What Is a Risk Taxonomy? How to Make One for Your Business

Risk taxonomy is a system of categorization that allows an organization to identify and classify various types of risks it may face.

Risk taxonomy involves breaking down risks into different categories and subcategories, providing a structured way to organize and manage potential threats. The aim of a risk taxonomy is to create a clear understanding of risks across the whole organization, support the assessment and management of risks, and facilitate more effective risk reporting. 

It may be based on factors such as the source or type of risk, organizational functions, operational areas, or according to different industry standards.

Why Is Risk Taxonomy Important?

Risk taxonomy is important for several reasons:

• Consistency and Clarity: It provides a shared language and consistent structure for identifying and classifying risks throughout an organization, aiding clear communication and understanding across different departments or teams.
• Comprehensive Risk Coverage: A well-built risk taxonomy ensures that all types of risks an organization faces, whether operational, financial, strategic, or regulatory, are covered. This allows for a more comprehensive and holistic view of the organization's risk profile.
• Risk Prioritization and Management: By classifying and organizing risks, risk taxonomy can support in determining the severity and likelihood of different risks. This helps in prioritizing risk management efforts and resources toward the areas where they are most needed.
• Enhanced Decision Making: A risk taxonomy can aid in recognizing patterns and relationships between different risks, providing valuable insights for strategic decision-making and planning.
• Regulatory Compliance: Many industries, especially financial services, are subject to regulatory requirements for risk identification, analysis, and reporting. An effective risk taxonomy can assist in meeting these requirements.
• Better Risk Culture: Finally, establishing a risk taxonomy supports in creating a stronger data risk management culture within the organization, as it standardizes the approach to risk and makes it a part of everyday business operations.

How Does Risk Taxonomy Work?

Risk taxonomy works by defining and classifying risks into organized categories. This structured framework allows an organization to understand the types of risks it faces systematically.

Here's a simplified breakdown of how it works:

• Risk Identification: First, all potential risks that an organization could face are identified. These risks could include operational risks, market risks, credit risks, strategic risks, and so on.
• Risk Categorization: Each identified risk is then classified into categories based on the nature and characteristics of the risk. For example, risks related to financing might be categorized as "financial risks", those related to operations as "operational risks", and so forth.
• Sub-Categorization: Within each category, risks are further divided into subcategories for greater precision. For example, under the category of "financial risks", subcategories might include "credit risk", "liquidity risk", "market risk", and so on.
• Risk Analysis and Prioritization: Once the risks are classified, they are analyzed based on potential impact and likelihood. This allows organizations to prioritize risks so they can focus resources on managing the most significant risks.
• Risk Management: Then, appropriate strategies and tactics to mitigate, transfer, avoid, or accept each risk are developed and implemented. The organization periodically reviews the risk taxonomy structure, and adjustments are made as necessary.

By classifying risks in this way, organizations can ensure that they have considered all possible types of risks and take a structured approach to risk management. It enables consistent communication about the risks within the organization and gives a comparative analysis of risks for better decision-making.

The Steps Required to Create Risk Taxonomies

Creating a risk taxonomy involves several steps:

1. Understand the Business Context: Before creating a risk taxonomy, it is vital to understand the business context and its objectives and strategies. This informs the types of risks that are most pertinent to the organization and how they can threaten its goals.
2. Identify Risks: Identify and list all existing and potential risks that the organization may face. This could include things like operational risks, financial risks, strategic risks, hazard risks, market risks, etc.
3. Categorize Risks: Sort the identified risks into categories. An organization can either use standard risk categories like strategic, operational, financial, and compliance or create its own based on its specific risk landscape.
4. Sub-Categorize the Risks: Break down categories into subcategories for more detail. For example, under the category of operational risks, you might have subcategories like IT risks, supply chain risks, human resource risks, etc.
5. Define the Risks: Clearly define each risk in the taxonomy. This will help everyone in the organization understand the nature and implications of a particular risk.
6. Assign Metrics to Each Risk: These metrics will be used to perform data risk assessment, which measures and assesses each risk. This could be a rating system, quantifiable metrics, or any other measurement system that works for the organization.
7. Review and Update the Taxonomy: Once the risk taxonomy has been created, it's not a set-and-forget exercise. It needs to be regularly updated and reviewed as risks, business contexts, and strategies change.
8. Communicate and Implement: Ensure the taxonomy is communicated across the organization and integrated into its risk management systems and processes. It should be used to identify, assess, and manage risks. 

Remember, the aim of creating a risk taxonomy is not to capture every conceivable risk but rather to provide a framework that can guide the organization's risk management efforts in a structured and systematic way.

Examples of Risk Taxonomies

Risk taxonomies will vary based on the industry and specific organization, but general categories of risk that might be included in a taxonomy include:

• Operational Risk: This includes risks associated with day-to-day operations, such as technology failures, process inefficiencies, or employee errors.
• Intellectual Property Risk: Intellectual property (IP) involves works, inventions, innovations processes, and other creative endeavors of the mind protected by patents, copyrights, and trade marks. Organizations protect their IP rights to avoid risks from intellectual property infringement.
• Strategic Risk: These risks affect the company's strategic goals and objectives. They can include things like competitive pressure, market trends, mergers and acquisitions, etc.
• Financial Risk: This would cover risks related to the financial aspects of a business, such as liquidity, credit, market, and interest rate risks.
• Compliance/Legal Risk: This involves risks related to compliance with laws and regulations. It could include risks like lawsuits, fines, or penalties for non-compliance.
• Reputation Risk: This could involve public relations issues that could potentially damage a company's reputation.
• Environmental Risk: This could include risks related to the impact of the company's activities on the environment.
• Cybersecurity Risk: This focuses on risks related to information system breaches, data theft, hacking, and other digital threats.
• Human Resources Risk: This would include risks associated with staff, such as retention, hiring, performance issues, labor disputes, etc.
• Supply Chain Risk: This includes risks in procuring and delivering inputs necessary for the business to operate efficiently.

These are broad examples, and organizations may choose to subdivide these categories further based on their specific needs.

The Challenges of Embracing Risk Taxonomies

Risk taxonomies, while incredibly useful for risk identification and management, come with their own set of challenges:

• Complexity: One of the most common challenges is the complexity of creating and implementing a risk taxonomy. Organizations must consider numerous potential risks across various categories and geographies, making the development process fairly complex.
• Subjectivity: There can be a level of subjectivity involved when identifying and classifying risks. Different individuals or departments within an organization might have divergent viewpoints on the degree of the risk and its classification.
• Evolving Risks: The dynamic nature of business environments means new risks can emerge and develop rapidly. Keeping the risk taxonomy updated to reflect these changes can be challenging.
• Overlaps and Gaps: Ensuring the taxonomy covers all possible risks without overlaps can be difficult. Overlapping can lead to confusion and inefficiencies, while gaps can result in unidentified and unmanaged risks.
• Lack of expertise: Without extensive knowledge and understanding of the organization’s operations, it's challenging to identify potential risks and categorize them properly. Limited expertise or knowledge may lead to a flawed taxonomy.
• Adoption and Consistency: After a risk taxonomy has been developed, ensuring its widespread adoption across various departments in a consistent manner can be challenging.
• Scalability: As a company grows and changes, the risk taxonomy must adapt and scale. It can be difficult to reassess and reestablish the taxonomy to accommodate growth or company operations changes.
• Compliance: Different regulatory bodies may require different types of risk categorizations, posing a challenge in developing a taxonomy that complies with all regulations.
• Technological Challenges: The integration of technology for the purpose of implementation, tracking, and updating the risk taxonomy can pose challenges, particularly in organizations lacking the necessary IT infrastructure.

Learn How Digital Guardian Can Improve Your Risk Taxonomy Classification

In conjunction with data risk assessment, risk taxonomy should be performed as an ongoing process as part of your organization's overall risk management and data governance framework.

Schedule a demo with us today to properly implement risk taxonomy and classification.