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The fourth and last step for risk management suggested by the Bank of International Settlements in its Basel Norms is the continuous monitoring of key risk indicators. Key risk indicators are important metrics that can track the business environment and internal control factors. They can help an organization keep track of a rapidly changing internal and external environment. Risk management is all about continuous scanning and monitoring of the environment and key risk indicators are the best way to do so. In this article, we will have a closer look at what key risk indicators are and how they impact the risk management process.
In simple words, key risk indicators can be understood to be predictors of adverse events which are likely to impact organizations. Organizations are impacted when their environment changes. Hence, if the changes in the environment are continuously monitored then the changes in the risk exposure can be spotted early. This would help organizations to identify, report and manage risks better than other companies. The best way to think about the key risk indicators is to think about them as the dashboard of a car. The dashboard conveys important information which must be tracked numerically in order to ensure the smooth functioning of the organization from an operational risk point of view.
The main feature of the key risk indicator is that it should be expressed numerically. This also means that there should be a predefined level for these numbers and then when they vary from the predefined level, they should be immediately reported to the risk management team.
Key risk indicators can be considered to be the lens through which the company views its internal and external environment. This means that choosing the key risk indicators correctly is of utmost importance while designing the risk management system.
The designing of key risk indicators is quite complex since it requires an understanding of the various objectives of the organization as well as the environmental factors which can hinder the achievement of these organizational goals.
The first step in designing a key risk indicator is to understand the cause-effect relationship between the organization's goals and some root cause factors. The next step is to understand the relative significance that each of these root cause factors has on the overall achievement of the goals. The next step is to create a system that collects high-quality data about these indicators. The data collected must be genuine and there must not be too much time lag between the collection of the data and the passing of this data to the risk management decision-making process.
Also, it is important to ensure that only meaningful indicators are incorporated into the key performance indicator process. If too many metrics are simultaneously tracked, it dilutes focus and the company is not able to pay attention to what is really important. It is also important to determine the trigger levels of the key risk indicators in accordance with the risk appetite of the company that has been aligned during the creation of the risk policy.
Key performance indicators or KPIs are also tools that are used by organizations to manage their day-to-day operations. For instance, revenue being generated, costs being incurred, etc are examples of key performance indicators. However, key performance indicators are not the same as key risk indicators.
Key risk indicators can be thought of as being the precursor to the key performance indicators. The objective of the company is to ensure that the performance indicators are never affected. This is the reason that a separate set of indicators called the key risk indicators are used. The effect of the risk should ideally be shown first in the risk indicators before it starts showing up in performance indicators. If that is not the case, then the system has been designed poorly.
An effective operational risk management system also has key control indicators in place. These indicators help an organization determine the success of its key risk indicators. If the risk indicators are able to catch risks early and maintain control over the operational performance, then that will be reflected in the key control indicators. Key control indicators help a company decide whether its risk indicators are accurate or whether they need to be changed.
The key risk indicator approach is not free from challenges. Some of the commonly faced challenges have been mentioned below:
It may be difficult to identify the key risk indicators for all risks which are faced by an organization. This is because there are certain unknown risks that the organization is not even aware of
It may be difficult to build an automatic system that collects the values and intimates the decision-makers at the correct time.
It is also possible that companies may focus too much on the symptoms of the key risk indicators instead of focusing on the actual root cause.
Lastly, many companies may not have action plans ready. There may be ambiguity about the actions that need to be taken once an action crosses a certain threshold.
The bottom line is that the key risk indicator approach is an integral part of the advanced measurement approach suggested in the Basel norms. This is the reason that this approach is followed widely in different parts of the world.
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