risks
and the provision for funds to recover from losses that do occur.
35
Page | 36
The risk manager must be able to determine the potential impact of hazards on the
performance of the business and the attainment of predetermined objectives. The task of the
risk manager further includes the incorporation of alternative strategies to control the risk
consequences and impact on an organisation.
At a tactical or operational level it involves the handling of pure risk at the least possible cost
to the organisation but with the consideration of the impact it may have on the attainment of
other objectives.
Pure risk cause losses and should therefore be managed. An action plan or risk management
process is important to any individual or institution that can be implemented.
The risk management of pure risk is not the same as the management of financial and end-
economic risks. It could be argued that financial risks are more complex and ongoing as
compared to pure risks.
A financial institution, like a bank or other intermediaries such as insurance companies and
pension/provident institutions, or individuals can protect themselves against the potential
negative financial impact of a particular pure risk event. A bank’s financial risks, on the
contrary, are not insurable. Any financial institution, covering against pure risk losses, incurs
a cost. Corporate financial managers have to consider insurance budgets for risk reduction
and retention (self-insurance or self-funding).
Traditional risk management models focused on the following six areas in a business:
1. technical activities such as production, manufacture and adaptation

2. commercial activities such as buying, selling and exchange
3. financial activities such as the search for optimum use of capital
4. security activities such as the protection of property and persons
5. accounting activities such as stocktaking, compiling of financial statements,
determination of costs and the compilation of statistics
6. managerial activities such as planning, control, organisation, command and coordination
It could be argued that risk management is a broad based concept which covers various facets
of any business environment.
36
Page | 37
1.9 COSTS ASSOCIATED WITH RISK MANAGEMENT
Exposures to losses impose a specific cost as well as an opportunity cost to individuals

and organisations.
More specifically, the cost of risk broadly comprises:
1. insurance costs
2. self-funding costs
3. risk control expenditure
4. administrative expenses
Insurance costs consists of two main elements, namely, premiums payable to the insurer
and opportunity costs of those additional profits lost due to spending money on insurance
premiums. The money could have been channelled into more profitable investments.
Administrative costs are also important to manage pure risks. Pure risks are therefore
insurable (taking out insurance cover which is done at a price) to limit the negative financial
impact of an event on the business.
Opportunity cost means the Rand value spent on insurance premiums which could, for
example, have been spent on improving the production line. This opportunity of those
additional profits is lost due to having to spend the money on insurance premiums.
Self-funding is the decision to fund losses from own funds rather than to buy insurance. Self-
funding costs can arise from inadequate sums insured, breach of policy conditions or
warranties contained in policies and the consequent forfeiture of insurance protection and
uninsurable losses.
There are also risk control and administrative expenditures that have to be considered.
Administrative expenses include the following:
• clerical costs handling insurance matters
37
Page | 38
• costs of handling self-insured losses
• costs associated with reporting and investigating loss occurrences
• costs of an in-house risk management department
• cost of a broker
1.10 THE INFLUENCE OF RISK PREFERENCES
The degree to which an individual or an organisation will be prepared to take risk, is

determined by his particular risk preference, which in turn is influenced by the value the
individual perceives to obtain from making an investment.
Individuals can therefore be classified into the following three categories in terms of these risk
preferences:
• The Risk Indifferent Individuals, who do not require a change in return when there is a
change in risk.
• The Risk Averse Individuals, who will require an increase in return for an increase in risk.
• The Risk Taking Individuals, who will be prepared to accept lower returns for increased
risks.
It is however a general trend that most individuals tend to be more conservative when taking
risk. This implies that the Risk Averse individuals will be the most common group of the three
categories. The degree to which an organisation will be prepared to take is called “risk
appetite” and will be discussed in a later chapter.
1.11 THE RELATIONSHIP BETWEEN RISK AND TIME
It is a well established fact that the longer the time period involved, the higher the risk in
financial terms. This is so because of the increased uncertainty as to what the future may
hold. Given the fast growing pace of change in the environment, it is becoming more and
more difficult to make accurate projections as to potential future impact. It is for example much
more accurate to make predictions of what will happen to interest rates in the next two months,
versus a long-term view over the next two years.
38
Page | 39
1.12 PURE RISK MANAGEMENT PROCESS
The risk management process utilised by financial institutions and enterprises are different to
the financial risk management process because of the diverging nature of the two risk
categories. A discussion of the risk process for individuals and in many small businesses to
medium businesses is discussed below. The larger businesses usually adopt particular
models such as ISO 31000 that will be discussed in a chapter of its own later.
The pure risk management process consists of various steps.
Step 1: Risk Identification
The first step of the risk management process focuses on risk identification which embraces
the recognition of loss possibilities. Identifying potential losses is the most important step in
the risk management decision process. It could be said that if no risk identification is
incorporated in the process to manage pure risks, the other three steps in the process implies
an unidentified exposure that cannot be effectively managed. It is important to understand the
nature of the business and to understand the elements of risk which are perils, hazards and
the actual exposures or losses associated with the business.
The risk identification process further incorporates the development and implementation of a
structured framework for risk identification which includes risk management methods and
techniques. There are various methods and techniques that could be used to identify pure
risks ranging from inspections of the site, personal interviews and the study of documentary
information.
There are two broad approaches to identify risks:
• The first approach is the traditional approach which considers the perils to which an
organisation is exposed to and the assessment of their potential loss impact.
• The second approach is a risk sensitive approach where the risk sensitive areas and the
possible loss producing events are determined first, and then the perils identified which
may trigger off such events and their likely impact on the business.
Before starting the formal task of identifying loss-producing events, the risk manager should
conduct an overview and a risk inspection of all aspects related to the business such as its
39
Page | 40
assets, facilities, liabilities, equipment, machinery and workforce.
Step 2: Risk Evaluation
In practice, risk evaluation is probably the most difficult of the four steps involved in the pure
risk management process which forms the link between risk identification and the treatment
of risk.
Risk evaluation measures the relationship between different risks associated with an
organisation. An important difference between pure and financial risks is the hedging methods.
Pure risks are mostly insurable whereas financial risks are not. Pure risk evaluation also forms
the basis from which insurers will ultimately calculate premium requirements and determine
the extent to which they are prepared to insure the client. Risk evaluation is the only option
available to risk managers for assessing the organisation’s exposure, need for insurance or
the necessity of implementing specific risk control measures.
Risk evaluation deals with two key issues, namely loss size and loss frequency.
The monetary value associated with a loss associated with a pure risk event forms one of the
elements of the cost structure of an organisation. It is important to bear in mind that loss size
is not restricted to the cost of replacing or repairing a damaged asset. The opportunity cost
associated with the event also needs to be incorporated. The damage to say a production line
machine could result in the interruption or total failure of the production process resulting in a
loss of income and profit.
One of the most difficult aspects of gauging loss size involves liability type losses in which
injury, damage or loss only becomes evident years after the loss occurring event. It is
important that risk management should also have an idea of maximum possible loss positions.
Loss frequency is difficult to determine because of the nature of loss occurring events and
the unpredictability thereof. In order to establish the potential loss frequency the risk manager
relies not only on past statistics. The process should also incorporate potential and actual
changes in the environment that could influence the future loss frequency of an organisation.
40
Page | 41
The final step in evaluating the impact of a potential loss on the organisation is to combine the
loss size and the potential frequency of losses by multiplying the frequency of the loss by its
severity to provide an estimate of the expected value of the loss.
Step 3: Risk Control
The third step in the pure risk management process involves risk control. Risk control involves
loss-prevention and control measures for individual risk exposures. There are two theories
related to accident causation, namely Heinrich’ and Haddon’s theories. These theories outline
some ideas on why accidents happen in the workplace and management should be
understand why accidents happen in order to implement prevention programmes.
Risk control involves techniques, tools, and strategies that seek to avoid, prevent or, reduce
the frequency and severity of losses. Effective risk control reduces an organisation’s exposure
to risk. Risk control should be the basis for effective risk management.
Risk control needs to be viewed in the broader context of achieving corporate objectives such
as considering that anticipated benefits must exceed the value of resources. It will be
meaningless to devote resources to protect a building against destruction that is contributing
little to revenue.
A risk control programme has to be managed effectively and this invariably requires that
performance be measured against prescribed standards.
There are five techniques of risk control:
Risk avoidance is sometimes the best method of handling pure risks. Risk avoidance means
that the chance of loss has been eliminated.
Risk elimination introduces standards, procedures and actions necessary to eliminate risk.
Having a back-up facility at a distant location will, for example, eliminate the loss of data by
fire.
Risk reduction is aimed at reducing the likelihood of occurrence of loss and severity of loss
41
Page | 42
should it occur. Risk reduction activities is aimed at preventing the occurrence of losses or
focussed at reducing the frequency ratio of losses.
Risk transfer implies that the consequences of a loss are transferred to another party. Risk
transfer must be distinguished from insurance. In the case of insurance the financial
consequences of the loss are transferred to an insurance company. In the case of risk transfer
the risk itself is transferred to a third party. A lease agreement is an example where the risk is
transferred to a third party.
It should also be mentioned that many risk control measures are prescribed by law.
Organisations’ will therefore have to abide by the prescribed lawful procedures besides the
internal risk control measures. The most well known legislative measures are those contained
in the Mines and Works Act and Machinery and Occupational Safety Act. In addition to the
legislation, there are a number of recognised codes of practice. It is essential that an
organisation and its management be aware of the content of the regulations as well as to
ensure compliance thereof.
Management should continuously review the cost/benefit ratio of the organisation’s risk
management and control procedures.
Step 4: Risk Financing
Risk financing focuses on the financial matters related to pure risks and involves a process of
arranging a source of finance to cover the effect of financial losses from a pure risk event.
There are two main financing resources available to an organisation-namely self-funding and
insurance.
Whereas the principle of insurance assumes that the insurers will reimburse the insured for
the costs incurred as a result of an insured event, self-funding is the collective name given to
the principle of arranging alternative means of finance from which the loss costs can be
financed. In self-funding operations the financial burden of a pure risk event is therefore not
transferred to a professional risk carrier or insurer. The organisation arranges to finance the
losses internally from its own financial resources by setting funds aside for such financing
needs.
42
Page | 43
These steps will be discussed in or detail according to the ISO 31000 model in a later chapter.
1.13 MEASUREMENT OF RISK
The question of how to measure risk is fundamental in order to manage it effectively.

Conventionally, risk is measured by the variance or standard deviation (volatility) of a variable
because it provides a statistical calculation of the size of deviations of the actual value from
its expected value.
This raises a practical problem because risk management should be forward looking whereas
standard measures of volatility refer exclusively to historic movements.
There are two approaches to solve this problem:
• The first, the historical approach, assumes that past movements (assume price
movements) of a variable (say share prices) are a reliable guide to future movements
and estimates risk on the basis of a measure of historical equity price volatility.
• The second approach deduces an estimate of volatility from current asset prices using
a theory of asset pricing that incorporates a measure of volatility as a determinant.
Both approaches to the estimation of future risk are flawed. Historical approaches suffer from
the weakness that past movements of a variable may not be a reliable guide to future
movements of that variable. Implied approaches, on the other hand, supply estimates that
are only as reliable as the underlying asset pricing models are valid.
Perhaps the most important point made is that the approach used to measure risk is also risky.
Forward-looking estimates of risk are themselves random variables. At a theoretical level, this
finding is significant because it can be used to justify the common assumption that changes
in asset prices are drawn from a normal distribution (albeit one that changes over time). At a
practical level, it becomes apparent that historical measures of volatility can be very
misleading. Risk appears to reflect macro-economic volatility. It follows an auto-regressive
pattern so that increases or decreases in risk tend to persist all the time. There is also an
association among risks arising from different sources. Studies related to the nature of risk,
helps financial institutions to understand and correctly price their products according to
changing financial risks. Banks or enterprises can, for example, build a premium into the price
of a product if they are faced with volatile market conditions, which pose a financial risk.
43
Page | 44
Statisticians conclude that the probability distribution of the returns on an investment does not
have to be symmetrical, but may be skewed.
If an investment portrays large movements in return over a period of time, risk increases. On
the other hand, if an asset has no variability in return, it has no risk. A Treasury bill (TB)
purchased at an interest rate of 10% and held to maturity will yield 10%.
With virtually no possibility of default by the National Treasury, the TB’s return is certain and
it would be considered a risk-free investment.
A non-guaranteed investment, such as buying a share, will be a riskier investment because

no guarantees are given regarding dividend payments and an appreciation in its price.
In risk management terms central tendency is concerned with measuring the centre of a
probability distribution, where the mean is the most widely used.
The mean is calculated as the sum of a set of measurements, X., X2, X3, ..... Xn, dividend by
n. The mean is calculated by multiplying each outcome by probability of its occurrence.
The variance is a measure of how widely spread a distribution is. The variance of return is a
weighted sum of the squared deviations from the expected rates of return. Squaring the
deviations ensures that those above and below the expected value contribute equally to the
measure of variability, regardless of sign. The standard deviation is a number that measures
how close a group of individual measurements is to the expected value.
 Question time
1 What is pure risk?
2 Discuss Pure Risk, Hazards and Perils.
3 List and explain the different hazards.
4 Define and explain the classes of pure risk.
44
Page | 45
5 What is the difference between financial risk and non-financial risk?
6 List six areas that traditional risk management models focus on in a business.
7 What are the costs associated with risk management?
8 What are the steps in the pure risk management process?
9 List and explain the techniques of risk control.
45
Page | 46
LEARNING UNIT 2: THE ROLE OF THE FINANCIAL SYSTEM IN THE

ECONOMY
To understand the role of the financial system and to understand how the financial
system is used to reduce risk
At the end of this unit you should be You will be assessed as competent if you
able to do the following: can
• Explain the nature of the financial • Explain the basic nature of financial
system and markets markets
• Explain the role of markets in the economic
system
• Explain the financial markets and the
financial system
• Distinguish between the money and • Explain and identify elements of the money
capital markets market
• Explain and identify elements of the capital
market
• Describe the efficiency of financial • Explain the efficiency of financial systems
markets
• Describe the structure of the financial • Explain the structure of the financial system
system in SA in SA
• List the SA financial intermediaries
SECTIONS TO FOCUS ON: The role of the financial system and its structure.
Topics related to the assessment structure.
46
Page | 47
2.1 BASIC NATURE OF FINANCIAL SYSTEM
The financial system is defined as a set of arrangements embracing the lending and borrowing
of funds by non-financial economic units and the intermediation and transfer (flow) of funds by
financial institutions, and to create markets in debt instruments so that the price and allocation
of funds are determined efficiently.
This introductory talk is devoted to a study of the financial system which refers to the collection
of markets, individuals and institutions, laws, regulations and techniques through which
shares, fixed interest stocks and other securities are traded and interest rates determined.
The financial system is one of the most important inventions of modern industrial societies. Its
vital task is to move scarce loanable funds in the form of credit from those who save to those
who borrow for consumption and investment. By making funds available for lending and
borrowing, the financial system provides the means whereby modern economies grow, and
the standard of living enjoyed by citizens of a country can increase. Much of the credit which
is obtained by various entities goes to purchase machinery and equipment, to construct new
bridges, highways, factories and schools, and to stock the shelves of businesses with
inventories of goods. Without the financial system and the credit it supplies, individuals in
modern industrial societies would lead very different and probably less rewarding lives.
The financial system determines both the cost of credit and how much credit will be available
for the thousands of different goods and services which are purchased daily. Equally
important, what happens in this system has a powerful impact upon the health of the nation's
economy. When credit becomes more costly and less available, total spending for goods and
services generally falls. As a result unemployment rises, and the economy's growth slows
down as businesses cut back production and reduce inventories. In contrast, when the cost of
credit declines and loanable funds become more readily available, total spending in the
economy usually increases, more jobs are created, and the economy's rate of growth
accelerates.
In truth, the financial system is an integral part of the economic system, and cannot be viewed
in isolation from it.
The financial system plays a key role in the economic policies of governments and central
banks. Many nations now conduct their economic policies principally through the financial
system, manipulating interest rates and the availability of credit to all sectors of the economy.
47
Page | 48
Many central banks today pursue tight monetary policies in an effort to control inflation, and
they operate through the mechanism of the financial system. Central banks do not usually
deal direct with the public; rather they are 'bankers' banks', communicating and dealing mainly
through that part of the financial system which comprises the banking system.
2.2 THE ROLE OF MARKETS IN THE ECONOMIC SYSTEM
The financial system forms part of the broad economic system of a country, and the latter
normally functions along market oriented lines. In most economies today markets are used to
carry out the complex task of allocating resources, distributing income, and producing needed
goods and services. Markets in turn represent institutions set up by society to allocate
resources which are scarce relative to the demand for them. Modern societies use markets to
allocate labour, raw materials, energy, managerial skills, and capital in order to produce the
many goods and services demanded by the community. Markets are the channel through
which buyers and sellers meet to exchange goods, services, and resources.
The market place determines what goods and services will be produced, and in what quantity.
This is accomplished essentially through changes in the prices of commodities and services
offered in the market. If the price of a commodity rises, for example, this stimulates business
firms to produce and supply more of it to consumers. In the long run new firms may enter the
market to produce those goods or services experiencing increased demand and rising prices.
A decline in price, on the other hand, usually leads to reduced output of a product or services,
and in the long run some firms will desert such a market. Markets also distribute income. In a
pure market system the income of an individual or business firm is determined solely by the
contributions each makes to production.
There are essentially three types of markets at work within the economic systems, namely
factor markets, product markets and financial markets. In factor markets consuming units sell
their labour, managerial skills, and other resources to those producing units offering the
highest prices. The factor markets allocate the factors of production (land, labour, capital and
enterprise) and distribute incomes in the form of salaries, wages, rental income, profits and
interest to the owners of productive resources.
The factors of production receiving incomes from the factor markets in turn spend most of this
money to acquire goods and services in the product markets. Food, clothing, cans, and shelter
48
Page | 49
are among the many goods and services sold in the product markets. The financial markets
in turn partly stem from savings generated by factor income which is not spent.
2.2.1 Flow of funds in the financial system
The financial system is one of the most important inventions of modern industrial societies, its
vital task being the channelling of scarce funds in the form of credit from those who save
(surplus economic units) to those who borrow (deficit economic units) for consumption
and investment. By making funds available for lending and borrowing, the financial system
provides the means whereby modern economies grow, and the standard of living enjoyed by
citizens of a country can increase.
Surplus economic units have excess funds to either invest or save. There are various ways in
which these funds can be saved or invested. Surplus units expect a return on investment.
Surplus economic units can for example buy shares in company (deficit economic unit that
issues shares) in order to gain if the share price increases, or by receiving a possible dividend
payment. The company that issued the shares can use the funds for investment purposes.
Investment generally refers to the acquisition of capital goods such as machinery, and the
purchase of inventories of raw materials, semi-finished good and finished products. Modern
economies require enormous amounts of capital equipment (i.e. machinery and robot driven
production units) in order to produce goods and services. Investment in new technological
advanced assets should increase productivity (measured as a ration of output per unit of input
over time – it is a measure of efficiency and is usually considered as output per person-hour),
and ultimately result in a higher standard of living.
Investment requires substantial funding from surplus economic units (local and foreign-foreign
funding essential for developing countries that have limited savings). South Africa is an
emerging market (market of a developing country with high growth expectations – any country
that is attempting to improve its economy, and whose economy generates a gross national
product per capita of less than $10 000 annually). South Africa’s domestic savings is too low
(savings ratio [savings as a ration to GDP-Gross domestic product] of about 14%) to support
economic growth and therefore the country relies on foreign investments.
The financial markets channel savings to households and other deficit economic entities who
need more funds for spending than are available from current income. Most of the funds set
aside as savings flow through the financial markets to support investment by business firms
and governments.
49
Page | 50
Deficit economic units sell or issue financial claims (debt instruments of IOUs) to raise funds
from surplus economic units. The borrowed funds will then be repaid out of future income.
Financial markets facilitate the exchange of current income for future income.
Surplus economic units or lenders of funds receive payment promises in return for the lending
of funds to deficit economic units. These promises are packaged in the form of claims such
as:
• Shares
• Bonds
• Bank and other types of deposits.
Financial claims promise the supplier of funds a future flow of income which may consist
mostly of dividends and interest income. In general, there is no guarantee that the expected
flow of future income will be received. There is a risk element involved. However, suppliers of
funds expect not only to recover their original (principal value) commitment of funds, but also
to earn additional income as a reward for risks.
The figure 3.1 illustrates the flow of funds in the South African financial system:
LENDERS FINANCIAL SYSTEM BORROWERS
(surplus economic units) (deficit economic units)

HOUSEHOLD HOUSEHOLD
SECTOR money money SECTOR
FINANCIAL
INTERMEDIARIES
CORPORATE CORPORATE
(indirect financing)
SECTOR Indirect Primary SECTOR
securities money securities
GOVERNMENT (direct financing) GOVERNMENT

SECTOR SECTOR
Primary securities
Figure 3.1 Funds flow in the SA Financial System
Source: Van Zyl, C., Botha, Z., & Skerrit, P. (ed), 2002, Understanding South African Financial Markets, Pretoria,
Van Schaik Publishers, p. 5.
Additional information
50
Page | 51
The ultimate lenders (surplus economic units) and borrowers (deficit economic units) of funds
are described as non-financial economic units. Different members of the four categories, or
even the same members at the same period of time, may be either surplus or deficit units.
The ultimate lenders and borrowers can be divided into four main sectors:
1. Household sector
The household sector consists of:
• Individuals and families

• Private charitable, religious and non-profit institutions
• Unincorporated businesses such as farmers, retailers and professional partnerships
– the transactions of these businesses cannot be separated from the person
(owners).
2. Corporate (or private business) sector
The corporate sector consists of private or listed companies directly or indirectly engaged in
the production and distribution of goods and services.
3. Government sector
4. Foreign sector
2.3 THE FINANCIAL MARKETS AND THE FINANCIAL SYSTEM
The key function of financial markets is to facilitate the flow of funds from surplus to deficit
economic units in the economy. The financial markets are critical for producing an efficient
allocation of scarce capital, which contributes to higher production and efficiency in any
economy.
Not all factor incomes are spent. A significant proportion of after tax income received by
households each year is earmarked for personal saving.
In addition, business firms save billions of Rands each year to build up revenue reserves for
future contingencies and to finance long term capital investment. It is here that the third kind
of market, financial markets, performs a vital function within the economic system.
51
Page | 52
The financial markets channel savings to those individuals and institutions that need more
funds for spending than are available from current income. The financial markets are the heart
of the financial system, determining the volume of credit available, attracting savings, and
setting interest rates and security prices.
Most of the funds set aside as savings flow through the financial markets to support investment
by business firms and governments. Investment generally refers to the acquisition of capital
goods such as machinery, and the purchase of inventories of raw materials, semi-finished
goods and finished products. Modern economies require enormous amounts of capital
equipment in order to produce goods and services. Investment in new equipment increases
the productivity of labour and ultimately leads to a higher standard of living. However,
investment generally requires large amounts of funds, often far beyond the resources available
to a single firm or government unit. It is therefore the case that by selling financial claims, large
amounts of funds can be raised quickly, and the loan repaid out of future income. Indeed, the
financial markets operating within a country's financial system make possible the exchange of
current income for future income.
Those who supply funds in the financial markets receive only promises in return for the loan
of their money. These promises are packaged in the form of attractive financial claims such
as shares, bonds, bank deposits, insurance policies, etc. Financial claims promise the supplier
of funds a future flow of money income which may consist of dividends, interest payments,
capital gains or other returns. There is of course no guarantee that the expected flow of future
income will ever materialize. However, suppliers of funds to the financial system expect not
only to recover their original commitment of funds, but also to earn additional income as a
reward for waiting and for incurring risks.
2.4 TYPES OF FINANCIAL MARKETS WITHIN THE FINANCIAL SYSTEM
The financial markets where financial claims and financial services are traded represent the
heart of the financial system. These markets may be viewed as a vast pool of funds, continually
being drawn upon by demanders of funds and continually being replenished by suppliers of
funds. The level in the pool rises when the volume of funds contributed by savers exceeds the
amount of funds demanded. At such times an ample supply of credit is available, and the cost
of credit in the form of the rate of interest tends to decline. On the other hand, when the inflow
of funds is small relative to the demand for funds, the level in the pool falls, and the relatively
scarce supply of credit available usually leads to higher interest rates. The price mechanism
52
Page | 53
at work in the financial system serves to adjust the demand for and supply of available funds
until all those seeking credit and willing to pay its cost are satisfied.
2.4.1 Distinction between Money Market and Capital Market
The pool of funds represented by the financial markets may be divided into different segments,
depending upon the characteristics of financial claims being traded and the needs of different
groups. One of the most important distinctions in the financial system is between the money
market and the capital market.
The money market is designed for the making of short term loans where individuals and
institutions with temporary surpluses of funds meet borrowers who have temporary cash
shortages. By convention, a security evidencing a loan which matures within one year or less
is considered to be a money market instrument. One of the principal functions of the money
market is to finance the working capital needs of companies, and to provide government with
short term funds.
In contrast, the capital market is designed to finance long term investments. The tapping of
funds in the capital market makes possible the construction of factories, office buildings,
highways, bridges, schools, homes and flats. Financial instruments traded in the capital
market have original maturities of more than one year.
The most important suppliers of funds to the money market are the commercial banks who
lend funds to both business firms and governments. Non-financial business firms and local
authorities with temporary cash surpluses also provide substantial short term funds to
commercial banks who can then lend out the money in the money market. On the demand
side the largest borrower in the money market is usually the government, while companies
can also be active borrowers.
Central banks are also active in the money market. Such banks normally have responsibility
for regulating the flow of money and credit in the financial system, and thus operate on both
sides of the money market. Through its open market operations a central bank buys and sells
securities to maintain credit conditions at levels deemed satisfactory to meet a country's
economic goals.
53
Page | 54
The demanders of funds in the capital market tend to be quite varied. Individuals tap the capital
market when they borrow to finance a new home or car, while businesses of all sizes can be
important borrowers in this market. Local governments rely upon the capital market for funds
to build highways and public buildings, and to provide essential services to the public.
Governments are often the biggest borrowers in the capital market, often issuing their
securities for this purpose through the medium of central banks.
The latter can also be active in the capital market conducting open market operations by
buying and selling government stocks.
The bulk of funds made available in the capital market tend to come from financial institutions.
These encompass short and more particularly long term insurance companies, pension funds,
finance companies, merchant banks, and banks.
2.5 EFFICIENCY OF FINANCIAL MARKETS
Efficient financial markets are vital. Countries that do not have such markets tend to be
retarded in their economic development. The concept of efficiency in financial markets in turn
can be broken down into two types: operational and allocational efficiency.
Operational efficiency is measured by the costs involved in the financial process relative to
results. If the going rate on mortgages is 8%, the rate that a financial intermediary could return
to savers after covering costs would be a measure of operational efficiency. If one institution
could return 6% and still make a satisfactory profit but another only 5%, the first is obviously
more efficient. The level of transactions costs in the share market or in the foreign exchange
market can also be considered tests of operational efficiency.
Allocational efficiency refers to the effectiveness in channelling the flow of saving into
productive uses. A capital market that invested funds in low-return companies and industries
or uses capital that has little social value would be allocationally inefficient. A capital market
that channelled funds into highly productive uses would be efficient.
Operational efficiency in the context of the financial markets refers to the possibility of a range
of possible failures in the operations of the financial markets, and in particular possible failures
54
Page | 55
in the operations of a financial firm, such as computer breakdowns, errors of judgement,
deliberate fraud, etc.
In some cases lapses in operational efficiency can be insured against or hedged. For example,
a bank can insure itself against losses arising from computer hardware problems or it can
hedge the risk by investing in a back-up system. The price of this insurance and the cost of
such a hedge raises the question of the economic rationale of removing the risks. Inevitably,
the institution such as a bank will need to assess the potential loss against the known
insurance cost for each kind of potential operational risk.
Failure to identify operational inefficiencies, and take appropriate action, can translate into
huge losses. For example, the actions of a single derivatives trader at Barings Bank, who was
able to take extremely risky positions in a market without authority or detection led to $1,5
billion in losses that brought about the liquidation of the bank in 1995. This episode showed
that management teams in a company need to fully understand their businesses if operational
efficiencies are to be high, and have in place strong internal controls.
2.6 MAINTAINING A FAIR PRICE
Efficient financial markets are also able to maintain prices which are judged to be fair. A
security listed upon an organized stock exchange for instance is likely to have a fair price
because the brokers representing the buyers or sellers operate as an auction market which is
aimed at creating a market in each stock. A fair price does not refer to book value or investment
value of an item. Instead, it means that the transaction price is related to the total demand and
supply factors at a given time. A fair price is therefore closely related to a competitive price.
2.7 ROLE OF CENTRAL BANKS IN FINANCIAL MARKETS
Central banks perform various functions and duties not normally carried out by other banks,
and they are charged with certain responsibilities not borne by other banking institutions. It
has already been mentioned that central banks are responsible for implementing monetary
policies which lead to extensive participation in the financial markets by such institutions.
55
Page | 56
Implementing monetary policies means that central banks materially influence liquidity
conditions in the economy, and thereby influence the position and operations of other financial
institutions, and especially those of banks.
It should also be noted that central banks act as financial intermediaries. They act as banker
to the government by holding deposits for the latter and extending credit to the government
when necessary. They also act as the bankers' bank in the sense that banks have to maintain
cash reserves with the central banks, while the latter offer short term loan facilities to the
banks. In the case of the South African Reserve Bank its role as a financial intermediary is
further emphasized by the role of its subsidiary the Corporation for Public Deposits, which
accepts short term funds from the public sector and invests them mainly in short term assets
in the financial markets. Central banks are also increasingly involved in trying to preserve the
stability of the financial markets. They try to avoid unruly conditions prevailing in the money
and capital markets, and wish to see public confidence maintained in financial institutions, and
particularly banks. In general central banks exert more impact on the financial systems in their
respective countries than any other entities, and the purpose of this series of lectures is to
explain in detail the workings of central banks in the contemporary world.
2.8 STRUCTURE OF FINANCIAL SYSTEMS IN SOUTH AFRICA
Total financial activities in countries with more advanced financial systems are indeed
conducted at three distinctly different levels:
(a) At the top the monetary authorities influence the system through their monetary policy
actions. The monetary authorities will normally include the Finance Department of
Government, the central bank and supportive regulatory and supervisory authorities.
(b) In the middle financial markets serve the function of price determination and the
allocation of resources. The financial markets as already indicated include a capital
market, a money market, and a foreign exchange market. These markets can be further
divided into specialised sub-markets such as an equity market, a bond market and a
market for derivatives.
(c) At the third tier there are the individual specialised institutions such as banks, insurance
companies, finance houses and securities dealers which furnish financial services to
governments, businesses, and the general public.
56
Page | 57
In the twelve member countries of the Southern Africa Development Community (Angola,
Botswana, Lesotho, Malawi, Mauritius, Mozambique, Namibia, South Africa, Swaziland,
Tanzania, Zambia and Zimbabwe), there are at this stage major differences in the structure of
the overall financial system. These differences apply to all three levels of the financial system,
i.e. the monetary authorities, the markets, and the financial institutions operating in each one
of the twelve countries. Monetary authorities do not always have the same objectives, financial
markets do not even exist in some of the member countries, and independent and competitive
financial institutions must still be established, nurtured and developed in some countries. In
short, there are major differences in the stage of development of the financial structures of the
participating countries.
The following table illustrates the financial intermediaries in South Africa.
South African financial intermediaries
DEPOSIT INTERMEDIARIES
SARB
Corporation for Public Deposits (CPD)
Land and Agricultural Bank
Private banks
Mutual banks
Post banks
NON-DEPOSIT INTERMEDIARIES
Contractual intermediaries
Long-term insurers
Short-term insurers
Pension and provident funds
Public Investment Commissioners (PIC)
57
Page | 58
Portfolio intermediaries (called collective investment schemes)
Unit trusts
Property unit trusts
Participation mortgage bond schemes
Development finance intermediaries (DFIs)

Development Bank of Southern Africa (DBSA)
Industrial Development Corporation (IDC)
National Housing Finance Corporation (NHFC)
Khula Enterprise Finance (KEF)
Infrastructure Finance Corporation (INCA)
 Question time
1 Define the term "financial system'.
2 What are the main tasks of markets in an economy?
3 Name and explain the role of each of the three markets at work within the economic
system.
4 What is the main function of financial markets in an economy?
5 What are a central bank's responsibilities in financial markets?
6 The capital market consists of
7 Financial markets developed because …..
8 List the different financial markets and explain the main function of each.
9 Explain the role of banks within the financial markets.
10 What is the structure of the South African economy?
11 Distinguish between the primary, and secondary sectors of South Africa.
12 Explain the relationship between the different sectors, markets and flows.
13 Why does structural change take place?
58
Page | 59
LEARNING UNIT 3: DIFFERENT KINDS OF FINANCIAL RISK
To understand the different financial risks.
• Describe key financial risks • List and describe the different financial risks
SECTIONS TO FOCUS ON: List and describe the different financial risks
59
Page | 60
DIFFERENT KINDS OF FINANCIAL RISK
3.1.1 Credit risk
Banks extend loans to various entities ranging from household units to large multi-national
companies. Credit risk is associated with the quality of individual assets and the likelihood of
default. It is extremely difficult to assess individual asset quality because limited published
information is available. In fact, many banks that buy other banks are often surprised at the
acquired bank’s poor asset quality even though they conducted a due diligence review prior
to the purchase.
Whenever a bank acquires an interest-earning asset (i.e. loan), it assumes the risk that the
borrower will default. Credit risk is the potential variation in net income and market value of
equity resulting from the non-payment or delayed payment of interest and/or principal
amounts. Different types of assets and off-balance sheet activities have different default
probabilities. Loans typically exhibit the greatest credit risk. Changes in general economic
conditions affect the ability of borrowers to repay their loans and to service their debt
obligations. Similarly, an individual’s ability to repay debt varies with changes in employment
and personal net worth. For this reason, banks perform a credit analysis to assess a
borrower’s capacity and willingness to repay their debt.
Unfortunately, loans tend to deteriorate long before accounting information reveals any
problems. Credit risk, from a bank’s point of view, also arises when the latter buys debt
instruments issued by governments and companies. The bank is exposed to credit risk if the
issuer does not pay the interest and principal amounts. Bank investment securities generally
exhibit less credit risk because the borrowers are predominantly government and semi-
government units and large companies.
Banks that lend funds in foreign countries take on an additional risk - country risk. Country
risk refers to the potential loss of interest and principal on international loans due to borrowers
in a country not making timely payments. In essence, foreign governments and corporate
borrowers may default on their loans due to government controls over the actions of business
and individuals, internal politics that may disrupt payments, general market disruptions, and
problems that arise when governments reduce or eliminate subsidies used as a source of
repayment.
60
Page | 61
3.1.2 Liquidity risk
Liquidity risk is the current and potential risk to earnings and the market value of stockholders’
equity that a bank cannot meet payment or clearing obligations in a timely and cost effective
manner. This risk can be the result of either funding problems or market liquidity risk. Funding
liquidity risk is the inability to liquidate assets or obtain adequate funding. The inability of a
bank to easily unwind or offset specific exposures without significant losses from inadequate
market depth or market disturbances is called market liquidity risk.
Liquidity risk also occurs when a bank cannot anticipate new loan demand or deposit
withdrawals and does not have access to new cash sources. Liquidity is generally discussed
in terms of assets with reference to an owner’s ability to convert the asset to cash with minimal
loss from price depreciation. Most banks hold some assets that can be readily sold to meet
liquidity needs. However, banks can access new funds both through the sale of liquid assets
as well as by directly issuing new liabilities at reasonable costs. Thus, when banks need cash
they can either sell assets or, increase their borrowings.
Core deposits are stable deposits that are not highly interest rate sensitive. These types of
deposits are less sensitive to interest rates paid but more sensitive to service fees charged,
services rendered and the location of the bank. Thus, a bank will retain most of these deposits
even when interest rates paid by competitors increase relative to the bank’s own interest rates.
As such, the interest elasticity of the demand for core deposits is relatively low. The greater
the core deposits, the lower unexpected deposit withdrawals and potential new funding
requirements.
Banks purchase short-term securities to generate a return and to satisfy liquidity needs. Short-
term securities are generally more liquid than longer-term securities because they are less
volatile in price and the bank gets its principal amount back earlier if it holds the securities until
maturity. However, banks are generally more willing to sell any security that trades at a price
above book value because they can report a profit.
Cash is held mostly to meet customer withdrawals and legal cash reserve requirements.
Banks attempt to minimise cash holdings because they do not earn interest.
61
Page | 62
The return on loans granted by banks positively impact on a bank’s cash flow and liquidity
position. The default on interest repayments as well as principal redemptions negatively
impact on the bank’s liquidity position. There is therefore a close link between liquidity and
credit risk.
Liquidity for other enterprises have a similar problem it is the risk that the business will be
unable to obtain funds to meet its obligations as they fall due either by increasing liabilities or
by converting assets into money without loss of value. The more liquid an asset, the more
easily it can be converted into money. Near money is an example of an asset that can be
quickly converted into a medium of exchange at little cost. In SA the most obvious type of near
monies is time deposits with banks. They pay higher rates of interest than current accounts.
Depositors need to give notice if they wish to withdraw from the account. Extreme liquidity
results in bankruptcy. Hence liquidity risk can be a “fatal” risk. However, such extreme
conditions are commonly the outcome of other risks. For instance significant losses due to the
default of key a customer can raise liquidity issues and doubts as to the future of the business.
All companies will only stay solvent by ensuring that all cash obligations (such as salaries,
rents, tax etc.) can be met by a combination of investment liquidity, funding sources and
contingent liabilities (liabilities that can be terminated quickly).
One crude measure of liquidity is the “current ratio”, which measures the relationship between
the current assets and the current liabilities.
3.1.3 Market risk
Market risk is the current and potential risk to earnings and stockholders’ equity resulting from
adverse movements in market interest rates or prices. The four areas of market risk are
interest rate or reinvestment rate risk, equity, security price risk and foreign exchange risk.
Traditional interest rate risk analysis compares the sensitivity of interest income to changes in
asset yields with the sensitivity of interest expense to changes in interest costs. This is done
via a funding GAP analysis. The purpose of a GAP analysis is to determine how much net
interest income will vary with movements in market interest rates. A more comprehensive
portfolio analysis approach compares the duration of assets with the duration of liabilities via
duration GAP analysis to assess the impact of interest rate changes on net interest income
and the market value (or price) of stockholders’ equity.
Both funding GAP and duration GAP measurements focus on mismatched asset and liability
62
Page | 63
maturities and durations as well as potential changes in interest rates. An asset or liability is
interest rate sensitive if it can be re-priced within a certain time period. A bank’s net interest
sensitivity position, or funding GAP, between assets and liabilities is approximated by
comparing assets with liabilities that can be re-priced over similar time frames.
The difference between interest rate-sensitive assets and interest rate-sensitive liabilities for
different time periods indicates whether more assets or more liabilities will re-price within a
given time interval. If this measure is positive, the bank will realise a decrease in net interest
income, if the level of short-term interest rates falls. If the measure is negative the bank’s net
interest income will likely increase with a decline in interest rates, but decrease with rising
interest rates. The larger the absolute value of the ratio, the greater the risk. In practice, most
banks conduct sensitivity or simulation analysis to examine volatility in net interest income and
stockholders’ equity to best identify interest rate risk exposures.
Equity and security price risk examines how changes in market prices, interest rates, and
foreign exchange rates affect the market values of equities, fixed income securities, foreign
currency holdings, and associated derivative and other off-balance sheet contracts.
Foreign exchange risk arises from changes in foreign exchange rates that affect the values
of assets, liabilities, and off-balance sheet activities denominated in currencies different from
the bank’s domestic (home) currency. It exists because some banks hold assets and issue
liabilities denominated in different currencies. When the amount of foreign assets is different
to foreign liabilities, any change in exchange rates produces a gain or loss that affects the
market value of the bank’s stockholders’ equity. This risk is also found in off-balance sheet
loan commitments and guarantees denominated in foreign currencies. This risk is also known
as foreign currency translation risk. Banks that do not conduct business in non-domestic
currencies do not directly assume this risk.
Most banks measure foreign exchange risk by calculating measures of net exposure for each
currency. A bank’s net exposure is the amount of assets minus the amount of liabilities
denominated in the same currency. Thus, a bank has a net exposure for each currency for
which it books assets and liabilities. The potential gain or loss from the exposure is indicated
by relating each net exposure to the potential change in the exchange rate for that currency
versus the domestic currency.
63
Page | 64
3.1.4 Operational risk
Operational risk refers to the possibility that operating expenses might vary significantly from
what is expected, producing a decline in net interest income. There are many causes of
earning variability in a bank’s operating policies. Some banks are relatively inefficient in
controlling direct costs and employee processing errors. Banks must also absorb losses due
to employee and customer theft and fraud. A bank’s operating risk is closely related to its
operating policies and processes and whether it has adequate controls. This risk is difficult to
measure, but is likely to be greater the higher the number of divisions or subsidiaries,
employees, and general operations.
Because operating performance depends on the technology a bank uses, success in

controlling operational risk depends on whether a bank’s system is efficient and functional.
Many banks have in-house support systems that provide check-clearing and cash settlement
services. Other banks contract these services out to third-party vendors. Operational risk
also arises from the more difficult to measure risks of unexpected losses that might occur as
the result of inadequate information systems, breaches in internal control, fraud, or unforeseen
catastrophes.
There is no meaningful way to estimate the likelihood of fraud or other contingencies from
published data.
Operational risk is not a well-defined concept and it is broad based. In the context of a bank
or financial institution, it refers to a range of possible operational failures that are not directly
related to market-, or credit risk. The management of an institution should make a list of
possible events that should be included in operational risk in order to minimise the degree of
conceptual variances. Another problem is the quantification of operational risk. For example,
how can one quantify the expected loss of a computer breakdown - expected loss is the
product of the probability of the event occurring and the cost associated with the event of a
computer breakdown if it does indeed occur. Both these numbers are difficult to calculate. By
their nature, major operational risks occur infrequently and in the form of discrete events.
The difficulties in assessing operational risk do not imply that it should be ignored or neglected.
On the contrary, management must pay attention to understanding operating risk and its
64
Page | 65
potential sources in the organisation precisely because it is so difficult to identify and quantify.
In some cases operational risk can be insured against potential losses. For example, the bank
can insure itself against losses arising from computer problems or pay an insurance premium
to cover losses associated with natural disasters.
Failure to identify an operational risk, or to defuse it in a timely manner, can translate into a
huge loss.
Banks are becoming more aware of the fact that technology is a double-edged sword. The
increasing complexity of instruments and information systems increase the potential for
operational risk. Unfamiliarity with instruments may lead to their misuse, and raises the
chances of miss pricing and wrong hedging techniques. At the same time, advanced analytical
techniques combined with sophisticated computer technology create new ways to add value
to operational risk management. The introduction of e-banking (electronic banking) also poses
new threats to banks providing such services.
3.1.5 Legal and reputation risk
Legal and reputation risk is difficult to measure. Legal risk is the risk that an unenforceable
contract, lawsuit or adverse judgement could disrupt or negatively affect the operations,
profitability, condition, or solvency of the institution. Reputation risk is the risk that negative
publicity, either true or false, adversely affects a bank’s customer base and brings forth costly
litigation, hence negatively affecting profitability. Because these risks are basically
unforeseen, they are difficult to measure.
3.1.6 Capital or solvency risk
Capital risk is not considered a separate risk because all of the risks mentioned previously will
in one form or another affect a bank’s capital and hence solvency. It does, however, represent
the risk that a bank may become insolvent. A firm is technically insolvent when it has negative
net worth or stock holders’ equity. The economic net worth of a firm is the difference between
the market value of its assets and liabilities. Thus, capital risk refers to the potential decrease
in the market value of assets below the market value of liabilities.
65
Page | 66
If such a bank were to liquidate its assets, it would not be able to pay all creditors, and would
be bankrupt. A bank with equity capital equal to 10% of assets can withstand a greater decline
in asset values than a bank with capital equal to only 6% of assets. One indicator of capital
risk is a comparison of stockholders’ equity with the bank’s assets. The greater equity is to
assets, the greater the amount of assets that can default without the bank becoming insolvent.
A bank that assumes too much risk can become insolvent. Operationally, a failed bank’s cash
inflows from debt service payments, new borrowings, and asset sales are insufficient to meet
mandatory cash outflows due to operating expenses, deposit withdrawals, and maturing debt
obligations. A cash flow deficiency is caused by the market’s evaluation that the market value
of bank equity is negative. High credit risk typically manifests itself through significant loan
charge-offs. High interest rate risks manifest itself through mismatched maturities and
durations between assets and liabilities. Banks operating with high risks are expected to have
greater capital than banks with low risk. When creditors and shareholders perceive that a
bank has high risks, they demand a premium on bank debt and bid share prices lower. This
creates liquidity problems by increasing the cost of borrowing and potentially creating a run
on the bank. Banks ultimately fail because they cannot independently generate cash to meet
deposit withdrawals and operate with insufficient capital to absorb losses if they were forced
to liquidate assets. As such, the market value of liabilities exceeds the market value of assets.
Capital risk is closely tied to financial leverage, asset quality, and a bank’s overall risk profile;
the more risk taken, the greater the amount of capital required.
High amounts of fixed-rate sources of funds increase the expected volatility of a firm’s income
because interest payments are mandatory. If a bank was funded entirely from common equity,
it would pay dividends, but these payments are discretionary. Omitting dividends does not
produce default.
Firms with high capital risk - evidenced by low capital-to-asset ratios - exhibit high levels of
financial leverage, have a higher cost of capital, and normally experience greater periodic
fluctuations in earnings.
Finally, many banks engage in off-balance sheet activities. This means that they enter into
agreements that do not have a balance sheet reporting impact until a transaction is effected.
66
Page | 67
An example might be a long-term loan commitment to a potential borrower. Until the customer
actually borrows the funds, no loan is booked as part of the bank’s asset. Banks generally
earn fees when they engage in off-balance sheet agreements. These agreements, in turn,
entail some risk, as the bank must perform under the contract. Off-balance sheet risk refers
to the volatility in income and the value of bank equity that may arise from unanticipated losses
due to these off-balance sheet liabilities.
To account for the potential risk of off-balance sheet activities, the new risk-based capital
requirements require a bank to convert off-balance sheet activities to on-balance sheet
equivalents and hold capital against these activities.
3.1.7 Purchasing power risk
Inflation can be defined as a process where the prices of goods and services increase
continuously. Banks have to form an opinion (take a view) of what they expect about inflation
in the future. This inflation expectation must then be priced into the prices of their products.
If a bank’s inflation estimates are wrong, then their pricing of their products will also be
miscalculated. Purchasing power risk refers to the potential variability in returns caused by
unanticipated changes in inflation. It arises when actual inflation does not equal expected
inflation. Investors who buy fixed-rate securities lose purchasing power when the actual
inflation rate exceeds the after-tax expected rate of return from interest and principal
payments. They have deferred consumption expenditures by purchasing securities, yet their
realised return buys less when it is actually received. Accordingly, banks like other investors
should require a nominal after-tax return on investments that exceed the expected inflation
rate. Purchasing power risk at banks is mitigated by the intermediation function. As long as
depositors’ inflation expectations are identical to that of bank management, both asset yields
and interest costs of liabilities incorporate the same inflation premiums. Inflation poses serious
problems to a bank when its inflation expectations are below those of its depositors’ and actual
inflation is high. In this instance, a bank is willing to accept lower yield on its investments (a
smaller spread) relative to its deposit rates. Higher than expected inflation reduces the spread
even more, and a bank’s profitability worsens.
67
Page | 68
 Question time
1. Distinguish between financial and non-financial risks.
2. Name and define the six financial risks inherent to the business and in particular the
banking industry.
3. Define and discuss Credit risk.
4. Define and discuss Liquidity risk.
5. Define and discuss Market risk.
6. Define and discuss Capital/solvency risk
7. Define and discuss operational risk
8. Briefly discuss the five types of operational risk
9. The cost of risk reduction and competitiveness has an inverted relationship. Explain
10. What are the elements of a workable risk management programme? Name and
discuss briefly.
68
Page | 69
LEARNING UNIT 4: FACTORS INFLUENCING RISK MANAGEMENT
To understand the different external environmental factors and how these factors
cause risk.
• Identify and understand the internal • Discuss or explain and list the internal factors
factors which influence risk. that need to be considered in risk
management
• Identify and understand the various • Identify, explain and discuss the various
macro risk elements and external factors influencing risk management
environments organisations are
faced with.
• Identify and discuss the market • Identify, explain and discuss the various
environment as far as risk is market factors influencing risk management
concerned
SECTIONS TO FOCUS ON: The external factors affecting risk. Topics related to
the assessment criteria
69
Page | 70
FACTORS INFLUENCING RISK MANAGEMENT
4.1 INTRODUCTION
The environment within which a bank will grant credit contains many different variables which
have a real or potential impact on the risk involved. This environment can be divided into the
internal and external environments.
4.2 THE INTERNAL ENVIRONMENT
The internal environment of a bank refers to those factors or variables that can affect the credit
risk, but may be influenced indirectly or directly by the management of the bank, in other words
they do have some degree of control over these variables.
4.2.1 The Credit Policy of the Bank
The Credit Policy of a bank should be the document that will give staff involved with credit the
necessary guidelines and principles to be applied when granting credit. It should be used as
the official reference document to determine what types of credit may be granted, the credit
terms required, acceptable security or collateral and qualifying principles and criteria.
The Credit Policy must be developed by senior levels of management and be approved by the
top management. It is of vital importance that the document is constantly updated and
streamlined to deal with the current issues on credit risk faced by the bank. All credit staff
must be well trained in the content and implications of the Credit Policy at all times.
4.2.2 Credit Management and Control Systems
Client information, the monitoring of clients’ conduct in terms of their contracts, facilities, record
keeping in terms of contracts and securities, credit reports, etc. are mostly computerised in
modern times. There is however some information that cannot be dealt with on computer and
must be kept in files and safely stored. The credit control systems of a bank are vital for the
continuous management of credit risk in terms of both the current and pro-active identification
of potential risk areas. Credit control systems and the monitoring of credit risk must therefore
be updated and modified to meet the requirements of both effective and efficient credit control.
70
Page | 71
4.2.3 Employees of the Bank
Credit decisions are made by the people employed and if they are not knowledgeable and
competent in doing so, the bank will be exposed to credit risks. Credit training programmes
are used to give staff the necessary skills and knowledge. Most banks will only be prepared
to authorise credit staff to grant credit up to certain specified limits once they have successfully
completed the required training programmes.
It is important that the correct profile employee is placed in a credit position, as it is a highly
complex environment with a lot of stress involved. The wrong type of person in this situation
can be a great risk to the bank.
Fraud and deliberate bad credit decision making also constitute major risks to the bank,
especially in situations where staff are not objective in granting credit.
4.2.4 Products and Markets
It is essential for a bank to do thorough research as to the type of products it wants to sell to
the specified target markets. The risk involved when selling cheque accounts and overdraft
facilities to high income individuals will be substantially different from the scenario where the
same product is sold to small businesses. In the last few years, the level of competition
between banks in South Africa has become very aggressive, especially with the opening up
of the economy and a vast number of foreign banks entering the field. This meant that banks
were often forced to enter into markets that are not necessarily very rewarding and the risk of
potential losses due to staff that do not have the necessary knowledge and experience of
granting credit to that type of market segment became a real threat. High levels of competition
can also put pressure on banks to become more lenient in granting credit, especially if it is a
newly entered target market.
4.3 THE EXTERNAL ENVIRONMENT
71
Page | 72
The external environment of the bank refers to those factors or variables that can have an
effect on the credit risk, but cannot really be influenced by the management of the bank. When
and if banks do have some effect on these factors, it will mostly be negligible.
The external environment can be classified under the following eight categories:
• The marketing environment
• The economic environment
• The physical environment
• The international environment
• Legislative and the institutional environment
• The social environment
• The technical environment
• The political environment
4.3.1 The Marketing Environment
When discussing the marketing environment in which banks operate, there are two major
factors to focus on, namely competition between organisations and the type of clients they
draw. We have already referred to this when we discussed products and markets and will
now expand on the topic in some further detail.
(a) Competition
It is a well known fact that the market in South Africa is small in comparison to some overseas
countries and the number of competing banks makes it one of the most fierce and competitive
banking industries known in the developing world. Because of this situation, we have seen a
number of amalgamations and take-overs in recent years and certain critical aspects such as
cost-to-income ratios, market share and technological advantage have become very
prominent in this battle. New products are one of many ways whereby banks try to penetrate
new markets and gain advantage over competitors.
Banks are also dependant on one another for information relating to clients in the form of bank
reports. Due to the fierce competition to draw clients, the quality and usability of these reports
are often questionable in terms of their value to identify potential risky clients. The quality of
credit information available to banks has become a serious problem over the last few years.
(b) Clients and Risk
72
Page | 73
Clients who do not meet their financial commitments towards the bank will normally do so
because of an inability to repay debt, an unwillingness to do so or due to fraud and illegal
conduct. The inability to meet short-term financial commitments is called illiquidity and
insolvency occurs in the case where the client’s liabilities exceed his assets. Huge sums of
money are written off as book debts by banks on an annual basis due to client default.
The concepts of liquidity and solvency were dealt with in more detail in CREDIT RISK
ASSESSMENT I. At this stage it is appropriate to say that the liquidity and solvency of a client
poses a major credit risk if not managed properly by the client himself.
The willingness to meet financial commitments towards the bank will normally be determined
by the client’s degree of integrity and this can also be a major credit risk factor to be considered
by the bank.
A client who obtains credit illegally or under false pretences, poses a fraud risk to the bank.
Dishonesty can also be a major factor here, especially in terms of the client’s need. In any
credit transaction, there will always be a certain amount of information that is directly
dependent on the client’s honesty and often the credit staff must accept that the client is in
fact honest in giving the information.
4.3.2 The Economic Environment
This topic is covered in great detail in the subject “THE ECONOMIC ENVIRONMENT” which
is part of the Credit Diploma.
In this discussion we will focus on the following key issues that will impact on credit risk:
(a) Cyclical economic movements
(b) The role of inflation
(c) The role of interest rates
(a) Cyclical Economic Movements
The economy of a country experiences periods of increased economic activity and decreased
economic activity. When the economy is in the phase of an upswing, it normally means higher
consumer expenditure and therefore an increased demand for credit. In the phase of an
economic downswing, consumers will spend less and the demand for credit will decrease.
The risk involved during these phases of the cycle is that in times of prosperity consumers can
73
Page | 74
over-extend themselves and experience difficulty with their cash flow when the economy cools
off again. Banks must always be aware of the future economic prospects when granting credit
and take the potential impact of the economic cycle into consideration. In South Africa we
have seen low economic growth and increased unemployment in recent years and this
situation also contributed to high bad debts in the banking sector.
(b) The Role of Inflation
Inflation refers to the tendency that there is a continuous increase in the general price level as
measured by the CPI (Consumer Price Index) and the PPI (Producers Price Index.)
Because the net effect of inflation is to decrease the purchasing power of money, there is a
constant increase in the price of goods and services. In South Africa we have been living with
double digit inflation rates for many years and it is only in recent times that our inflation rate
declined to ±6%. If one considers the fact that an inflation rate of 15% can more than halve
the value of purchasing power of R1 over a period of five years, the seriousness of this factor
becomes very obvious. Consumers and businesses who constantly have to pay more and
more for products and services, whilst their income and turnover do not increase with 15% or
more per year, will experience a gradual decline in their ability to meet debt commitments in
such a scenario.
(c) The Role of Interest Rates
South Africa is a country where we experience high interest rates because of the fact that we
are not saving enough money to meet the demands of our growing economy. Foreign
investors are also not very keen to invest large sums of money in our economy and prefer to
keep their investments in the form of stock and shares that can be sold off easily if necessary.
Given the fast growing population and development needs of the country, it is clear that the
demand for money exceeds the supply and therefore the interest rates (price of money) are
generally high.
It is important to understand that the high interest rates make it difficult for businesses to
employ more loan capital because of the high cost of capital. During 1983/84 we experienced
a prime overdraft rate of 25% and it had a devastating effect on the profitability of businesses
which had large debts at that stage. Consumers are also restricted as to their ability to service
more debt. The net result of all this is that economic growth is low and the credit default risk
very high.
74
Page | 75
There are two theories that are often used to explain the term structure of interest rates. The
expectations theory maintains that interest rates are influenced by the expectations of
investors about the future interest rates. When for example investor A expects the interest
rates to rise in the short-term, he will prefer to invest his money in the short-term. This will
enable him to reinvest it every time the interest rate rises and get the benefit of the increased
rate. If all investors should have the same expectations, this will cause the demand for short-
term investment to be greater than that for long-term investments.
This demand will force the interest rate on short-term investments down as the supply of funds
for this type of investment will exceed the demand. The factor that will influence the
expectations of investors to a very large extent is the expected inflation rate. The liquidity
preference theory maintains that long-term interest rates tend to be higher than short-term
interest rates. The main reason for this is that investors argue that short-term investments are
less risky than long-term investments and they are prepared to take a lower return on short-
term investments.
4.3.3 The Physical Environment
The physical environment refers to the climate in the country, the availability of good
infrastructure such as electricity, dams, bridges, roads, railways, airports, etc. and the impact
of environmental protection and conservation. All these aspects will influence the decision of
a business as to where it should locate, the choice of agricultural activities, etc. The whole
issue of environmentalism has grown in stature and importance over the last few years and
businesses could be faced with law suits and boycotts. It will be irresponsible of banks not to
take these aspects into consideration when dealing with credit risk assessment.
4.3.4 The International Environment
The South African Economy is regarded as a very open economy and we are sensitive to the
influences of the foreign sector.
From the perspective of credit risk there are two important factors to consider in this
environment:
(a) Fluctuations in the Exchange Rate
Where bank clients do transactions with businesses and individuals in foreign countries, the
use of foreign currencies become very important. A South African importer of goods from
75
Page | 76
America will have to convert enough Rands into American Dollars to pay the price charged in
dollars. This is done via the foreign exchange markets. The exchange rate is the price of one
currency expressed in terms of another currency. The exchange rate between the Rand and
the American Dollar will for example be expressed as:
$ 1 = R 7,13
This rate of exchange is mainly determined by the demand and supply for a particular currency
within a country.
The impact of fluctuations in the exchange rate can be enormous in terms of the credit risk for
a bank.
EXAMPLE
If for example Company A, who is situated in South Africa, imports goods from America and the
exchange rate moves from $1 = R 7,00 at the time of placing the order to $1 = R 8,20 at the time of
payment one month later, this could mean that Company A must pay an additional ± R 120 000 on a
purchase price of $ 100 000. The potential impact on the payment ability of Company A must be
carefully analysed if the transaction is financed by the bank.
It is of course also possible for the reverse situation to occur, where the exchange rate actually
moves in favour of a business or individual. It must also be remembered that a devaluation of
the Rand can be in favour of businesses in South Africa that export goods to other countries
because the effect is that the price of goods from South Africa is decreasing and is thus more
competitive. This will stimulate exports as we have seen during the last few months of 2001.
(b) The Country Risk
The degree to which a government can interfere in the normal business activities within a
country by means of rules, regulations, control systems, nationalisation, confiscation and
76
Page | 77
freezing of assets of foreign companies and individuals can pose a potential risk. This risk is
also known as the political risk. Political instability and turmoil can bring about unpredictable
changes and protection for local businessmen. Foreign companies can suffer serious losses
because of this. Banks who finance companies with foreign branches will have to look at the
political stability and degree of government influence and regulation in those countries,
especially if their clients’ future existence is dependant on these foreign branches.
4.3.5 Legislative and Institutional Environment
(a) The Influence of Monetary Policy on Banks
In South Africa monetary policy is implemented by the SA Reserve Bank by means of the
following:
• Variations in the reserve assets requirements for banks.
• Quantitative restrictions on bank lending.
• Selective credit controls.
• Lending interest rate controls.
• Variations in the conditions and terms of hire-purchase and instalment credit.
• Moral suasion – in other words requesting banks to act / not to act in a particular way.
• Exchange control regulations.
These measures have a direct impact on the ability of banks to grant credit and potential
changes in the monetary policy plays a significant role in determining credit risk.
(b) The Fiscal Policy of the Government
Government spending and taxation are the two main components of the fiscal policy in any
country. The degree and manner in which a government spends money will have a very big
effect on such aspects as job creation, economic growth and development, education, etc.
Taxation will also impact directly on the disposable income of consumers and profits made by
businesses. It should be clear that fiscal policy will influence the ability of people, businesses
and institutions to meet their current financial commitments with banks, as well as their ability
to take up more credit with banks in the future.
(c) The Impact of Legislation
In the subject LEGAL ASPECTS OF BANKING, which forms part of the CREDIT DIPLOMA,
the topic of legislation and its impact on the banking environment is covered in detail. In this
77
Page | 78
section the aim is to give a summarised overview of the acts that will have an influence on the
credit risk of a bank.
• The Insolvency Act:- This act is of crucial importance to the banker, as it deals with
insolvent persons and businesses and has serious impact on the rights of banks in terms
of the security or collateral held by them.
• The Landbank Act:- The Landbank as first bond holder over immovable property of a
farmer, has certain preferential rights above that of commercial banks. Credit officials
must take serious note of the impact of this act when granting credit to farmers.
• The Co-operatives Act:- In terms of this act, Cooperatives can also grant credit to
farmers. The ownership, as well as the right to pledge goods financed in this way, is
vested in the Co-operative. This has important implications for Banks when it comes to
collateral and the ability of farmers to sell these goods to meet their debt commitments
with Commercial Banks.
• The Agricultural Credit Act:- In terms of this act farmers are given special privileges
with their creditors. This will enable them to continue with their family activities and have
time to recover from financial disasters. It can imply prolonged periods of waiting by
Commercial Banks to have debt commitments settled.
• The Matrimonial Affairs and Matrimonial Property Acts:- These acts prescribe the
contractual capacities of married spouses in terms of being married in community of
property or with antenuptial contract. It also deals with ownership in terms of property
and the right to conduct business independently. Banks must be well aware of these
laws or it could lead to financial losses in terms of granting credit and obtaining collateral
from spouses, which are not binding in terms of the legal requirements.
• The Age of Majority Act:- In terms of this act a person can only be held liable for
contractual commitments if the requirements of majority were met at the time of
conclusion of the contract. This means the person must have been 21 years of age, or
18 years old and declared a major by the Supreme Court, or a minor who got married
with the consent of his/her parents or guardian. The effect of dealing with minors will
obviously create a potential credit risk for banks.
• The Companies Act:- Companies are legal persons and are managed by the directors
on behalf of the shareholders. It is of vital importance that banks make sure that the
directors are not acting beyond their legal powers as set out in the Articles of Association
and outside the scope of the nature and objectives of the Company as set out in the
Memorandum of Association. Section 226 deals very specifically with the issue of
guarantees and collateral. Ignorance of the law is not a valid plea, therefore banks who
deal with companies must always make sure that the requirements of this act are
met or suffer the consequences of potential financial losses and even legal prosecution.
78
Page | 79
• The Close Corporations Act:- The Close Corporation (CC) is also a legal person and
the Association Agreement is a confidential document. When the members of a CC
exceed their borrowing powers as set out in this document, the bank will have a right to
institute legal proceedings against the CC in the case of dispute and credit default. It is
also important for a bank to obtain written consent from all the members for a suretyship
by a CC.
• Labour Legislation:- In South Africa we have seen the emergence of many labour laws
in the last few years. This created a scenario where the rights of labourers to strike
under certain conditions and the granting of privileges became a reality in the economic
environment. The implementation of equality and affirmative action are but two of a host
of labour market issues that business must deal with. The emergence of organised
labour movements also gave more bargaining power to the labourer. Businesses must
deal with these realities and it can have a very serious impact on their cash resources,
thus influencing their ability to repay debt commitments with banks. Labour intensive
businesses will obviously be more sensitive to these issues and credit officials must take
this into consideration when granting credit.
(d) The Influence of Organised Business
Individual businesses will find it very difficult to bargain and negotiate in the external
environment in order to protect their own interests when under threat. Co-operation amongst
businesses on various issues such as protesting against regulations and laws, joint research
and projects, etc. are very common.
Most industries are also organised in some way or another. There are different Chambers of
Commerce, the Chamber of Mines, the SA Agricultural Union, etc. By joining these units of
co-operation, the individual businesses are better informed and equipped to deal with the
threats and opportunities that may arise in the external environment. The sensitivity of
individual businesses to external threats and the degree to which they form part of organised
business, will be important to a banker when assessing the credit risk potential of a business
client.
4.3.6 The Social Environment
In a country like South Africa with its diversity of cultures, languages, religions and customs,
as well as the uneven distribution of the population over the geographical area, the social
environment can be a very important influence on risk potential. Markets and the demand for
79
Page | 80
products will therefore be influenced by such factors as the geographic distribution of people,
the growth rate of population groups, the enormous influx to cities and depopulation of rural
areas, the changing face of residential areas in the new South Africa, the rise and prominence
of women in the labour market, the high level of illiteracy and improved educational
opportunities, the availability of skilled and unskilled labour in certain areas and trades. This
is a complex environment and poses wonderful opportunities, but also major threats and risks
to the business world. In recent years businesses have become very sensitive and aware of
their social responsibilities, especially to be seen as being active in the upliftment and
development of people. There is much more pressure on businesses to put something back
into the people and communities who form part of their target markets.
4.3.7 The Technical Environment
The fast pace of changing technology and technological development is one of the drivers of
change in the modern world. A good example of this is how dramatically the use of computers
has changed the face and pace of doing business. Technology will impact on the products,
procedures and equipment used by businesses. It will also require new skills and expertise
from the labour market. The potential for products, procedures and know-how to become
outdated is a serious risk factor. The more sensitive a business client is to the changing
technology, the more prominence this aspect will have to receive when doing credit risk
assessment.
4.3.8 The Political Environment
The political environment can be described as the influence that the people elected from
different political parties to serve in the government of the country, will have within the country.
This influence will manifest itself in the government’s ideological standpoint, policies and
expectations on matters such as education, the free market economy, privatisation,
rationalisation of industries and many more. The degree of stability of the government, the
effect of political pressure groups and the influence of international political trends on local
politics, will all form part of this very important component of the external environment.
80
Page | 81
 Question time
1. List the internal factors influencing risk management.
2. List and discuss each of the external factors influencing risk management and the
role they play in risk management.
81
Page | 82
LEARNING UNIT 5: RISK MANAGEMENT ENTERPRISE RISK

MANAGEMENT AND THE RISK MANAGEMENT
PROCESSES ACCORDING ISO 31000
To discuss the process of risk using the ISO31000 model.
At the end of this unit you should You will be assessed as competent if you can
be able to do the following:
• Risk management definitions and • Discuss why do we need Risk management

concepts. • Discuss why bother with risk management
• Explain the critical requirements and questions
for risk management.
• Risk management models • List and explain the different steps for pure risk
management process
• List and explain the different steps for the
ISO31000 risk management process
• List and explain what other models are
available
• Importance of communication in • Explain the importance of communication in
risk management risk management
• The importance of the review • Explain the importance of the monitoring and
process in risk management review process in risk management
• The importance of stakeholders in • List and explain the different stakeholders in
risk management risk management
SECTIONS TO FOCUS ON: The management risk process and the process of
risk. Topics related to the assessment criteria.
82
Page | 83
RISK MANAGEMENT ENTERPRISE RISK MANAGEMENT AND THE RISK
MANAGEMENT PROCESSES ACCORDING ISO 31000
5.1 INTRODUCTION
Financial markets and banks are often characterised by uncertainties such as changing
economic conditions and unstable political environments as mentioned before. In terms of
markets where demand and supply determines the trading in that market, the characteristics
of financial markets are unique in the sense that the primary product is money. Because of
the unique characteristics of financial markets and financial institutions including banks, in
particular, certain financial risks exist which do not exist elsewhere and which must be
managed. The management of financial risks has resulted in an evolution in financial
institutions and has become a crucial element of the financial institutions.
The evolution in financial markets had a progressive influence on both the complexity and the
availability of opportunities. Across the world investors are offered a wide range of investment
opportunities - some with great success. Products to manage the risk of financial investments
are developing rapidly. Volatile and uncertain market conditions continuously force financial
market participants, including banks, to hedge their portfolios and to become more innovative.
The risks faced by financial institutions are not constant and they are ever changing. Banks
need to become pro-active in terms of how they manage their risk profiles.
5.2 DEFINITION OF RISK MANAGEMENT
The concept of risk management was introduced in America during the early 1950s. However,
despite growth of professionalism in the risk management field over a period approaching 60
years, it has become increasingly obvious to practitioners that there is no clear understanding
of what the term definitively means. In fact, it is often said that if you asked six individual
practitioners for a definition of risk and risk management then you would get six different
answers, each probably sufficient for the individual’s business needs and available skills level.
There is a difference between risk management and risk control. Risk control is the core
activity of a risk programme whereas management attempts to take matters further than just
trying to stop a particular incident from happening. Risk management includes aspects of
funding as well as insurance and emergency planning. However this has not always been
83
Page | 84
universally understood and it is still common to find companies undertaking a fire survey and
calling it risk management.
Risk management includes all risk types, and not only pure risks.
The primary need for a risk management standard is to ensure that when the term is used all
practitioners are talking about the same thing. There is a need to get away from the situation
where risk management can mean anything from a fire and security survey to a health and
safety audit or from currency exposure considerations to the long-term implications of
developing new product lines. Although the standard will not actually be able to identify risks,
it will put into place a common and systematic method of analysing risks that are identified
and ensure that the same method is used.
This will greatly assist with the prioritisation process which is often required to ensure the
efficient use of available funds. The standard will be just what it says - a standard approach
to risk management so that everyone in the field knows exactly what we are talking about and
what our terminology actually means.
Effective judgement is crucial to design a risk management system for a particular institution.
No system and no amount of internal control will prevent losses if there is poor judgement on
which business decisions are based. Risk management practices and procedures are
different between financial institutions for a number of reasons. One is that different lines of
business give rise to different needs for risk management. A second reason is that attitudes
towards particular types of risk, and thus the incentive for risk management, may vary across
institutions. A third reason for differences in risk management practices stems from the nature
and source of regulatory control. Where financial institutions are forced to comply with various
reporting guidelines and meet certain externally imposed prudential standards, the choice of
a risk management system is affected. Finally, financial sophistication, perceptions and the
ability to implement risk management procedures vary across institutions. In this respect, the
size and the type of operations are commonly perceived as important factors.
The rules and guidelines set by regulatory authorities influence the risk management practices
adopted by institutions. In this regard, the risk based capital adequacy guidelines play an
important role, but only in the area of linking capital requirements to banking risk.
84
Page | 85
The management of risks in the banking industry has come a long way from the era of
guaranteed margins (fixed interest rates) and basic credit evaluations. Risk management has
become a highly sophisticated field of financial engineering that takes cognisance of local and
international interest and exchange rate fluctuations, global capital flows, monetary policy
goals, personal and corporate financial information and technological innovation.
Risk management systems and procedures should be an integrated process to manage risk
across all risk categories in a bank. Another feature of an effective risk management system
is that it should identify, measure and aggregate all risks on a consistent basis as well as
taking all correlations and interrelationships into account. Such a system would therefore
reflect the bank’s exposure to any given risk factor at any time.
At its core, a bank is an enterprise that packages risk for profit. The more risk assumed, the
greater the potential for profit (or loss). The proper measurement of risk embodied in a
portfolio is the key ingredient necessary to ensure the efficient allocation of capital. While risk
measurement focuses on strategies to prevent phenomenal losses, risk management uses
risk related information to understand the business and to pro-actively manage financial
exposures.
Risk optimisation more accurately determines what types and combinations of risk to accept,
what the rewards for such risk should be and how to price a product accordingly. Financial
risk management is a process that attempts to achieve the optimum balance between risk (the
cost of capital) and return (capital reward).
With this objective in mind, the financial risk management process comprises the activities of
risk measurement, return measurement and capital allocation.
Organisations which implement risk management procedures for the sake of satisfying
regulatory requirements lose sight of the real value of effective risk management. Regulation
is sending a clear message to banks. Risks are inherent in the business, managing them in
a sound and prudent manner is not only the responsible thing to do but, if carried out correctly,
can give a bank the edge in a rapidly changing and competitive environment.
5.3 RISK MANAGEMENT PROCESS

85
Page | 86
Effective planning and good judgement are very important before a risk management system
is incorporated. It is important to have a clear definition of what risks a financial institution is
exposed to before designing a risk management system. It is not sufficient to only understand
what is meant by the risk concept, but managers also have to understand how risk should be
managed because it threatens the continued existence of any going concern. If it is accepted
that risk must be managed, where does it start? There are different levels in an organisation
where risk management takes place.
Key questions in the risk management process focuses on:
• the different levels of control in an organisation

• at what level should risk be managed in an organisation
There are different decision-making levels in an organisation, including banks. The strategic
management process consists of various objectives and strategies. The question to be
answered is, where does risk management fit in?
To ensure that risk management supports the long-term overall objectives of the business, it
should be controlled at the highest managerial level. Decisions taken at the strategic or middle
management level should be executed at the operational level in order to ensure the effective
implementation of the risk management strategy.
Risk management is complex and its complexity is influenced by various factors. Due to the
complexity of risk management, it has to be analysed and implemented in a structured and
systematic manner. Although the risk management process may differ from one organisation
to the next and may be different for different types of risk, certain steps are fundamental to
this process and should therefore always be present in one form or another.
5.3.1 Simple Risk Management Process
In order to effectively manage risk, a systematic approach involving five different steps should
be used. The analysis will focus primarily on risk management processes in banks.
86
Page | 87
1 Identify risk
2 Evaluate risk
4 Implement and
monitor 3 Determine strategy
Figure 6.1: Simple Risk management process
In order to identify risks, it is essential for management to understand the organisation’s key
risk profiles. Depending on the size and type of an organisation, risks will vary and some risks
will be more applicable than others. The identification of risks in an investment bank will be
different to that of a commercial bank which is mostly involved in lending and borrowing
operations. An investment bank will, for example, be more exposed to market risks compared
to credit risk because they are mostly involved in trading operations.
The risk management process must take account of the organisation’s long-term business
strategy and goals. The risk management process also has different time dimensions which
complicates the identification of risks, especially long-term risks. Organisations should have
a time frame to identify risk exposures.
Identifying the types of exposures may take place in the medium to long-term, although new
exposures may be identified in the day-to-day risk management process. The risk structure
of an organisation is not constant and it is important to incorporate a flexible risk management
system to take account of new developments.
Once the different risk parameters have been identified, it is important to evaluate the potential
87
Page | 88
impact it might have on the bank’s financial position.
Projections must also be carried out in order to determine the possible future risk position of
the bank. “What if” analyses could be performed to determine which factors will have a
material influence on the net interest income of the bank in the future.
These decisions are usually of a short- to medium-term nature, and have to do with
establishing or quantifying the bank’s current risk position. During this phase risk
quantification has to be done by using certain techniques.
Step 3: Strategy
Once risks have been identified, a well formulated strategy to minimise the negative
consequence/s of the perceived risks needs to be established. A well formulated strategy is
important to ensure proper implementation of risk management decisions. The strategy
should guide the implementation process. If the strategy is wrong, then the implementation
will produce insufficient results.
Step 4: Implementation
Once risks have been identified and evaluated, the practical problem of implementing a policy
to achieve desired results becomes paramount.
Banking institutions manage their risk exposures in a number of different ways.
One approach is to take offsetting positions. For example, a foreign currency loan matched
by a foreign currency deposit eliminates currency risk by setting two equal and opposite
foreign currency exposures against each other.
Another approach to risk management is to use specialised financial instruments to transfer

risk from one party to another. Use of derivative (product’s value determined or derived
from the current market value - an interest rate derivatives’ value will be derived from the
current interest rate level) products such as options, swaps and futures contracts enables a
financial institution to fine tune its exposures to various financial risks by ‘laying them off’ to
88
Page | 89
other players in the marketplace who are willing to bear this risk for a fee. A more detailed
explanation of these derivative instruments will be outlined in Chapter 12.
A third approach is to self-insure and therefore attempt to incorporate an appropriate risk

premium in the price of the product. Credit risk arising from loan facilities to large customers
is generally borne by the issuing bank.
A simple but effective means of limiting exposure to credit risk is to set limits on the extension
of credit to particular customers or group of customers.
Step 5: Feedback
If the incorrect strategy has been chosen, corrective measures should be taken and once all
the steps have been completed, the process should then start again.
The key steps in any risk management programme follow each other in a logical order. Once
risks have been identified, they must be quantified and evaluated. If the current exposures
are known, management then formulates a strategy to minimise losses and to optimise return.
The strategy must then be implemented and monitored to ensure that its objectives are
realised.
5.3.2 RISK MANAGEMENT PROCESS ACCORGING TO ISO 31000
Figure 3.2 describes the Enterprise Risk Management (ERM) process according to the ISO
31000 AS\NZS 4360 model
89
Page | 90
Figure 5.2: Risk management process according to ISO 31000 model
The process adopted in ERM is discussed below;
90
Page | 91
Figure 5.3: The Process approach to ERM
Step 1: Business Analysis
Analysis of the business is the first stage in the overall six-stage process of enterprise risk
management. Analysis of the business is concerned with gaining an understanding of;
1. the background to the business as a whole, in general terms, and

2. the specific business activity, process or project, forming the subject of risk
management study.
It provides a basic foundation for everything that follows. How well this processes completed
will determine the quality of the remainder of the risk management process. The objective of
this first stage is to discover timely and accurate data. However, its degree of usefulness will
depend on its relevance breath, depth and currency, in terms of providing sufficient insights to
create a prompt tool with substance and teeth.
91
Page | 92
It is not uncommon for representatives of the business under examination to either regard
activities such as investigation, research or diagnosis as expensive and wasteful, or be
frustrated by the time required to carry them out. Typically these representatives fail to recall
that their own knowledge has been built up over months or even years. But even when time
is of the essence, discipline and rigour needs to be applied so that important issues are not
missed or overlooked. The three most important aspects of risk management are preparation,
preparation and preparation.
To manage risk an organisation needs to know what risks it is facing and then to evaluate
them. Identifying risk is the first step in building the organisation’s risk profile. There is no
single right way to document an organisation’s risk profile. All risk management process
frameworks state a need to identify risk events (upside and downside) at the outset of
activities. Identifying risks requires undertaking two activities:
1. thinking trough and recognising the source of the risk and opportunities (upside
risks) and
2. searching out and identifying both the risks and opportunities.
What makes the identification process interesting is that the market place is in a constant
flux due to macro and market forces.
However it is of utmost importance that it should be documented. Risk identification can be

separated into two distinct phases.
Initial risk identification. For an organisation that has not previously identified it’s risk in a
structured way.
Continuous risk identification. To identify new risks, changes in existing risk, or risk that
ceases to exist.
In both cases risk should be related to objectives. Risk can only be assessed and prioritised
in relation to objectives.
When a risk is identified it may be relevant to more than one of the organisation’s objectives
– and the impact may vary in relationship to the objectives. In stating risk, care should be
92
Page | 93
taken to avoid stating impacts which may arise as being the risk themselves, and to avoid
stating risks which do not impact on objectives. Care should be taken to avoid defining risks
with statements which are simply the converse of the objectives.
NB. All risk, once identified, should be assigned to a risk owner who has the responsibility
for ensuring that the risk is managed and monitored over time.
A risk owner should have sufficient authority to ensure that the risk is effectively managed.
Two most common approaches in identifying risk:
Commissioning a risk review: A designated team is established to consider all the

operations and activities of the operations in relation to its objectives and to identify the
associated risks.
Risk self-assessment: An approach by which each level and part of the organisation is
invited to review its activities and to contribute its diagnosis of the risks it faces. Not mutually
exclusive.
The purpose of risk evaluation is to make decisions, based on outcomes of the risk analysis,
about which risks (strategies, processes, procedures, activities) are acceptable, the treatment
required and the treatment priorities.
This stage is central to the understanding of the likely risk exposure or potential opportunity
arising from a business activity. It involves the important step of understanding what
relationship is between risks and opportunities so that when they are combined together their
true effect is portrayed.
The following are some tools that can be used in this stage of the risk management process.
Scenario planning an important tool.
Risk analysis allows you to compare various strategies, goals, objectives, procedures and
process with the level of risk found during each scenario.
Context important again.
93
Page | 94
Choice between options – higher potential losses may be associated with higher gains – but
the choice will depend on the context.
Step 3: Risk Analysis
Three principles for analysing risk:

1. Ensure that there is a clearly structured process in which both likelihood and
impact are considered for each risk.
2. Record the assessment of risk in such a way which facilitates monitoring and
the identification of risk priorities.
3. Be clear about the differences between inherent and residual risk.
The risk assessment needs to be done by evaluating both the likelihood of the risk being
realised, and the impact if the risk realised.
Figure 5.4 Likelihood and impact of risk

94
Page | 95
When the assessment is compared to the risk appetite the extent of action becomes clear.
Not the absolute values of assessed risk which is important, rather whether or not the risk is
regarded as tolerable. More likely that a level of exposure which is acceptable can be defined
in terms of both a tolerable impact if a risk is realised, and tolerable frequency of the impact.
It is against this that the residual risk has to be compared to decide whether or not further
action is required.
Thinking about risk frequently focuses on residual risk (i.e. the risk after control has been
applied – assuming control is effective – will be the actual exposure of the organisation). Care
should be taken to capture information about inherent risk. If this is not done the organisation
will not know what its exposure will be if control should fail. If inherent risk is within the risk
appetite, resources may not need to be expanded on controlling that risk – over control. Once
risks have been assessed, the risk priorities for the organisation will emerge. The less
acceptable the exposure in respect of a risk, the higher the priority which should be given to
addressing it. The specific risk priorities will change over time as specific risks are addressed
and prioritisation consequently changes.
Step 4: Risk Planning
The plan stage uses all the preceding risk management stages/efforts and specific action
plans to address the risk and opportunities identified to secure the business objectives.
Ensuring these plans are prepared, considered, refined and implemented is the purpose of
this stage. If risk management is to be effective this stage is essential. To spend time, effort
and energy in identifying and addressing the potential risks and opportunities and not to plan
responses to them would be a poor use of resources. This is where competitive advantage is
borne rather than just being envisaged.
Step 5: Risk Management
This stage is critical to the successful implementation of the risk management process as a
whole. All risk management process maps state a need to ensure risk responses to identified
risks are implemented and implementation is proactively managed. Risk management
requires undertaking four key activities:
1. Reacting to early warning indicators to forewarn managers of the need to make risk
95
Page | 96
management interventions.
2. Registering changes in the details of the risk and opportunities on the risk register.
3. Reviewing whether the risk actionees and managers are implementing the responses
for which they are responsible.
4. Reporting on the success or otherwise of the risk and opportunity management actions
and the changes in the overall risk profile.
Step 6: Implementation
Implementation entails ensuring that the right direction towards satisfying the goals of the
organisation a met. It entails completion of the deliverables, commonly describing the findings
in a report and presentation of the results expected. The key to ERM is to ensure that;
1. It has added value to the overall business performance

2. There are demonstrable benefits to spending money on risk management
Thus leading to the Monitoring and review what has been implemented.
Therefore management of risk has to be reviewed and reported on for two reasons:
• To monitor whether or not the risk profile is changing
• To gain assurance that risk management is effective, and to identify when further
action is necessary
Review and report processes should be in place to:

1. Review whether the risk still exist
2. Whether new risk has arisen
3. Whether the likelihood and impact of risk has changed
4. Changes which adjust risk priorities
Deliver assurance on the effectiveness of control.
Ultimately to see that the, strategic, operational and tactical objectives of the organisation are
met.
96
Page | 97
5.4 FEATURES OF RISK MANAGEMENT SYSTEMS
5.4.1 Forward looking
Most financial institutions and corporations use measures based on historical information to
guide their risk management practices.
To successfully measure and manage risk, it is important to consider what might happen in
the future. An effective risk management system should value a bank’s different portfolios
under different scenarios against one or more future reference points.
The system should measure present and possible future risks by keeping track of events that
affect the bank’s portfolio over a specified time period. It should also manipulate or forecast
risk factors to determine their impact on a bank’s operations. The forward looking process
helps to calculate how much capital is needed to cover the banks operations and to optimise
on the use of capital.
6.4.2 Identify efficient portfolios
Risk
Inefficient
portfolio
Efficient
+ portfolio
Reward
Figure 5.5: Capital allocation and efficient portfolios
97
Page | 98
Using optimisation techniques, a bank can compress complex portfolios for analysing
purposes and construct an efficient portfolio frontier to yield the highest possible expected
return for a given level of risk.
The graph illustrates the efficient portfolio’s approach of risk management emphasising the
need to have sufficient capital to cover a bank’s operations.
Also, instead of focusing solely on minimising risk, the risk management system determines
the trade-off between risk and reward optimal capital allocations. If capital is not allocated
efficiently and in a cost effective manner, then it will be reflected in the financial statements
and regulators will ask questions. A bank that optimises its capital will therefore be more
financially sound than banks not operating in such a manner.
5.4.3. Perform stress testing analysis
The risk management system should be able to perform a stress testing analysis. Stress
testing involves “what-if” scenarios, for example, how would the bank’s financial position
change if interest rates had to move higher or if the local currency exchange rate weakens.
The stress testing exercise must be done in terms of the existing portfolios of a bank.
5.4.4 Effective process controls
With a large system that relies upon many computers, systems and network links to be
operational to execute a daily risk management process successfully, it is highly likely that
something will go wrong. The risk management system is computer driven so that the system
is reliant on correct data inputs for processing needs.
The risk management system should be able to update and manage the complex stream of
information it receives in order to use data in the system reliably. The system should be able
to interface various processes. Problems in the system should be corrected easily and the
system restarted timeously. If the only recourse in the event of a system failure is to restart
the process, the day’s results might be irretrievably lost. The system should also provide
management with reliable reports.
98
Page | 99
5.5 PROACTIVE RISK MANAGEMENT
The increasing complexity of financial instruments, escalating market volatility, pressure on

credit lines, desire to avoid losses and intense competition are driving financial institutions to
re-examine the way they manage risk. The benefits of implementing a risk management
system extend far beyond regulatory compliance. By assuming a proactive risk management
view, financial institutions can allocate capital more efficiently. Risk management is more
valuable when it is proactive.
5.6 STAKEHOLDERS IN THE RISK MANAGEMENT PROCESS
A key issue in managing risk in financial institutions is the identification of the different interest
groups. In principle, there are at least five groups of stakeholders in a financial firm whose
interests can be affected through risk exposure: employees, depositors/creditors, loan
customers, owners and governments. Ideally, management decisions should be taken in the
interests of shareholders; exposure to risk, in particular, should be directed to the achievement
of results valued by shareholders. In practice, bank exposure management is often more
directed towards the interests of depositors than that of shareholders.
This reflects the pressure placed on financial institutions by regulators, whose statutory
responsibilities centre upon the protection of depositors, but also the legitimate fear of a crisis
of confidence among depositors and the destructive effects of a “run on a bank”.
By its nature banking operations involve risk taking. Various classes of risk can be
distinguished such as operational and control risks, liquidity risks, interest rate risks, currency
risks, credit risks, investment risks, market- or price risk and capital risks. A prerequisite for
sound banking is that these risks are assessed properly, and managed prudently. Risk
management is first and foremost a responsibility of bank management, and bank regulation
aims to improve the management of risks by banks. A bank's success or failure depends to
a great extent on the experience, capability, judgement and integrity of its board of directors
and senior executives. Very often when a bank fails it is due at least in part to weaknesses at
these levels.
Central banks emphasise risk management as the basis for supervision of banks to a
considerably greater extent than was previously the case.
99
Page | 100
Supervisors therefore basically review the risk management systems of banks, and satisfy
themselves that the risk managers within the institutions have proper procedures and
information to determine and manage the various risks to which each institution is exposed.
To this end various returns have to be completed and submitted to the regulating authority
which consists of information related to the balance sheet, off-balance sheet activities, income
statement, capital adequacy and large exposures. These returns are deemed necessary to
unbundle the risks, focus on individual risks, components of risks and sensitivity to various
risks, and also act as a catalyst to involve management and the board of directors of each
bank in the process of risk management.
Bank supervision departments of central banks identify management as a key player in the
supervision field. The management team of a bank is the single most important factor
determining the success of a particular institution. When the partnership between and the
responsibilities of the key players are considered, the importance of the individuals comprising
management becomes apparent. The managing director leads the process, but relies on the
management and the personnel in the organisation.
In any bank the risk management process starts when a prospective employee is screened
for employment, or for promotion to a senior position, to ensure that only “fit and proper” people
are employed to perform risk management tasks.
Management is appointed by the board of directors, which delegates the powers and
responsibilities required to adhere to and implement the policies laid down by the board of
directors.
To enable the board of directors to decide on an appropriate policy, it is the responsibility of

management to formulate policy proposals for consideration by the board. It is imperative that
the members of management are also “fit and proper” persons capable of fulfilling their
responsibilities. On the one hand, the “fit and proper” concept encompasses appropriate
ethical standards such as integrity, with which management is required to comply. By
implication, past behaviour involving fraud, gross negligence or misuse of a position of trust
could indicate that a person is not “fit and proper” to be appointed as a member of the
management team of a bank. On the other hand, the phrase refers inter alia to the appropriate
knowledge, skills, experience and judgement that a member of the management of a bank is
required to possess.
100
Page | 101
The management team is also responsible for appointing the internal auditors, who assist
management in ensuring that there is compliance with laid-down policies and procedures. It
is, however, also important that the internal auditors maintain a certain measure of
independence in the sense that they should be able to gain direct access to the board of
directors via the audit committee, if the need should arise. Management is responsible for the
day-to-day management of the affairs of a bank. In the course thereof, management performs
detailed risk management related tasks and, accordingly, requires a high degree of
competence in identifying and managing the different risks to which the bank is exposed.
Management is a vital cog in the system of checks and balances that is in place to ensure that
the concepts of accountability and risk management can be applied effectively.
The board of directors is responsible for setting policy. Management, in turn, implements
the approved policies and makes policy proposals.
The audit committee assists the board and management by monitoring the implementation
of and compliance with laid-down policies and internal controls to ensure, inter alia, that there
is proper disclosure by management.
In contrast, the external auditors evaluate the effectiveness of risk management policies and
controls, and compliance with such policies and controls.
The investing public should be aware of the financial standing of a bank before depositing
money with the institution by understanding who is taking the risks by applying prudent
investment procedures and criteria. They are supported in this role by the media, financial
analysts and rating agencies, which analyse and comment on the financial position of banks.
Rating agencies analyse banks according to various criteria and accordingly rate banks
according to their assessments.
The supervisory authority is responsible for creating an environment that will facilitate the
optimisation of the quality and effectiveness of risk management in the banking system.
In addition to these key players the shareholders, as ultimate financial stakeholders in a bank,
are subject to the discipline of the market. It is important that they play a constructive and
active role in a bank. It is the shareholders who ultimately decide on board appointments and,
101
Page | 102
through the board, decide indirectly on the appointment of management, as well as internal
and external auditors.
Bank regulation and supervision is focused on effective risk management within each banking
institution. However, the bank supervision department alone cannot guarantee the safety,
solvability or profitability of any bank.
This is and always will be the responsibility of the board of directors and the management of
each bank.
 Question time
1. Define risk management.
2. List and explain the simple risk management process with the use of a diagram.
3. List and explain each step of the ISO3 1000 risk management process with the use
of a diagram.
4. Define proactive risk management and why it is important.
5. Describe the risk management risk analysis process. Why is it used?
6. Discuss the mitigating strategies that can be adopted to reduce risk.
7. List and discuss the stakeholders and their roles in the risk management process.
8. Describe the risk management risk analysis process. Why is it used?
102
Page | 103
THE ASSIGNMENT
The individual assignment consists of the below case study and must
be complete and submitted on UJ’s Blackboard system. This will be
discussed in class as to what the requirements will be.
THE DUE DATE FOR THIS ASSIGNMENT:
The link for submission will open on the date the lectures start. The
last date for access for the online completion of the assignment is:
………………………………………………… at 11:59 midnight.
Late assignments.
uLink is set up in such a way that students that miss the due date,
can attempt to complete the assignment after the due date BUT the
system will deduct 10% per day for late submission.
This means that 10 days after the due date, you get 0% for the
assignment.
NO RESUBMISSIONS !!!!
THE SEMESTER RESULT WILL BE CALCULATED AS FOLLOWS:

❖ 10% for class attendance; and
❖ 15% for in-class assessment
❖ 75% Blackboard assignment.
Risk Management Assignment
Case Study
Council to take over failed housing projects.
103
Page | 104
The cThekwini Municipality will soon take over six incomplete housing department projects
that failed because of the collapse of Section 21 companies contracted to do the work. Many
of the houses at the developments are incomplete, in a state of disrepair or simply not up to
standard. All of the six projects are near the Inanda area in the north of the municipality.
A report presented to the municipality’s executive committee yesterday said that the project
at Mshayazane (1000 houses), two projects at Richmond Farm (5000 houses) and projects
at Matanfana (324 houses), Emaplazini (1178 houses) and Amatikwe (778 houses) were
being cancelled by the housing department because of the collapse of community-based
Section 21 companies. The projects were started in the late 1980s and continued into the
early 1990s; when the housing department entered into agreements with community based
private developers.
Paralysed
“the initiatives uplifted communities in terms of skills and resources, but also paralysed the
projects as most were not completed successfully and standards were below requirements,”
the report said. Residents and ward councillors have complained to the municipality and
these were forwarded to the housing department and the companies, “but no major
intervention was implemented”.
“About 80 percent of these communities have not been given any form of tenure. The
housing unit is constantly finding itself having to provide assistance at its cost…During heavy
storms, these projects have been affected owing to a lack of proper control of storm water,”
the report said, citing major problems with infrastructure, top structures and allocations.
Housing committee chairperson and ANC executive committee member Nigel Gumede said
it was a positive move that the municipality was taking responsibility for the projects.
Repackaging the projects would cost about R1,2 million, to be paid by the department.
Thereafter, the municipality would do the remaining work and apply to the department for
subsidies.
Source (http://www.iol.co.za/news/south-africa/council-to-take-over-failed-housing-projects-
1_423964)
104
Page | 105
1 Risk management is a systematic process of identifying, analysing, and responding
to risk.
Using the information in the case study above, Compile a Risk Register showing:
A Risk Management plan for the eThekwini Municipality by
1.1 Identifying the risks

1.2 Analysing the risks using a risk matrix
1.3 Evaluating the top ten risks
1.4 On the Risk register discuss the risk response strategies you would recommend to the
municipality to mitigate the risks. This to be done for only the top ten risks.
105
Page | 106
Test Format
❖ Class Test - 40 marks
Multiple Choice Questions (10 marks)
Ten questions
True False Questions (10 marks)
Ten questions
Short Questions (20 marks)
Four 5 mark questions
Typical class Test
A. Multiple Choice Questions [15]
1. As part of the ISO 31000 risk management process, ‘monitoring and review’ is best
thought of as which of the following?
A. An extra stage.
B. A feedback loop.
C. Part of risk assessment.
2. The consequence of a failure to identify all significant risks that an organisation faces is
likely to be
1. business objectives may not be achieved.
2. operating costs may increase.
3. opportunities may be overlooked.
4. Risks will be better identified in future.
A. 1 and 2.
B. 1, 3 and 4.
C. 1, 2 and 3.
3. Risk Management includes all of the following processes except:

A. Risk Monitoring and Control
B. Risk Identification
C. Risk Avoidance
D. Risk Response Planning
E. Risk Management Planning
106
Page | 107
4. A Pure Risk is defined as:
A. an event that offers no opportunity for financial gain

B. the chance a loss will occur
C. a diversifiable risk
D. a contingency that increases the chance of a loss
5. Which of the following is not an example of a Catastrophic Loss Event?
A. Hurricane Katrina
B. Death of Michael Jackson
C. September 11, 2001 terror attacks
D. 2004 Tsunami in the Indian Ocean
6. Defective electrical wiring that may lead to a fire is an example of a:
A. Pure risk
B. Non-diversifiable risk
C. Speculative risk
D. Physical hazard
7. When the labours become more expansive due to increase in government mandated
minimum wage. Which type of risk will be face by the companies?
A. Production Risk
B. Market Risk
C. Price Risk
D. Economic Condition risk
8. On which base company selected the risk technique?
A. Minimization the cost

B. Maximization of profit
C. To secure the company
D. Both A and C
9. Costs associated with risk management are:
A. Insurance costs
B. Self-funding costs risk control expenditure
C. Administrative expenditure
D. All of the above
107
Page | 108
For the following Questions answer which is incorrect.
10. Today’s organisations are concerned about:
A. Risk Management
B. Governance
C. Employee wellbeing
D. Control
E. Assurance
11. Major stakeholders in RM are the following;
A. Shareholders
B. Media
C. Employees
D. Customers
E. Government
12. The following are financial risks;
A. Credit risk
B. Defamation risk
C. Investment risk
D. Interest rate risk
E. Capital risk
13. All the following are direct losses except:
A. A house is burglarized;
B. A store loses R200,000 in sales because a fire closes it down for two weeks
C. A corporation must pay R1 million in ransom when its CEO is kidnapped
D. An delivery truck needs R15,000 in repairs after a collision
14. The structure of the financial industry consists of:
A. Banking and credit

B. Insurance
C. Investment and retirement
D. All of the above
E. None of the above
15. Financial intermediaries are involved for the following reasons:
A. Government growth
B. Profit motive pooling of funds
C. Risk reduction
D. Dealing in security instruments.
E. All of the above
108
Page | 109
B. True or False Questions [10]
Answer true or false for each of the following statements.
1. If something is very risky then it must also be very difficult to do.

2. Risk is only to do with industry and accidents at work.
3. Communication is not an important function of RM.
4. The ISO 31000 Risk model deal with a process approach to RM.
5. RM is important as the underlying principle is to create value for its shareholders.
6. Risk management is about dealing with the risks identified and consists of various
measures and techniques to ensure that we can survive the risks. Risk management is
aimed at reducing the frequency of risk and also at minimising the effects of the risk.
7. Risk avoidance entails taking alternative action to avoid a potential peril before exposure
to the risk.
8. A peril is the cause of loss or a loss event.
9. A hazard relates to the environment surrounding the cause of loss.
10. Risk is caused by uncertainty.
C. Short Questions [20]
1. List 5 Macro Environmental factors that affects RM. (5)

2. How should a risk matrix look like for the ISO 31000 ERM model? (Show this in a diagram
format). (5)
3. Draw a diagram showing the processing for a risk model. (All flow lines must be shown).
(5)
4. List the different risks and give an example of each. (end-economic risk, financial risk,
pure risk). (5)
D. Case Study [5]
Foods Company is a cold storage warehouse, storing and delivering frozen foods for
supermarkets. Established in 1999, Foods Company employs 30 people.
• The warehouse has a good sprinkler system with a regular maintenance programme in
place
• Goods inwards are stored on pallets and stacked in chiller units or freezer compartments
• Temperatures in the cold storage ranges from -5 degrees Celsius in the chiller units to -30
degrees Celsius in the freezer units.
An accident book is kept on site. Normally there are only a few minor injuries recorded but
the last month has seen 2 employees go off ill and subsequently diagnosed with asthma. A
potential cause is the dry atmosphere when working in extreme cold temperatures increases
the likelihood of employees showing signs of asthma.
109
Page | 110
A bi-weekly meeting takes place on site between the site manager and the health and safety
manager to discuss risk management matters. The agenda for today’s meeting is risk
assessment with a review of health and safety hazards and the matters discussed are
restricted to operational risks.
Questions
1. Which one of the following would help reduce the level of risk when working in the
warehouse?
A. Training employees in working in cold conditions.
B. Increasing the frequency of meetings.
C. Regular reviews of the accident log.
2. What corrective action could the two managers consider to reduce the likelihood of more
employees going off sick with asthmatic conditions?
A. Reduce the length of time employees are exposed to cold conditions by job rotation.
B. Increase training and the supervision of staff wearing protective clothing.
C. Provide employees with a booklet on keeping warm.
3. The health and safety manager confirms the company has insurance to compensate
employees who are injured or suffer ill-health at work.
Which statement best explains why the company has this insurance?
A. The company has 25 or more employees.
B. Insurance to cover the payment of compensation to injured employees is a compulsory
class of insurance.
C. The employees who are away sick may seek compensation from Foods Company.
4. To ensure employees are complying with health and safety standards in the warehouse,
which directive controls could be instigated?
1. Protective suits are available for employees to wear to provide extra warmth in the freezer
units.
2. Protective suits are provided and employees have to follow the guidelines on when to
wear the suits.
3. There is a requirement on employees to check that protective suits are in good condition.
4. Employees are trained to recognise the symptoms of hypothermia.
A. 1 and 2.
B. 1 and 4.
C. 2 and 3.
5. Which of the following is relevant to the agenda for today’s meeting?

110
Page | 111
A. The company has changed its transportation supplier and delivery using the new
company starts next month.
B. The company has a new supplier of ice-cream products and it is anticipated the product
will be in great demand by its customers.
C. The company has updated its health and safety risk assessment and new safety rules
and procedures are being introduced.
Exam Format
❖ Exam 2 hours - 100 marks
Multiple Choice Questions (20 marks)
Ten questions
True False Questions (15 marks)
Fifteen questions
Short Questions (25 marks)
Five 5 mark questions
Long Questions (40 marks)
Two questions of 20 marks each
The format for the exam will be similar to the class test but below
are examples of long questions.
The following questions need to be discussed.

1. Discuss the Risk Management process using the ISO 31000 model and explain what
needs to be done at each step in this process and what should be considered in each
step. (25)
2. Using a matrix discuss how this can be used to analyse risk and the different basic
techniques that can be used for control. (25)
3. Discuss the main macro factors influencing/affecting Risk Management currently in
South Africa. Hint How? (25)
111

Module Guide Risk Management Cep - 2021

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Module Guide Risk Management Cep - 2021

Uploaded by

Copyright:

Available Formats

College of Business and Economics

Department of Business Management

Continuing Education Programmes

Copyright © University of Johannesburg, South Africa

© All rights reserved.

Section A: ADMINISTRATIVE INFORMATION ..................................................................................................... 7

Department of Business Management: Strategic viewpoint statement ........................................................... 7

Equality clause ................................................................................................................................................... 7

Contact information ...................................................................................................................................... 8

Guidelines for student behaviour.................................................................................................................. 8

Policies and procedures............................................................................................................................... 10

Section B: Programme and module information............................................................................................. 12

Composition of the qualification ................................................................................................................. 12

Section C: SUBJECT INFORMATION ................................................................................................................. 13

FACILITATION OF LEARNING AND ASSESSMENT ......................................................................................... 13

Action words lecturers often use ........................................................................................................... 13

Module name .............................................................................................................................................. 15

Module NQF level ........................................................................................................................................ 15

Assessment schedule/opportunities ............................................................................................................... 16

Purpose of this module ............................................................................................................................... 16

Module outcomes ....................................................................................................................................... 17

STUDY MATERIAL ...................................................................................................................................... 18

LEARNING UNIT 1: AN INTRODUCTION TO RISK MANAGEMENT ........................................... 19

INTRODUCTION TO RISK MANAGEMENT ........................................................................................... 20

1.1 RISK PERCEPTIONS ...................................................................................................................... 20

1.2 DEFINITION OF RISK ..................................................................................................................... 20

1.3 UNCERTAINTY AND RISK ............................................................................................................ 22

1.4.1 End-economic risks ................................................................................................................... 24

1.4.2 Financial risks ............................................................................................................................. 24

1.4.3 Pure risks ...................................................................................................................................... 25

1.5 NATURE OF PURE RISKS ............................................................................................................... 28

1.6 CLASSES OF PURE RISK ................................................................................................................ 31

1.7 THE DIFFERENCE BETWEEN FINANCIAL AND NON-FINANCIAL RISKS ....................... 32

1.7.1 Financial Risks .......................................................................................................................... 32

1.7.2 Types of Financial Risks .......................................................................................................... 33

1.7.3 Non-Financial Risks (also known as pure risk) .................................................................... 34

1.8 RISK MANAGEMENT OF PURE RISKS ........................................................................................ 35

1.9 COSTS ASSOCIATED WITH RISK MANAGEMENT ................................................................... 37

1.10 THE INFLUENCE OF RISK PREFERENCES ............................................................................. 38

1.11 THE RELATIONSHIP BETWEEN RISK AND TIME .................................................................. 38

1.12 PURE RISK MANAGEMENT PROCESS...................................................................................... 39

Step 1: Risk Identification ........................................................................................................................ 39

Step 2: Risk Evaluation ............................................................................................................................ 40

Step 3: Risk Control.................................................................................................................................. 41

Step 4: Risk Financing ............................................................................................................................. 42

1.13 MEASUREMENT OF RISK............................................................................................................. 43

2.1 BASIC NATURE OF FINANCIAL SYSTEM ................................................................................ 47

2.2 THE ROLE OF MARKETS IN THE ECONOMIC SYSTEM ....................................................... 48

2.2.1 Flow of funds in the financial system ............................................................................... 49

2.3 THE FINANCIAL MARKETS AND THE FINANCIAL SYSTEM ............................................... 51

2.4 TYPES OF FINANCIAL MARKETS WITHIN THE FINANCIAL SYSTEM.............................. 52

2.5 EFFICIENCY OF FINANCIAL MARKETS .................................................................................. 54

2.6 MAINTAINING A FAIR PRICE ...................................................................................................... 55

2.7 ROLE OF CENTRAL BANKS IN FINANCIAL MARKETS ....................................................... 55

LEARNING UNIT 3: DIFFERENT KINDS OF FINANCIAL RISK .................................................... 59

3.1.1 Credit risk ................................................................................................................................. 60

3.1.2 Liquidity risk ............................................................................................................................ 61

3.1.3 Market risk ................................................................................................................................ 62

3.1.4 Operational risk ....................................................................................................................... 64

3.1.5 Legal and reputation risk ...................................................................................................... 65

3.1.6 Capital or solvency risk ........................................................................................................ 65

3.1.7 Purchasing power risk .......................................................................................................... 67

LEARNING UNIT 4: FACTORS INFLUENCING RISK MANAGEMENT ........................................ 69