What is vendor risk management and why do you need it?

Navigating the world of third-party suppliers can feel like walking a tightrope—you're balancing potential rewards against very real risks. Our recent data reveals a stark reality: 94.8% of fintech executives have faced vendor-related risks in the past three years, with a shocking 61.9% experiencing three or more incidents. This highlights the crucial need for effective vendor risk management.

This article dives deep into the essentials of vendor risk management, offering practical strategies to protect your organization. We'll explore the tangible benefits of a solid risk management policy and guide you through the process of creating one.

What is vendor risk management (VRM)?

Vendor risk management focuses on identifying, assessing, and mitigating vendor risks, whether they're financial, operational, reputational, or related to data security. 

Just as you wouldn't let a stranger into your home without checking them out, you shouldn't onboard a supplier without understanding the potential risks they bring. Vendor risk management is essentially your company's due diligence process for dealing with third-party providers. 

Beyond simply preventing the worst-case scenarios, a robust vendor risk management strategy cultivates strong, reliable relationships. This strategy helps you make smart decisions about who you work with, ensuring they align with your company's values and standards.

It's a continuous process, not a one-time check, because the risk landscape is always changing. By staying proactive, you can protect your organization from unexpected disruptions and maintain a smooth, efficient workflow.

Types of vendor risks

Every supplier relationship carries some level of risk, and understanding the different types is essential for effective management. The potential pitfalls are diverse, from financial instability and operational disruptions to data breaches and compliance failures—especially with evolving global regulations.

Let's break down some of the most common vendor risks that could impact your business.

Financial risk 

Financial risk is the possibility that your supplier might go belly-up or experience financial instability, leaving you in a lurch. 

Imagine you're relying on a small supplier for a critical component in your product. If they suddenly can't deliver due to cash flow problems, or worse, go bankrupt, your production line grinds to a halt. That's financial risk hitting you where it hurts, impacting your bottom line and disrupting your operations.

Operational risk

Operational risk centers around the supplier's ability to actually deliver on their promises. Think of it as the "can they actually do what they say?" factor. 

A recent example of this can be seen with the ongoing disruptions in global shipping and logistics. Many businesses rely on third-party logistics providers for timely delivery of goods. When these providers face unexpected delays due to port congestion, labor shortages, or geopolitical instability, businesses experience significant operational disruptions. 

If a retailer relies on a logistics supplier to deliver seasonal inventory, and those deliveries are severely delayed, it can lead to empty shelves, lost sales, and frustrated customers. That's operational risk disrupting your day-to-day, leading to unhappy customers and a damaged reputation.

Compliance risk

Compliance risk boils down to whether your supplier is playing by the rules—and whether those rules align with your own. With evolving global regulations like DORA, this area is growing increasingly complex. 

For instance, if your data storage vendor isn't adhering to the latest data privacy laws or if your financial services vendor fails to meet new operational resilience standards, your company could face hefty fines and legal headaches. It's not just about their compliance; it's about how their non-compliance reflects on you.

Strategic risk

Strategic risk is when your supplier's business goals or practices diverge from your own, potentially hindering your long-term plans. This misalignment can create unforeseen obstacles and derail your strategic objectives.

Picture this: You've partnered with a tech vendor that's shifting its focus to a different market segment, leaving your specific needs behind. Suddenly, your critical software is no longer supported, forcing you to scramble for a new solution and delaying your strategic initiatives. That's strategic risk in action, where a misaligned supplier can throw a wrench in your company's growth trajectory.

Reputational risk

Reputation risk is all about how your supplier's actions reflect on your own company's image. If they mess up, you get the blame by association.

Here's a very recent example of how a supplier issue can cause major reputational damage: Think about the ongoing concerns with Boeing and their third-party suppliers. There have been multiple reports about quality control issues with parts supplied by Boeing's suppliers. Even though Boeing isn't making those faulty parts themselves, the fact that their suppliers are supplying them is causing significant damage to Boeing's reputation. People are worried about the safety of their planes, and that's directly tied to the performance of Boeing's suppliers. This shows how a supplier's failures can seriously impact a company's brand image and customer trust.

Information security risk

Information security risk is the danger that your supplier's data handling practices could expose your sensitive information to breaches or leaks. It's about how well they protect the data you share with them. 

A recent example highlighting this risk is the widespread impact of the MOVEit transfer vulnerability in 2023. This file transfer software, used by numerous organizations across various sectors, contained a critical vulnerability that allowed hackers to steal sensitive data. Because many companies relied on this third-party tool, a single flaw exposed countless organizations to data breaches, causing significant financial and reputational damage. 

Cybersecurity risk

Cybersecurity risk focuses on the danger of your supplier's systems being compromised, which can then expose your own data and infrastructure to attacks. Whereas information security risk is the broader category encompassing the risk of unauthorized access, use, disclosure, disruption, modification, or destruction of any form of information, cybersecurity risk specifically focuses on threats to information in its digital form and the systems that process it. It's essentially about how well the supplier protects their digital environment, and by extension, yours.

A prime example is the recent surge in ransomware attacks targeting third-party software providers. If a vendor supplying your critical business tools gets hit with ransomware, it can cripple your operations, expose sensitive data, and cost you a fortune in recovery.

Imagine your customer relationship management software provider falls victim to a cyberattack, and your entire customer database is compromised. This can lead to data breaches, operational shutdowns, and severe reputational damage.

Environmental, social, and governance (ESG) risk

ESG risk centers on how your supplier's environmental, social, and governance practices align with your company's values and regulatory requirements. Think of it as ensuring your partners are responsible citizens, not just service providers. 

For example, if you're a company committed to sustainable sourcing, but your packaging supplier sources materials from companies with poor environmental track records, you face ESG risk. If reports surface of labor violations or unsustainable practices within their supply chain, your reputation takes a hit, and you may face regulatory scrutiny. It's about ensuring you’re sourcing suppliers who uphold the same ethical and sustainable standards you do, because their actions reflect directly on your brand.

Why is vendor risk management important?

Relying on third-party vendors is essential, but it also opens your company up to a range of vulnerabilities. A complete vendor risk management strategy acts as your first line of defense, navigating threats and safeguarding your operations. Let's explore the key reasons why every business needs vendor risk management.

• Data privacy and security: A strong vendor risk management strategy protects sensitive customer and company data by ensuring suppliers adhere to strict data handling and security protocols, minimizing the risk of costly breaches.
• Regulatory compliance: Risk management helps companies stay compliant with evolving industry regulations and legal requirements, avoiding penalties and maintaining legal standing.
• Operational continuity: This strategy minimizes disruptions by ensuring suppliers have the capacity and stability to maintain consistent service delivery, safeguarding your business operations.
• Financial stability: It reduces the risk of financial losses due to supplier instability or bankruptcy, protecting your bottom line and preventing unexpected expenses.
• Reputational protection: Effective vendor risk management shields your brand from negative publicity associated with supplier failures or unethical practices, preserving customer trust and business credibility.
• Cybersecurity defense: It strengthens your overall cybersecurity posture by assessing and mitigating vendor-related vulnerabilities, preventing costly cyberattacks.
• Supply chain resilience: A robust strategy builds a more adaptable supply chain by diversifying suppliers and assessing their ability to withstand disruptions.
• Contractual compliance: Vendor risk management ensures suppliers adhere to agreed-upon contractual obligations, minimizing disputes and protecting your company's interests.
• Cost optimization: Risk management identifies potential cost inefficiencies and helps negotiate better supplier contracts, maximizing value and minimizing unnecessary expenses.

How to implement an effective VRM strategy

Setting up a vendor risk management strategy might sound like a big undertaking, but it's really about creating a system that fits your company's specific situation. By breaking it down into clear steps, you can set up guidelines that keep your business safe and help you build solid, trustworthy partnerships.

1. Establish a VRM

The first step is to lay the groundwork for your VRM strategy. You'll want to get crystal clear on your objectives. What are you trying to achieve? Are you focused on data security, financial stability, or maybe compliance? Defining these goals will keep your efforts on track. 

Next, you’ll need to assign roles for each part of the vendor risk management process, like:

• VRM program owner/manager: This individual oversees the entire VRM program, ensuring policies are implemented, risks are assessed, and processes are followed.
• Procurement/sourcing specialist(s): These roles are crucial during supplier selection and onboarding, evaluating potential vendor risks before contracts are signed.‍
• Legal/compliance officer(s): This role ensures suppliers comply with all relevant laws, regulations, and contractual obligations.‍
• Information security officer/team: They assess vendor cybersecurity risks and ensure data protection standards are met.

Clear responsibilities avoid confusion later on.

2. Lay out your policies and procedures

Step two is all about creating your vendor risk management playbook. You're drafting the rules of the game so everyone knows what to expect. These clear, easy-to-follow guidelines should cover everything from how you'll assess new suppliers to how you'll monitor existing ones, and what steps you'll take if things go sideways. These policies should reflect your organization's risk appetite—the level of risk you're willing to accept when working with suppliers.

Here are some examples of policies and procedures you might want to include:

• Supplier onboarding policy: This outlines the steps for evaluating and selecting new suppliers, including due diligence checks, risk assessments, and contract reviews.
• Vendor risk assessment procedure: This details how you'll assess various types of risks (financial, operational, compliance, etc.) and how often you'll conduct these assessments.‍
• Vendor monitoring policy: This explains how you'll track supplier performance, monitor compliance, and stay on top of any changes that could affect your business.‍
• Incident response plan: This outlines the steps you'll take if a vendor-related incident occurs, such as a data breach or service disruption.‍
• Contract management procedure: This covers how you'll manage supplier contracts, including renewals, terminations, and dispute resolution.‍
• Data security policy: This explains the requirements for suppliers who handle company data and how audits will be conducted.‍
• Offboarding policy: This covers how you will end a supplier relationship and what steps you need to take to protect company data.

3. Identify and categorize your suppliers

While we encourage you to treat every supplier as a trusted partner, we know some are more important than others. Categorization helps you prioritize your risk management efforts, focusing on the suppliers that pose the greatest potential threat.

First, you'll want to create a comprehensive list of every third-party supplier you use. Include what services they provide and their contact information. Think of it as taking inventory of all your supplier relationships. 

Then, you'll classify these suppliers based on how critical they are to your operations and the sensitivity of the data they handle. For example, a supplier that manages your core financial systems and has access to customer data would be "Critical" or "High" risk. A supplier providing office supplies might be "Low" risk. Consider things like their access to sensitive data, their impact on your essential business processes, any relevant regulations, and the potential financial hit if something goes wrong. 

Here’s a quick example of what a supplier categorization sheet might look like:

4. Conduct vendor risk assessments

Now we're diving into the heart of vendor risk management: conducting vendor risk assessments. Think of this as your supplier health check. It's about taking a close look at each supplier to understand the potential risks they bring to the table. 

Here's a breakdown of what a thorough vendor risk assessment should include:

• Financial stability: Review of financial statements, credit ratings, and any history of financial difficulties
• Operational capabilities: Assessment of the supplier's ability to deliver on their promises, including their capacity, resources, and track record
• Data security and privacy: Evaluation of their data handling practices, security certifications (like ISO 27001 or SOC 2), and compliance with data privacy regulations
• Compliance with regulations: Verification that the supplier adheres to all relevant industry regulations and legal requirements
• Reputational risk: Checks on the supplier's reputation, including any history of ethical lapses, legal disputes, or negative publicity
• Cybersecurity posture: Review of their cybersecurity defenses, including vulnerability assessments and penetration testing
• Business continuity and disaster recovery: Evaluation of the supplier's plans for maintaining operations in the event of disruptions or disasters
• Contractual risks: Review of the contract terms and conditions to identify any potential risks or liabilities

Here's where AP automation solutions like Zip can really come in handy. They can streamline this process by automatically screening suppliers for fraud and non-compliance with global regulations, saving you time and reducing the risk of human error. Think of it as having a digital assistant that helps you spot red flags early on. Learn how Zip can help.

5. Assess risk domains

Let's move on to assessing those risk domains, diving deeper into each type of risk you've identified in your risk assessment. Think of it as taking a magnifying glass to each area, like cybersecurity, compliance, and financial stability, to see exactly where the potential problems might lie. 

Once you've analyzed each domain, you'll want to assign risk scores or ratings to your suppliers. This helps you prioritize and focus on the suppliers that pose the highest risk to your business. It's like creating a risk scorecard, so you can easily see who's doing well and who needs closer attention. 

Don't forget to keep detailed records of all your risk assessments and due diligence activities. This documentation is your paper trail, providing evidence of your efforts and helping you track changes over time.

6. Develop mitigation strategies

Now that you've identified and assessed the risks, it's time to develop your plan of attack to minimize those risks. You'll want to address each identified risk with a specific plan of action. For example, if a supplier has weak cybersecurity, you might require them to implement stronger security controls or undergo regular security audits. 

A big part of mitigation also involves negotiating contractual terms. This is where you work with your legal team to ensure your contracts clearly outline each party's responsibilities and liabilities and that there are clauses in place to protect your company in case something goes wrong. 

You'll also want to think about implementing security controls, like access restrictions or data encryption, to further protect your sensitive information. By proactively addressing these risks, you're building a safety net that protects your business from potential vendor-related procurement risks.

7. Ongoing monitoring and review

It's not enough to just assess risks once; you need to keep a close eye on your suppliers to ensure they're still meeting your standards. You'll want to establish a vendor risk monitoring process that includes tracking key performance indicators (KPIs), conducting regular audits, and staying informed about any changes that might affect your supplier's performance or risk profile.

This ongoing monitoring helps you catch potential problems before they escalate. You'll also want to conduct periodic reviews of your VRM program to make sure it's still effective and up-to-date. And, most importantly, you need a plan for how to respond to vendor-related security incidents so you're prepared if something does go wrong. By staying vigilant and proactive, you can ensure your supplier relationships remain strong and secure over the long haul.

Best practices for managing vendor risk

Rather than reacting to problems, effective vendor risk management focuses on proactively building robust and reliable partnerships. By implementing best practices, you can minimize potential threats and maximize the value of your supplier relationships. Let's explore some key strategies to enhance your vendor risk management program.

• Seek customer recommendations: Want to know the real deal about a supplier? Ask their other customers. You'll get honest feedback that goes beyond the sales pitch, giving you a much clearer picture of what they're like to work with.
• Have suppliers sign a service-level agreement (SLA): Clearly define expectations, performance metrics, and responsibilities in a formal agreement. This keeps everyone on the same page and avoids misunderstandings.
• Establish a centralized risk management program: Consolidate vendor risk management processes under a single, cohesive program. This makes everything more organized and efficient, so you can keep a consistent eye on things.
• Implement a risk-based approach: Don't waste time worrying about every tiny risk. Focus on the suppliers that could cause the biggest headaches. This way, you're putting your energy where it matters most.
• Foster strong communication and collaboration: Build open lines of communication with your suppliers. Open communication makes it easier to spot problems early and work together to find solutions. 

Safeguard your bottom line with risk orchestration

Modern business is more interconnected than ever before, leading to a slew of new vendor-related risks to navigate. By understanding the types of risks, implementing a solid supplier relationship management strategy, and following best practices, you can build stronger, more secure supplier relationships and protect your bottom line.

And that's where Zip comes in. Zip's risk orchestration solution can help you streamline and automate your supplier risk efforts. From initial assessment to ongoing monitoring, Zip provides a centralized platform to identify, evaluate, and mitigate vendor risks with the help of smart automation. 

Key features like cross-functional risk approval, real-time risk monitoring, and comprehensive reporting empower you to make informed decisions about your suppliers and stay ahead of potential issues. 

Ready to take control of your vendor risk? Explore Zip's risk orchestration capabilities today.