Risk Analytics

Unit 1 - Introduction

Arup Duttaroy | Jul 2022

Agenda
§ Definitions
§ What is Risk?
§ What is Risk Management?
§ What is Risk Analytics?
§ Why Risk Analytics?
§ Industries & Risk

§ Types of Risk & Measures of Risk

§ Types of Risk
§ Types of Risk Measures
§ Common Risk Measures by Risk Types

2
 Risk Analytics
Unit 1 – Introduction
Topic 1.1 – Definitions of Risk & Risk Analytics
 What is Risk?

§ Dictionary meaning
§ Noun - a situation involving exposure to danger.
§ Verb - expose (someone or something valued) to danger, harm, or loss.

§ Other Definitions
§ In simple terms, Risk is the possibility of something bad happening. Risk
involves uncertainty about the effects/implications of an activity with
respect to something that humans value (such as health, well-being,
wealth, property or the environment), often focusing on negative,
undesirable consequences

§ Risk is defined in financial terms as the chance that an outcome or

investment's actual gains will differ from an expected outcome or return.
Risk includes the possibility of losing some or all of an original investment.

4
Introduction to Risk and Compliance
§ According to the 2015 report by European System on Financial Supervision on misconduct of risk in the
banking sector, more than 200 billion Euro fine has been levied on almost all major banks combined for non-
compliance of various risks and other regulations
§ Owing to this fact, risk and compliance finds itself as a primary concern for the top management year after
year
§ The banks find it as a challenge to identify newer ways to innovate and add value to the business in spite of
working on stringent guidelines, tight regulations and pressure to cut down on operational costs
§ Thus an effective risk and compliance management backed by technological strength and business
intelligence and analytics insights tops the wish-list of every Chief Risk Officer

5
Risk Management and Compliance Analysis Areas
Counterparty Risk Credit Risk
• Counterparty performance trends • Mortgage and loan production
• Risk calculation • Delinquencies and charge-offs
• Credit valuation adjustment • Transaction activity analysis
• Right way /wrong way risk analysis • Deposits and withdrawals
• Risk correlation • Payments and collections
RISK
Operational Risk Liquidity Risk
• Internal / external events • Intraday liquidity snapshot / trend
• External loss events • Limit management
• Risk control self-assessments • Idiosyncratic survival
• Advanced measurement approach • Cash flow events
• Data quality and controls • Liquid vs. Illiquid products

Enterprise Risk Management Market Risk

• Economic and regulatory capital • Trade book performance & what-if:
• Risk & exposure analysis - Equity performance
• Credit, operational, market, liquidity - Interest rates and FX rates
• Regulator and board ad hoc requests - Commodity prices
• Executive risk dashboards • Portfolio VaR, Stressed VaR
COMPLIANCE

Regulatory Compliance AML and Fraud

• Basel II+ (Banking) • Fraud detection and investigation
• Solvency II (Insurance) • Suspicious activities / transactions
• Know Your Customer (KYC) • Watch list and case management
• Treating Customers Fairly (TCF) • Transactional pattern analysis
• Sarbanes Oxley (SOX) • Social profiling

6
What is Risk Management?

§ Risk Management is the process of finding and controlling threats to the company’s
well-being, as well as ways to minimize those threats
§ The risks can appear for different reasons, including legal liabilities, natural disasters,
financial uncertainties, pandemics, frauds, management errors, etc.
§ A successful risk management program helps an organization consider the full range
of risks it faces. Risk management also examines the relationship between risks and
the cascading impact they could have on an organization's strategic goals
§ This holistic approach to managing risk is sometimes described as Enterprise Risk
Management (ERM) because of its emphasis on anticipating and understanding risk
across an organization. In addition to a focus on internal and external threats, ERM
emphasizes the importance of managing positive risk. Positive risks are opportunities
that could increase business value or, conversely, damage an organization if not
taken.

7
Risk Appetite vs. Risk Tolerance

8
Why is Risk Management Important?
§ Risk management has perhaps never been more important than it is now. The risks modern
organizations face have grown more complex, fueled by the rapid pace of globalization
§ New risks are constantly emerging, often related to and generated by the now-pervasive
use of digital technology
§ Climate change has been dubbed a "threat multiplier" by risk experts
§ A recent external risk that manifested itself as a supply chain issue at many companies -- the
coronavirus pandemic -- quickly evolved into an existential threat, affecting the health and
safety of their employees, the means of doing business, the ability to interact with
customers and corporate reputations
§ These are making it imperative to reassess the risk exposure and examining risk processes
for enterprises. There is heightened interest in supporting sustainability, resiliency
and enterprise agility
§ Companies are also exploring how advanced analytics interventions using artificial
intelligence technologies and sophisticated governance, risk and compliance (GRC)
platforms can improve risk management.

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Major Trends in Risk Management
01
Business Intelligence & 04 Emergence of
Newer Risks
Advanced Analytics along
with Technology Adoption
making a difference

02 More Informed Customer

with Increased 05
Better Risk
Decisions through
Expectations Elimination of Biases

03 Increased Regulation
differing widely among 06 Emphasis on
Reduction of
Geographies Operational Costs

10
Challenges faced in Risk Compliance

Increased Regulatory Costs

Since 2009, regulatory fees have dramatically increased
01
relative to banks’ earnings and credit losses

02 Greater Regulation with

Increased Scope
The number of regulators the banks report to and scope of
regulatory focus continues to expand. New topics, such as
Increased risk Exposure due conduct risk, next-generation Bank Secrecy Act and Anti-

to Disparate Systems
Large banks have several legacy and state-of-the-art computer
03 Money Laundering (BSA/AML) risk, risk culture, and third-
and fourth-party (that is, subcontractors) risk, among others
continue to emerge
systems co-existing to manage separate compliance processes
and programs. This poses huge risks since there is a lack of flow
of information between these disparate systems. Also, the
information alignment between systems is non-existent
.
04 Outdated Compliance Model
The traditional compliance model was designed in a different
era and with a different purpose in mind, largely as an
enforcement arm for the legal function but is still being
followed by the majority managers even today

11
 Risk Management Process
§ The risk management discipline has published many bodies of knowledge that document what
organizations must do to manage risk. One of the best-known sources is the ISO 31000 standard,
Risk Management -- Guidelines, developed by the International Organization for Standardization
(ISO). ISO’s 5-steps Risk Management Process is as below:

1 2 3 4 5

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Risk Identification
§ When identifying risks, it is important to understand that, by definition, something is
only a risk if it has impact

§ The following four factors must be present for a negative risk scenario:
1. a valuable asset or resources that could be impacted;
2. a source of threatening action that would act against that asset;
3. a preexisting condition or vulnerability that enables that threat source to act; and
4. some harmful impact that occurs from the threat source exploiting that vulnerability.

§ In identifying risk scenarios that could impede or enhance an organization's

objectives, many risk committees find it useful to take a top-down, bottom-up
approaches
§ In the top-down exercise, leadership identifies the organization's mission-critical processes and works
with internal and external stakeholders to determine the conditions that could impede them
§ The bottom-up perspective starts with the threat sources (earthquakes, economic downturns, cyber
attacks, etc.) and considers their potential impact on critical assets.

13
Risks by Categories
§ Organizing risks by categories can also be helpful in getting a handle on risk. The
guidance cited by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO) uses the following four categories:
§ Strategic risk (e.g., reputation, customer relations, technical innovations);
§ Financial and reporting risk (e.g., market, tax, credit);
§ Compliance and governance risk (e.g., ethics, regulatory, international trade, privacy); and
§ Operational risk (e.g., IT security and privacy, supply chain, labor issues, natural disasters).

§ Another way for businesses to categorize risks, is to bucket them under the
following four basic risk types for businesses:
§ People risks,
§ Facility risks,
§ Process risks and
§ Technology risks

§ The final task in the risk identification step is for organizations to record their findings
in a Risk Register. It helps track the risks through the subsequent four steps of the risk
management process

14
Risks Analysis
§ The likelihood and impact of each risk is analyzed to help sort risks
§ Making a risk heat map can be useful here, as it provides a visual
representation of the nature and impact of a company's risks

15
 Risks Evaluation & Treatment Strategies
§ Here is where organizations determine
how to respond to the risks they face.
Techniques include one or more of the
following:
§ Risk avoidance: The organization seeks to
eliminate, withdraw from or not be involved in the
potential risk.
§ Risk mitigation: The organization takes actions to
limit or optimize a risk.
§ Risk sharing or transfer: The organization contracts
with a third party (e.g., an insurer) to bear some or
all costs of a risk that may or may not occur.
§ Risk acceptance: A risk falls within the
organization's risk appetite and tolerance and is
accepted without taking action.
§ Risk treatment: This step involves applying
the agreed-upon controls and processes
and confirming they work as planned

16
Benefits of Risk Management
§ Effectively managing risks that could have a negative or positive impact
on capital and earnings brings many benefits
§ Benefits of risk management include the following:
§ increased awareness of risk across the organization;
§ more confidence in organizational objectives and goals because risk is factored into strategy;
§ better and more efficient compliance with regulatory and internal compliance mandates because
compliance is coordinated;
§ improved operational efficiency through more consistent application of risk processes and control;
§ improved workplace safety and security for employees and customers; and
§ a competitive differentiator in the marketplace.

17
Challenges in Risk Management
§ Risk Management also presents challenges, even for companies with
mature governance, risk and compliance strategies.
§ Following are some of the challenges risk management teams should
expect to encounter:
§ Expenditures go up initially, as risk management programs can require expensive software and services.
§ The increased emphasis on governance also requires business units to invest time and money to comply.
§ Reaching consensus on the severity of risk and how to treat it can be a difficult and contentious exercise
and sometimes lead to risk analysis paralysis.
§ Demonstrating the value of risk management to executives without being able to give them hard numbers
is difficult; i.e., determining the ROI is difficult for implementing a Risk Management Process & Solution

18
Risk Monitoring & Review
§ It is important monitor whether the controls working as intended? Can
they be improved?
§ Monitoring activities should measure key performance indicators (KPIs)
and look for key risk indicators (KRIs) that might trigger a change in
strategy.
§ It is precisely for this there is a need for a Risk Analytics solution or
platform
§ Such Risk Analytics solution will feed on the various data from disparate
sources and apply descriptive, diagnostic, predictive & prescriptive
analytics to provide actionable insights for the Risk Managers to take
informed decisions

19
 What is Risk Analytics?
§ Risk analytics is a set of techniques that
measures, quantifies, and predicts risk
with a large degree of accuracy
§ With the rise of Big Data, Cloud & other
enhanced computing capabilities,
and Advanced Analytics, companies can
leverage the power of Data, Artificial
intelligence, Machine Learning, Statistical RISK
ANALYTICS
Analysis, the Internet of Things etc. for
better decision-making.
§ These tools are crucial for risk managers,
who apply these techniques to risk
management to identify, measure, and
mitigate risk.

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Following Analytics Initiatives will help Organisations strengthen
Risk and Compliance

Digitization of 02 04 Enhanced Risk

Core Processes Imbibing Advanced Reporting
Analytics
03

Optimizing the Putting Enablers

01 05
Balance Sheet in Place

21
Effective Analytics also helps to answer following questions
How do we analyse
micro and macro
economic factors How do we validate
which have an effectiveness of our
impact on risk? risk models? How can we better manage
volatility risks and its
impact on balance sheet?
How can we better
understand potential
risks by utilizing more
holistic information How can we use our
about our business? data to better optimise
risk management
processes and
technology?
How can I integrate data from
disparate sources and ensure a
coordinated and cross-
organizational approach to risk How can we comply
management with both domestic as
well as global regulators

A comprehensive Analytics solution can help you answer all of them!

22
Analytics for Risk Analysis and Control

Financial Health CPG/

Telco Retail
Services Care Mfg.
§ Fraud analysis
Financial Analysis
§ Credit default analysis
§ Risk profiling
Customer Analysis
§ Portfolio risk analysis
§ Loss prevention
Supply Chain Analysis
§ Markdown analysis

Marketing/Merchandising Analysis

Risk Analysis and Control

23
Why Risk Analytics?
§ Implementation of Risk Analytics i.e. data analytics for risk management strategies
can alleviate risks by improving reporting, monitoring performance, timely
forecasting, and preventing repetitive losses.
§ The main goal of Risk Analytics is to help you understand potential threats to the
performance and growth of your company. Here are few signs and red flags that
point to the necessity of risk analytics:
§ You see high claim occurrences in some areas or specific departments of your company.
§ Your company regularly spends money on the same type of claims.
§ You want to improve the safety of your workplace.
§ You are eager to diagnose all the issues in your company and wish to fix them.
§ Your managers fail to meet monthly (or annual) goals.
§ You are looking for forecasting and want to get ready for potential risks.

24
Which Businesses are using Risk Analytics?
§ Banking, Financial Services, and Insurance – This being a highly regulated and
monitored vertical, and there are substantial penalties if compliance not met, Risk
Analytics is heavily used
§ Telecommunications – This sector faces stiff competition and is plagued with fraud
and has lost billions. Several telecom operators are turning to risk analytics solutions
to stem revenue leakage and increase revenue
§ Government Services – This sector uses risk analytics solutions intensely, not just for
risk prediction and pre-empting, but also for diverse activities such as weather
forecasting, border security management, tracking terrorist & other geo-political
activities, policy control, and calculated decision-making
§ Healthcare – This sector uses risk analytics to determine and ensure patient safety.
It reduces the chances of drug contamination and also helps to control, store, and
access user data

25
Which Businesses are using Risk Analytics?
§ There are other sectors that heavily invests in Risk Analytics
§ Consumer goods – For Fraud detection, Liquidity Risks
§ Retail – For Fraud detection, Liquidity Risks
§ Manufacturing – For Safety & Quality, Liquidity Risks
§ Transportation and logistics – For Fraud detection, Liquidity & Operational Risks
§ Information technology – For Operational Risks,
§ Media – For Liquidity & Operational Risks,
§ Energy and utilities – For Fraud detection, Liquidity & Operational Risks

26
 Risk Analytics
Unit 1 – Introduction
Topic 1. 2 – Types of Risk & Measures of Risk
Types of Financial Risk

§ Counterparty Risk is the probability that the other party in an investment, credit, or
trading transaction may not fulfill its part of the deal and may default on the
contractual obligations

§ Credit Risk is the possibility of a loss resulting from a borrower's failure to repay a
loan or meet contractual obligations. Traditionally, it refers to the risk that a lender
may not receive the owed principal and interest, which results in an interruption
of cash flows and increased costs for collection. Credit rating is a measure of the
creditworthiness of a borrower.

§ Market Risk s the possibility that an individual or an entity will experience losses due
to factors that affect the overall performance of investments in the financial markets.
Sources of market risk include recessions, political turmoil, changes in interest rates,
natural disasters, and terrorist attacks
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Types of Financial Risk

§ Operational Risk summarizes the chances and uncertainties a company faces in the
course of conducting its daily business activities, procedures, and systems. It is a
type of business risk, which is heavily dependent on the human factor: mistakes or
failures due to actions or decisions made by a company's employees

§ Liquidity Risk is defined as the risk of incurring losses resulting from the inability to
meet payment obligations in a timely manner when they become due or from being
unable to do so at a sustainable cost. Liquidity risk occurs when an individual
investor, business, or financial institution cannot meet its short-term debt
obligations. The investor or entity might be unable to convert an asset into cash
without giving up capital and income due to a lack of buyers or an inefficient market.

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Types of Risk Measures
§ There are essentially two classes of risk measures:

§ Scalar risk measures are measures that represent risk as a single value i.e., one value to represent
exposure for entire life of contracts with a counterparty. For example, Probability of Default (PD)

§ Profile risk measures are measures that represent risk over a time period i.e., one value for each time
point. For example, Potential Future Exposure (PFE)

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 Steps to calculate Counterparty Risk Measures
§ We can utilize mathematical formulae to price current value of all transactions, based on
the state of current market data, which is constantly changing over time
§ Additionally, we are required to compute credit risk exposure for future dates
§ Therefore, to accurately price transactions over lifetime of a portfolio, advanced
mathematical sampling and forecasting techniques are being used
§ Credit risk methodology team utilize Monte-Carlo simulation technique to simulate
market data on a range of scenarios over future timepoints, known as simulated paths.
The simulation of market data relies on probability distribution of variables such as
interest rate curves
§ Price of a trade is known as Market To Market (MtM). MtMs across scenarios and time
points are calculated and used to calculate a number of risk measures. These risk
measures are combined with other inputs such as probability of counterparty default,
recovery rate of getting money back from the counterparty along with a range of other
statistical measure to compute credit risk measures
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Some Common Counterparty Risk Measures
§ Some commonly used Counterparty Risk Measures are:
§ Expected Mark To Market (EMtM) – Price of a transaction is calculated from its cashflows during the lifetime
of a contract. EMtM considers both positive and negative amounts. EMtM profile is one MtM value for each
timepoint
§ Expected Exposure (EE) – EE amount indicates the positive amount that the trading party will lose if the
counterparty defaults. Negative MtMs are capped to 0. EE is a profile risk measure and is the average of MtM
distribution. EE is usually greater than MtM
§ Negative Expected Exposure (NEE) – This is a mirror image of how EE is calculated. Positive MtMs are floored
to 0. NEE tells trading entity how much counterparty is exposed to it. NEE is a profile risk measure
§ Expected Potential Exposure (EPE) – Once EE is calculated, an average value of EE is computed. EPE is a scalar
risk measure
§ Expected Negative Exposure (ENE) – Mirror image of EPE. It is the average value of NEE. ENE is a scalar risk
measure
§ Effective Expected Exposure (EEE) – For each time, maximum of (current EE value and maximum EE) is
selected. This then results in increasing EE profile. EEE is a profile risk measure
§ Effective Expected Positive Exposure (EEPE) – EEPE is the average of EEE profile. EEPE is a scalar risk measure

32
Some Common Counterparty Risk Measures …contd.
§ Some commonly used Counterparty Risk Measures are:
§ Potential Future Exposure (PFE) – Based on a confidence level (e.g. 97.5 percentile or 99 percentile), the
distribution of MtM is computed and a value is taken from the distribution for each time point. We can think
of PFE as the worst case scenario exposure to a counterparty. PFE is usually greater than EE. PFE is a profile
risk measure
§ Potential Exposure (PE) – As PFE is calculated over a number of time points, PE is the maximum value of PFE
across all time points. PE is greater than PFE. PE is a scalar risk measure
§ Exposure At Default (EAD) – Exposure at default (EAD) is the predicted amount of loss a bank may be
exposed to when a debtor defaults on a loan. EAD is a scalar risk measure. It is calculated as EEPE x 1.4
§ Loss Given Default (LGD) – LGD is the estimated loss incurred by a lender if a borrower defaults on a
financial obligation, expressed as a percentage of the total capital at risk.
§ Credit Value Adjustment (CVA) – CVA, by definition, is the difference between the risk-free portfolio and the
true portfolio value that takes into account the possibility if a counterparty's default. In other words, CVA
represents the market value of the counterparty credit risk. It is calculated as:
Sum of EE x Counterparty Probability of Default (time point) x (1-Counterparty Recovery Rate)

33
Market Risk Measures
§ Some commonly used Market Risk Measures are:
§ Value at Risk (VaR) –VaR is a statistic that quantifies the extent of possible financial losses within a firm,
portfolio, or position over a specific time frame.
§ This metric is most commonly used by investment and commercial banks to determine the extent and
probabilities of potential losses in their institutional portfolios.
§ Risk managers use VaR to measure and control the level of risk exposure.
§ One can apply VaR calculations to specific positions or whole portfolios or use them to measure firm-wide
risk exposure.
§ This metric can be computed in several ways, including the historical, variance-covariance, and Monte
Carlo methods.
§ For example, suppose a portfolio of investments has a one-year 10% VaR of $5 million. Therefore, the
portfolio has a 10% chance of losing $5 million over a one-year period
§ Standard Deviation (SD) – It measures the dispersion of data from its expected value. The standard deviation
is commonly used to measure the historical volatility associated with an investment relative to its annual
rate of return. It indicates how much of the current return is deviating from its expected historical normal
returns. For example, a stock that has high standard deviation experiences higher volatility and is therefore
considered riskier
34
Market Risk Measures …contd.
§ Some commonly used Market Risk Measures are:
§ Sharpe Ratio – It measures investment performance by considering associated risks. To calculate the Sharpe
ratio, the risk-free rate of return is removed from the overall expected return of an investment. The
remaining return is then divided by the associated investment’s standard deviation. The result is a ratio that
compares the return specific to an investment with the associated level of volatility an investor is required to
assume for holding the investment. The Sharpe ratio serves as an indicator of whether an investment's
return is worth the associated risk
§ Beta – It measures the amount of systematic risk an individual security or sector has relative to the entire
stock market. The market is always the beta benchmark an investment is compared to, and the market
always has a beta of one. If a security's beta is equal to one, the security has exactly the same volatility profile
as the broad market. A security with a beta greater than one means it is more volatile than the market. A
security with a beta less than one means it is less volatile than the market. Beta is helpful when comparing
across securities as well.

35
Some Common Credit Risk Measures
§ The quantification of Credit Risk is the process of assigning measurable and comparable numbers
to the likelihood of default risk. The factors that affect credit risk range from borrower-specific
criteria to market-wide considerations. The idea is that liabilities can be objectively valued and
predicted to help protect the lender against financial loss
§ Some commonly used Credit Risk Measures are:
§ Probability of Default (PD) – It expresses the likelihood the borrower will not maintain the financial capability
to make scheduled debt payments. For individual borrowers, default probability is most represented as a
combination of two factors: debt-to-income ratio and credit score.
§ Exposure At Default (EAD) – Exposure at default (EAD) is the predicted amount of loss a bank may be
exposed to when a debtor defaults on a loan. EAD is a scalar risk measure. looks at the total risk of default a
lender faces at any given time.
§ Loss Given Default (LGD) – LGD is the estimated loss incurred by a lender if a borrower defaults on a
financial obligation, expressed as a percentage of the total capital at risk. It looks at the size of the loans, any
collateral used for the loan, and the legal ability to pursue the defaulted funds if the borrower goes bankrupt.
There is no universally accepted method of calculating LGD. Most lenders do not calculate LGD for each
separate loan; instead, they review an entire portfolio of loans and estimate total exposure to loss.

36
Measuring Operational Risk - Top-down Approach
§ Top-down approach involves first estimating the Risk and the Capital required for the
Financial Institution as a whole

§ The Basic Indicator Approach calculates the Operational Risk Capital charge as 15% of
the organization’s Average Annual Gross Income over the past 3 years

Gross Income = Net Profit + Provisions & Contingencies + Operating Expenses –

§ Reversals during the year in respect of provisions and write-off made during previous year(s)
§ Income recognized from the disposal of items of movable and immovable properties
§ Realized profits/losses from the sale of securities in the “held to maturity” category
§ Income from legal settlements in favor of the organization
§ Other extraordinary or irregular items of income and expenditure
§ Income derived from insurance activities and insurance claims in favor of the organization

37
 Measuring Operational Risk - Top-down Approach
§ The Standardized Approach in the
New Basel Capital Accord – It involves
dividing the bank’s activities into eight
business lines
§ The total capital charge is calculated
by summing the capital charge for
each business line
§ The capital charge for each business
line is calculated by multiplying the
gross income of that business line by a
factor ranging from 12% to 18%

38
Measuring Operational Risk - Bottom-Up Approach
§ Bottom-up approach involves guidelines from Basel Committee – New Accord as
below:
§ It allows banks to use an internal operational risk measurement system provided some
qualitative and quantitative criteria are met
§ One of these is that the bank should be able to demonstrate that its model captures
potentially severe “tail” loss events
§ It should be able to capture loss comparable to a one-year horizon and 99.9%
confidence interval
§ Its historical loss database should be at least 3 years long, extendable to 5 years
§ In addition to loss data, banks should also capture key business environment and
internal control factors that can change its operational risk profile to make risk
assessments forward looking

39
Measuring Operational Risk - Bottom-Up Approach
A Bottom-up approach Calculation Framework is as below:

Historical Database Loss Historical Database Loss

Event Frequencies Event Impact

Causal Historical Database of Causal

Dependency Model Key Risk Indicators Dependency Model

Forecasting Model

Estimates of
Causal Causal
Key Risk Indicators
Dependency Model Dependency Model
over a future Horizon
Estimates of Estimates of
Loss Event Frequencies Loss Event Impact
over a future Horizon over a future Horizon
Aggregate Loss Data
over a future Time
Horizon

40
Measuring Liquidity Risk
§ One of the key elements of measuring and managing Liquidity Risk is the ability to identify the
warning signs of a liquidity crisis.
§ Beyond the identification of these signs, a business must also be able to measure risk magnitude
so that it can take immediate and appropriate action to stop a downward spiral
§ There are several ways of measuring liquidity risk, namely:
§ Analysis of Financial Ratios – These provide a business with current indicators of liquidity risk
based on its past performance, allowing it to make the required financial and operational tweaks
to ensure it attains desired future financial and operational outcomes. The most common ratios
are:
§ Current Ratio measures the liquidity level of a business and its ability to use short-term assets to repay short-term obligations. Current
ratio is calculated by dividing the current assets of a business by its current liabilities. A current ratio of over 1 is normally considered to be
comfortable. A ratio below 1 may indicate a shortage of funds to meet short-term financial obligations.
§ Quick Ratio on the other hand, measures how well a business can meet its short-term financial obligations. Quick ratio is calculated by
dividing the total cash, marketable securities and liquid receivables of a business by its total liquid current liabilities. A quick ratio of
more than 1 means that the business is well-positioned to meet its short-term financial obligations. Less than 1, and the outlook goes the
other way
§ Quick Ratio is preferred over Current Ratio because not all current assets are liquid.

41
Measuring Liquidity Risk …Contd.
§ Cash Flow Forecasting – During any time of uncertainty, businesses should re-evaluate their
operational strategy and profitability forecast. Importantly, management must have good visibility
into potential liquidity difficulties and opportunities. It is always prudent for a business to maintain
and revise its cash flow forecast, crisis or no crisis
§ A cash flow analysis must be realistic and informational, allowing visibility and execution of
management’s plans, justifying the merits of business strategies and aiding accountability
§ Capital Structure Management - Debt is usually the cheapest source of financing given that debt
has a lower cost of funding than equity and is also tax-deductible for a business. However, a
business must manage and monitor its debt-equity ratio closely so that it will not become over-
leveraged.
§ The more highly leveraged a business is, the greater its vulnerability to any downturn in cash flow.
This vulnerability becomes even more serious if it coincides with times for debt repayment. A
highly leveraged business has less capacity to absorb losses or obtain rollover funds.

42
Measuring Liquidity Risk …Contd.
§ To measure liquidity risk due to over-leverage, a business should look to see if it has enough
liquidity to pay its debt interest and principal, and it should compare its gearing ratios to its
competitors. The common leveraged (i.e., gearing) ratios are:
§ Debt-to-equity ratio measures the total liabilities of a business in relation to its shareholder equity.
§ There is no optimal ratio. It really depends on the current health of the business as well as the industry that it is competing in. For example,
a high ratio might be desirable for a business that is experiencing high growth because leverage significantly increases its returns.
§ However, if a business does not manage the amount of debt on its balance sheet, the high cost of borrowing will impede any benefits from
leverage and increase the likelihood that the business will not be able to service its debt (i.e., liquidity risk).

§ Return on equity (ROE) is a profitability ratio that measures the rate of returns generated by invested equity (i.e., common stock). A higher
ROE usually means that a business is more efficient in generating returns than its peers; a lower ROE means the opposite

ROE = [Net Income/Sale] × [Sales/Total Assets] × [Total Assets/Shareholder Equity]

ROE = Profit Margin × Asset Turnover × Financial Leverage

§ Interest coverage ratio measures how easily a business can cover its interest expenses on outstanding debts. Interest coverage ratio is
calculated by dividing earnings before interest and taxes (EBIT) by the total amount of interest expense on all outstanding debts. The
higher the ratio, the lower the credit risk is to lenders. In turn, lenders will be more willing to support financing needs, thereby decreasing
liquidity risk.

43
Pre-requisites for Risk Analytics

External Data from 02 04 Use of Machine Learning

3rd Parties or Public Application of & Artificial Intelligence
domain Statistical Analysis
03

Internal Data from Unified Platform for Data

01 05
Disparate systems Crunching, Statistical
processing & Model
management

44
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