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Taxonomies of risk and opportunity
Introduction — inspired by Basel
The Basel Accord is a global, voluntary regulatory framework for banks. It encourages risk management framed around three components: credit risk, market risk and operational risk. Whilst such a framework is banking-centric, it inspires generalisation to all types of business, and gives rise to the risk taxonomy described below. Moreover, this in turn inspires the creation of an opportunity taxonomy.
Basel generalisation
All businesses operate within a market and in trading, deal with money. Thus all businesses are exposed to market risks and trading risks. It just so happens that a bank’s market is the money market, and therefore a bank’s market risks are synonymous with its trading risks, see table 1.
Moreover, all businesses have products (or services) and are thereby exposed to product risks. The principal banking product is credit, and therefore its product risks are synonymous with its credit risks.
| Basel risk category |
Generalised risk category |
| Credit risk |
Product risk |
| Market risk |
Market risk |
| Trading risk |
| Table 1: correspondence of Basel credit and market risk categories to generalised risk categories |
There is another categorisation of risk, and that is the origin of the risk source: internal or external. Consider the risk “an organisation is not paid for work performed”. There are many reasons why it is not paid, e.g.:
- its work was of poor quality or otherwise did not fulfil its contractual specifications;
- it performed the work without a contract; and
- it did not invoice the customer.
All these have one thing in common — they are all within the organisation’s control, i.e., the source of risk is internal.
Despite ensuring that all such internally sourced risks are properly mitigated, the organisation still might not be paid — just because the customer is just like that, i.e., the customer just does not pay their bills. The source of risk in this case is external.
Moreover, this is an example of what Basel refers to as a credit risk and in the general case it is a product risk because if it wasn’t for the sale of a product, the risk of non-payment would not have arisen.
Basel refers to the internally sourced risks as operational risks. Thus, since all the risk categories in Table 1 can have internal and external risk sources, there will be operational risks that are associated with product, market and trading risks.
If product risk arises just because the organisation sells a product, it follows that market risk arise because of the market in which the organisation operates, and trading risks arise because money (and other assets) change hands, which need not be because a product is sold or work is performed.
In like vein, there is one other category of risk, that that is simply the risks to which an organisation is exposed merely because it exists. We refer to these as existence risks, for example risks associated with fire and flood.
Risk taxonomy
Putting all this together generates the taxonomy shown in Figure 1.
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CREDIT RISK |
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Primary risk category |
Definition: the risk of loss arising from… |
Associated operational risk: the inadequacy or failure of internal processes, people and systems that results in a risk of… |
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Product risk |
… default by a creditor (which will usually be a customer). |
… doing work and not making a profit. 1 |
| MARKET RISK |
Trading risk |
… changes in trading positions when prices move adversely. |
… the organisation’s money and other assets not being worth as much as they ought. 2 |
| Market risk |
… the market refusing to buy what the organisation has to offer at the price it wishes to sell. |
… being unable to sell what the market wants. 3 |
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Existence risk |
… the fact that the organisation exists 5 |
… spending money unnecessarily. 4 |
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OPERATIONAL RISK |
| Figure 1: A taxonomy of risk |
The table shows that the Basel operational risk category comprises of five risk areas. Thus, this generalised risks taxonomy gives structure to the Basel risk categories.
Want to see some example risks in each category?
Product risk
Project risk is the risk of loss arising from default by a creditor (which will usually be a customer). It can arise when a customer does not pay an invoice that has been properly presented for contracted products and services of adequate quality. The associated operational risk is the inadequacy or failure of internal processes, people and systems that results in a risk of doing work and not making a profit. It is also possible that a customer could ask for their money back or seek some other form of restitution.
- Payment is not received within the prescribed grace time (e.g., 30 days) of presenting a valid invoice.
Associated operational risks
- Invoices are not raised for products or services provided by the organisation under contract to a customer.
- Work is carried out for a customer either prior to contract award or in excess of the limit of liability.
- Quality of the delivered product or service is unacceptable to the client.
- Staff are insufficiently competent to build the product or deliver the service .
- The product does not meet required national/international standards.
- Overheads associated with the product reduce the operational profit to an unacceptable level.
- There are unanticipated costs.
- The organisation is unable to deliver the product or complete the work in the required time.
- The organisation’s technology proves ineffective in allowing it to carry out the contracted work.
- The organisation is unable to deliver its product or service on time.
- The project is under resourced.
Trading risk
Trading risk is the risk of loss arising from changes in trading positions when prices move adversely. It can arise when the organisation incurs losses due to fluctuations in foreign exchange rates, bank charges, interest rates and inflation. The associated operational risk is the inadequacy or failure of internal processes, people and systems that results in a risk of its money and other assets not being worth as much as they ought. For example, if the organisation agreed a price having made a gross error in the foreign exchange conversion.
- Actual payment is less than the Sterling equivalent of that invoiced because of bank charges and exchange rate fluctuations.
- High inflation or changes in the currency system (e.g. £ to €) reduce the organisation’s margins to an unacceptable level.
- Falling interest rates reduce the income contribution from the organisation’s bank accounts.
Associated operational risks
- Prices are agreed either by lack of foresight or error that are not adequately resilient to exchange rate fluctuations and inflation.
- The wrong price is given.
- The organisation makes bad investment decisions.
Market risk
Market risk is the risk of loss arising from the market refusing to buy what the organisation has to offer at the price it wishes to sell. The associated operational risk is the inadequacy or failure of internal processes, people and systems that results in a risk of being unable to sell what the market wants.
- A niche product or service transitions to a commodity offering, lowering prices and increasing competition.
- New regulations, specific to the organisation’s market, arise and have an adverse impact on organisation’s ability to work.
- A collaborative adventure in which the organisation is involved does not turn out to adequately meet the organisation’s objectives.
- The organisation’s business lacks diversity of customers and product/service offerings.
Associated operational risks
- The organisation fails to win revenue earning work and take the opportunities that can lead to such work.
- Having determined the regulations that apply to the organisation’s business (or have chosen them, as is the case with ISO 9001, ISO/IEC 27001 etc.) the organisation fails to establish and maintain compliance.
- The organisation fails to comply with relevant laws.
- The organisation’s website is unavailable or contains errors.
Existence risk
Existence risk is the risk of loss arising from the fact that we exist. The associated operational risk is the inadequacy or failure of internal processes, people and systems that results in a risk of spending money unnecessarily.
- The organisation suffers fire, flood, chemical or other environmental events, whether caused by Acts of God or direct/ indirect human action.
- Balance sheet assets and documents are stolen.
- Information is destroyed, corrupted, altered or undesirably disclosed by external parties.
- The organisation is unable to work due to strikes, war, disease, weather, or other environmental/ extremes.
- Legal action is taken against the organisation.
- Key staff are unable to continue as employees of the organisation due to health or other reasons.
Associated operational risks
- The organisation pays for goods or services that it does not receive.
- The accounting system or bank account is the victim of fraud or error.
- There is unintentional destruction, corruption, alteration and/or disclosure of information by the organisation’s personnel.
Opportunity taxonomy
We can proceed along similar lines to generate a taxonomy for opportunities, see Figure 2. In this case, there are three primary categories of opportunity: the first associated with the products and services that the organisation has to offer, and the second two being associated with general characteristics of all organisations: value and buying power. In each case, opportunities are facilitated either internally or externally. If the opportunity is created by the organisation, it is internally facilitated. If the opportunity is created by another organisation, it is externally facilitated.
| Opportunity category |
Description |
| Product opportunity |
Project opportunity is the opportunity for gain resulting from the organisation having products (or services) to sell (products for sale. Having something to sell provides the organisation with the opportunity to create and reinforce its market presence. In turn, this leads to a variety of externally generated sales and marketing opportunities. Customers take an interest in what the organisation has for sale and buys what it has to offer. There are also opportunities for R&D leading to new and improved products and services. |
| Treasury opportunity |
Treasury opportunity is the opportunity for gain resulting from making the best use of the money that the organisation has. Internally, it manages its cash flow, but in so doing it can take advantage of externally facilitated opportunities concerning credit facilities with suppliers, bank interest rates and other investment opportunities. |
| Corporate opportunity |
Corporate opportunity is the opportunity for gain resulting from being the type of business and market in which the organisation operates and how others perceive it as a corporate entity, for example, an organisation in which to invest. |
| Figure 2: A taxonomy of opportunity |
Want to see some example opportunities in each category?
Product opportunities
Project opportunity is the opportunity for gain resulting from the organisation having products (or services) to sell (products for sale. Having something to sell provides the organisation with the opportunity to create and reinforce its market presence. In turn, this leads to a variety of externally generated sales and marketing opportunities. Customers take an interest in what the organisation has for sale and buys what it has to offer. There are also opportunities for R&D leading to new and improved products and services.
Internally facilitated opportunities
- The organisation has products and services for sale, perhaps new/improved versions, success stories, white papers and generally something to talk about.
- The organisation initiates an internal R&D project.
- The organisation forms a partnership agreement with another organisation
Associated externally facilitated opportunities
- The organisation presents at conferences and seminars, and writes articles for magazines and journals.
- The organisation exhibits at exhibitions.
- The organisation advertises in journals and on the Internet.
- The organisation participates in Standards Committees and similar forums
- A customer, or potential customer, enquires about our the organisation’s products and services
- The organisation sells its products as a consequence of selling a service.
- The organisation obtains a grant to support its R&D.
- A supplier has a product that can be used profitably as part of the organisation’s own products and services.
- A supplier wishes the organisation to act as a distributor for one or more of their products (or services).
Treasury opportunities
Treasury opportunity is the opportunity for gain resulting from making the best use of the money that the organisation has. Internally, it manages its cash flow, but in so doing it can take advantage of externally facilitated opportunities concerning credit facilities with suppliers, bank interest rates and other investment opportunities.
Internally facilitated opportunities
- The organisation is able to manage its cash flow.
Associated externally facilitated opportunities
- The organisation’s suppliers offer credit facilities.
- The organisation’s bankers offer overdraft facilities, and they and venture capitalists are willing to lend the organisation money
- The organisation’s bankers pay interest on certain accounts.
- The organisation invests in stocks and shares, etc.
Corporate opportunities
Corporate opportunity is the opportunity for gain resulting from being the type of business and market in which the organisation operates and how others perceive it as a corporate entity, for example, an organisation in which to invest.
Internally facilitated opportunities
- The organisation commands low prices from its suppliers.
- The organisation acquires other organisations.
Associated externally facilitated opportunities
- The organisation is acquired by another organisation.
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