Key Risk Indicators: A Powerful Tool in Treasury Risk Management
Article 1 of 2: A practical primer on managing and monitoring treasury risks using KRIs.
Key risk indicators (KRIs) play a crucial role in treasury risk management by providing timely alerts on a company’s changing risk exposures. For treasury risk events—such as counterparty defaults, losses due to changes in foreign exchange (FX) or interest rates, missed loan payments, investment losses, or funding shortages—KRIs help to detect changes in:
- the likelihood (probability) that the event will occur;
- the impact to the company if the risk event does happen; and
- the benefit of mitigating controls, such as a derivative hedge.
KRIs quantify exposures using metrics that can be either direct measures of risk (e.g., value-at-risk, volatility) or proxies for risk, such as leverage ratios, interest coverage ratios, sales growth, inflation rates, and the results of customer surveys.
Sophisticated treasury and risk management functions produce KRIs for their company’s main risks and use the resulting metrics to make informed risk decisions. A company that learns a key risk is growing might choose to limit potential losses by reducing exposure to that risk, or it may maintain the increased risk level temporarily to take advantage of an opportunity. A KRI that shows the related risk is shrinking may indicate that a company is not taking enough risk and is missing out on potential profits. KRIs and their associated limits help ensure that a company’s risk profile remains aligned with corporate strategy and risk appetite as the business evolves.
A treasury team utilizing KRIs should develop a different set of indicators for different levels of the company: The board and senior management will typically focus on a select few KRIs, while operational managers will want to see a larger set of metrics. At every level, well-designed KRIs can act as forward-looking, or leading, indicators, predicting risk events before they occur so that decision-makers can take timely preventative actions or else proactively—and knowingly—accept higher levels of risk.
How to Develop and Use KRIs
KRIs should play a pivotal role in the corporate risk management process. When producing KRIs for treasury-related risks, the treasury team must work closely with the risk team to ensure that there is consistency of approach with the rest of the company—in particular, to ensure that the treasury KRIs align with the overall corporate strategic objectives and risk appetite. Here are the five basic steps for developing and using KRIs:
1. Identify risks. Treasury professionals can identify the treasury risks that their company faces by gathering senior management input, conducting stakeholder interviews, analyzing past results, and combing through economic and industry research. Then they may use common risk taxonomy systems to produce a comprehensive risk analysis that identifies the organization’s key treasury risk exposures.
Common treasury risks include liquidity risk, counterparty risk, FX risk, interest rate risk, commodity risk, investment risk, energy risk, operational risk, and IT risk. Consider, for example, a UK-based company that sells products to customers overseas and has receivables denominated in non-Sterling currencies. These sales expose the company to FX risk.
2. Measure risks. Once the treasury team has identified the company’s key risks, they can develop risk measures or proxies for each. Ideally, each key risk’s measure (or proxy) will take into account both likelihood and impact of the risk. In our example, the UK company with the currency exposures might decide to use value-at-risk (VaR) as one KRI to quantify its FX risk. VaR is the maximum expected loss over a specific time period (e.g., one month) at a predetermined confidence level (e.g., 99%).
3. Evaluate risks. Next, the treasury team should determine the company’s risk appetite so that they can produce the maximum and minimum KRI limits for each main treasury risk. A company’s risk appetite is the amount of risk that is acceptable given the company’s profile and strategy. Management’s appetite for each key risk should underlie its KRI limits, outside of which the company may take action to change its exposure.
This is a crucial step in the risk management process—but one that companies frequently overlook or address hastily. It is vital that treasury KRI limits not be developed in isolation from the other corporate KRIs (in a so-called “siloed” approach), which is why coordination with the group risk function is important. Collaboration between treasury and risk management means treasury KRIs can be aligned with overall corporate strategy. Note that the second article in this series will provide more details on risk appetite and setting KRI limits.
The company in our example might decide to set a total maximum KRI limit of £5 million in VaR (based on a one-month time horizon and a 99 percent confidence level) for all FX exposures that the company faces. Thus, the organization should expect to respond if FX VaR exceeds £5 million at some point in the future.
4. Respond to risks. When the treasury team has established KRIs and KRI limits for a particular exposure, they need to determine whether that key risk is currently falling within the limits. If not, treasury needs to respond appropriately.
If the KRI for a risk exceeds the set maximum KRI limit—and so the company’s risk level falls outside management’s risk appetite—then the team has two options: They can take action to reduce the risk exposure so that it falls back within the defined limit, or they can make a conscious decision to accept the increased risk exposure in the interest of taking advantage of an opportunity. If they choose the latter path, they should seek approval from management and/or the board to increase the company’s risk appetite for that particular exposure.
Consider again our UK company. If its VaR for FX exposures comes in at £7 million at a given point in time, then treasury can use derivatives such as FX forwards to bring down the company’s net FX VaR from £7 million to £5 million in order to keep the risk exposure within the established risk appetite. Alternatively, they could suggest to senior management that the company accept, either temporarily or permanently, £7 million as its new KRI limit for FX risk in order to take advantage of a commercial opportunity such as a new export market—assuming that this move is in line with corporate strategy and the company’s overall risk appetite.
5. Monitor and report on risks. Treasury staff must monitor KRIs on an ongoing basis to ensure that risk exposures remain within the KRI limits. This involves recalculating the KRIs regularly and tracking the progress of the risk responses. Typically, companies calculate KRIs monthly or quarterly; however, if the risk exposure is large and/or volatile—for example, due to a market stress—then more frequent monitoring may be required. KRI limits should be reset at least annually or anytime there is a significant change in the company’s risk profile, such as after a major acquisition.
Treasury and risk staff should regularly produce risk reports, which should include, as a minimum, a description of each treasury risk exposure, the KRIs and KRI limits (maximum and minimum), any breaches of those limits during the period, and any failures of risk controls.
For companies looking to build a system of KRIs, it’s important to note that, although the risk management description in Figure 1 is presented as linear, the process is often iterative in practice.
KRIs in Practice
BHP Group and British Land are two organizations that refer to KRIs in their 2023 annual reports.
BHP Group is a mining company based in Australia that produces commodities including copper, nickel, potash, iron ore, and metallurgical coal. BHP Group explains its use of KRIs in its annual report like this:
“Key risk indicators (KRIs) are set by management to help monitor performance against our risk appetite. They also support decision-making by providing management with information about financial and non-financial risk exposure at a Group level. Each KRI has a target or optimal level of risk we seek to take, as well as upper and lower limits. Where either limit is exceeded, management will review potential causes to understand if BHP may be taking too little or too much risk and to identify whether further action is required.”
British Land is a UK-headquartered company that creates, owns, and manages real estate, including offices and retail properties. It describes its KRIs as follows:
“We have identified a risk dashboard of key risk indicators (KRIs) for each principal risk, with specific tolerances to track whether our risk exposure is within our risk appetite or could threaten the achievement of our strategic priorities. The risk dashboard is reviewed at each Risk Committee and serves as a catalyst for discussion about how our principal risks are changing and whether any further mitigating actions need to be taken. The risk indicators are a mixture of leading and lagging indicators, with forecasts provided where available, and focus on the most significant judgements affecting our risk exposure, including: our investment and development strategy; the level of occupational and development exposure; our sustainability risks; our financial resilience; and our key operational business risks …”
Figure 2 shows the KRIs related to financing risks that British Land reports to its shareholders. This extract from the company’s 2023 annual report describes financing risk, explains the company’s process for risk monitoring and mitigation, and provides values for its financing-related KRIs. Note that British Land uses multiple KRIs for this risk and assesses both of the two common dimensions of risk (impact and probability): “… our financing risk is still considered overall a medium impact with low to medium probability.”
Keys to Success with Key Risk Indicators
KRIs and their limits play a powerful role in the management of treasury risks: They are an early warning system that allows the treasury team to take proactive action to prevent financial losses or to seize opportunities in a risk-controlled manner, and they help to optimize the overall risk profile of a company through the consideration and use of risk appetite levels.
To successfully develop a suite of KRIs and their respective limits, the treasury team must use a systematic approach such as the one described in this article. It is particularly crucial to build strong links between the treasury KRI limits and the company’s risk appetite.
Don’t miss the next article in this series, which will provide more details on how to design effective KRIs based on the company’s risk appetite levels.