A risky business

By Cheranka Mendis

Risk and rewards are an integral part of a business. With the global scenario for the last few months showing the increasing need for risk management and the need to look beyond traditional models into something more substantive, management of risks in an active way, i.e. enterprise risk management, has become a hot topic worldwide.

Corporate Finance Professor at University of Florence, Academic Chairman of International Risk Management as well as President of Risk Banking and Finance Society Oliviero Roggi last week asserted that the new perspective of risk management is such that whether one may define it as corporate strategy, risk governance, quantity risk management or financial risk management, the underlying objective is the same: To get a decent reward for the risks you are taking.

Stating that many were baffled by the term risk management, Roggi noted that risk management was not risk hedging, but the exploitation of the side risks. He was speaking at the CIMA Financial Forum hosted by CIMA Sri Lanka Division and RAM Ratings Lanka last week.

Role of the CEO

A CEO who plays a pivotal role in a business enterprise has a key role to play when it comes to risk management and risk rewarding. A CEO should, among other things, ask himself what the risks are, how the risks affect corporate performance, how the company can actively manage risks, the sources of competitive advantage in risk taking and how the company can exploit them in building a good enterprise risk management system for increasing corporate value.

“A CEO is asked to establish corporate risk policy so they are in charge of the exploitation of that implementation of strategies. A CEO must set up an enterprise risk management framework, make sure the risk management and risk officers act according to the board of directors’ risk appetite and be responsible of the losses generated to the management,” Roggi said.

Defining risk management, he stated that the terms stands for identification, assessment and handling of risks actively through a corporate action and control; and minimising adverse effects of unfortunate event as well as maximising the opportunity. “Risk taking and risk management allows you to take more risks in a conscientious way. It doesn’t allow you to just protect yourself from the downside risks.”

Lessons learnt

The first lesson to be learnt under the topic is that even if you don’t want to manage risks, the risks will indefinitely manage you. “If you don’t know the risks you are facing, you will retain it at a risk. A risk neglected is a risk retained. You cannot hide from it. Therefore it’s a good thing then, to invest money on some risk management practices,” he noted.

Claiming that the question about perfect software to mark and manage risks was a common one, he asserted that there was no good software to manage risks but it is what you add to your software that makes it good. “If you don’t treat risks and you don’t know your risks, you will retain it without knowing it and it will affect your performance severely.”

Embarking on lesson two, the differentiation between risk management and risk hedging, he said the two terms have been constantly misused in the past 20 years.

“Sometimes managers tend to over hedge the risks. During the last 20 years 70% of the CEOs in the gold mining industry were fired. Why? Gold is a booming bubble; pity they sold in advance all production in order to avoid a hedge increase in gold prices. This made shareholders lose 60% of the incremental value and due to that the CEOs got fired,” he said. “Sometimes you’ve got to stay with the risks but you should know which risk you want to stay with and what you don’t want to stay with.”

 Enterprise risk management

ERM or Enterprise Risk Management, yet another hot topic in the corporate world, was defined going by Manhanan’s (2008) theory as ‘dealing with an uncertainty for the organisation’. This means anything and everything is included in the practice.

“While we do have to set up an enterprise risk management framework, why is it valuable to have risks managed in an effective way?” Roggi questioned. “ERM is a tool to generate new value. It is a new perspective on your every day job. It will never affect your performance; it is what you put into the programme, your feed to the programme that is important.”

ERM is strongly related to corporate governance and should aim at generating new value. It should minimise risks through lowering cost of capital, default risk and default speed. Active RM generates incremental positive cash flow mainly through tax optimisation. “If you optimise the capital structure due to analysis you have done on your risks, you can lower the cost of capital. Here the equity value will automatically increase.”

Detailing the risk management process, he said the standard procedure was (a) setting the risk appetite (setting the firm’s risk management goals and implementing it), (b) risk assessment (risk analysis and evaluation), (c) risk treatment and (d) risk monitoring.

Roggi said: “You must ask yourself what your five big risks are and then move forward.”

The company should also look at how the risk is distributed, what the economic impact is, what the potential losses generated are and what it is going to do. “If I take it I must ensure I have the capital and equity to sustain it in case a sudden event occurs.”

Risk mitigation

Outlying the tools for risk mitigation and risk transfers, Roggi stated that the key tools were the in-balance and the out-balance sheet.

A capital structure which is a mix of financial suppliers is important in order to mitigate both market and firm specific risks. “If you have to manage a lot of risks, you have to have lot of equity. You need enough capital to sustain the expected loss. At the state level, this is not something that can work, but for a company it works,” he said.

Insurance linked securities issued by the firm are also a tool to ease risks, he asserted. Insurance is good for almost all types of risks but insurance cannot protect against core business risks, Roggi observed.

“Forwards futures and options are important mainly to mitigate commodities and currency risks. Swaps which include interest rate swap, credit default swap and currency swap also go to address market risks.” Contingent capital is also part and parcel of the bulk.

Equity, he said, should be collected as a source of competitive advantage for risk taking and active risk exploitation. It would give the company an advantage over information, speed, experience and resources while creating flexibility. With competition now coming by nation and not by company, intelligence and having a knowledge advantage is very important, Roggi said.

Proper risk mitigation will enable performance boost in a company, he stated. “Risk is everywhere. It is a threat and an opportunity. Risk management takes both these aspects into consideration – mitigating threat and enhancing opportunity and value creation.”