Third-Party Risk Management: Properly Rating Inherent Risk

Whether it’s outsourcing core functions or leveraging specialized technology, working with third parties can introduce significant risks. To mitigate these risks, financial institutions must effectively manage third-party relationships and, more importantly, assess the inherent risks that come with them.

In this blog, we'll explore the importance of third-party risk management, with a particular focus on how to properly rate a third party’s inherent risk to safeguard your institution’s operations, reputation, and compliance standing.

The Importance of Third-Party Risk Management

Financial institutions are tasked with safeguarding sensitive customer data, ensuring compliance with regulations, and maintaining the integrity of their operations. When engaging third parties, these responsibilities extend beyond internal controls, creating a need for risk management.

Third-party risk management (TPRM) is not just about monitoring and controlling risks; it’s about anticipating, identifying, and understanding the various risks that could arise from third-party relationships. The key to effective TPRM is properly assessing the inherent risk of each third party—before, during, and after the relationship is established.

What is Inherent Risk?

Inherent risk refers to the level of risk a third party introduces to your institution without considering any mitigating controls. It’s the risk posed by the third party based purely on the nature of its operations, the services it provides, and its relationship with your financial institution.

To assess a third party’s inherent risk, financial institutions must evaluate several factors, including the risk posed in each of the following categories: Business Risk, Contract Risk, Incident Management Risk, Information Security Risk, Management Information System Risk, Operational Resilience Risk, Physical Security Risk, and Risk Management Risk.

Steps for Properly Rating a Third Party’s Inherent Risk

1. Identify the Third Party's Role
   The first step in assessing a third party’s inherent risk is to understand the role they play in your organization’s operations. Is the third party a vendor providing basic support services, or are they integral to your core operations? The more central the third party’s role, the higher the risk. For instance, a third party that manages customer financial data will likely present a higher inherent risk than one that merely provides office supplies.
2. Evaluate Risk Categories
   To effectively rate the inherent risk, you’ll want to assess it across several risk categories, such as Business Risk, Contract Risk, Incident Management Risk, Information Security Risk, Management Information System Risk, Operational Resilience Risk, Physical Security Risk and Risk Management Risk. Within each category, determine the likelihood of a risk event occurring and the potential impact it would have on your institution if the event did occur.
3. Establish Risk Rating Criteria
   Develop a standardized risk rating system that allows for consistent and objective evaluation of third parties. Common risk rating systems might use a scale from low to high risk, with criteria defined for each level of risk. For instance:
   • Low Risk: Generally means that at a maximum only small losses could occur if the third-party did not meet the institutions expectations in each of the risk categories.
   • Moderate Risk: Generally means that moderate losses could occur is the third-party did not meet the institutions expectations in each of the risk categories but would not jeopardize the institutions existence.
   • High Risk: Generally means that the existence of the institution could be at stake if the third-party did not meet the institutions expectations in each of the risk categories.
4. Monitor and Reassess
   Rating a third party’s inherent risk is not a one-time task. Over time, the risks associated with a third party may evolve, requiring periodic reassessment. Regular monitoring should include periodic audits, performance reviews, and assessments of the third party’s compliance with agreed-upon standards.
   
   

Conclusion

Third-party risk management is crucial for protecting your institution’s operations, customer data, and reputation. Properly rating the inherent risk of third parties is an important step in this process. By understanding the factors that contribute to a third party’s inherent risk and establishing a consistent methodology for assessing it, financial institutions can better protect themselves from the potentially severe consequences of third-party failures.

Additionally, third-party risk management should be a continuous process—one that evolves in response to changing business conditions, emerging risks, and shifting regulatory landscapes. With the right approach to inherent risk assessment and mitigation, financial institutions can create secure and successful third-party relationships while minimizing exposure to risk.