This article looks at the changing view of risk management within companies.
In orthodox terms, says Anthony Santomero, managers ought not to be concerned with balancing risk within an organisation since the owners of the business the shareholders will have balanced their own risk though holding a diversified portfolio of shares. However, managers are concerned to manage risk within their organisations. This can be attributed to a number of factors: managerial self-interest the tax structure the costs of financial distress and imperfections in the capital market.
Santomero argues that managers are right to be concerned about risk since the effect of risk is to produce volatility in market value. The second part of his article deals with how risk should be managed and the steps that non-financial and financial companies have taken to manage risk. It concludes with a number of suggestions for a risk management policy.
lEconomic thought has traditionally regarded the world as a place where agents maximise their gain, subject to a series of constraints. The typical consumer is assumed to be interested in consumption, with more being preferred to less. The key constraint is a budget limitation, which identifies the problem as essentially an economic one where choices have to be made.
At the same time, companies organisations that are increasingly mere coalitions of individuals with investment opportunities are viewed as providing profit opportunities for investors. These companies have been characterised as selecting investment opportunities with a single-minded emphasis on expected profit.
Investors can select which companies to invest in, in order to obtain their preferred risk-return trade-off. Therefore, companies have no reason to bundle projects to obtain a particular risk profile because their owners can diversify across businesses to achieve a specific bundle of risk and reward.
Recently, however, this view of the companys goals and operating mode has changed. Economists have begun to recognise firm-level risk issues as important considerations and have gone on to develop a way of thinking about risk and its place in the firm. In doing so, economic theory has developed positive theories of optimum volatility management. These ideas have developed under the title of financial risk management.
Why manage risk?
Why do managers of organisations, who are presumed to be working on behalf of the companys owners, concern themselves with both expected profit and the distribution of firm returns around their expected value?
There are four reasons according to academic study:
l Managerial self-interest
l The tax structure
l The cost of financial distress
l The existence of capital market imperfections.
In each case, management is shown to be in an environment in which expected profit does not provide sufficient information about a project or investment decision managers must concern themselves with the variability of returns.
In the first case, the managers are risk averse, even though the shareholders are not. In the other three cases, a feature of the economic environment leads managers to maximise shareholder value by behaving in a risk-averse manner.
Managerial self-interest
The first reason given for risk aversion relates to managers self-interest.
It is argued that managers have limited ability to diversify their own personal wealth position, which is associated with their company-specific stock holdings and the value of their earnings in their current employment.
They, therefore, prefer stability to volatility because, other things being equal, such stability improves their own position at little or no expense to other stakeholders.
Objections have been offered to this line of reasoning. Some find it unconvincing because it offers no reason for a manager to hedge his or her risk within the company rather than directly in the market.
According to this view, managers could enter the financial market to off-set the effect of the close association of their wealth with company performance. By taking a short position in the market, managers could obtain any level of concentration in firm-specific profitability.
However, this argument misses at least three important features of the employment relationship.
First, it is probably problematic for senior managers to be seen to divest, or to be systematically diversifying away, investments correlated with company performance. Such a public divestiture would be required to properly hedge managements personal investment profile.
Second, to the extent that some outcomes, defined as financial distress, lead to their employment contracts being terminated, it may be in the best interest of management to constrain firm-level outcomes, so that the future value of their employment earnings is not lost.
Thirdly, arguments in favour of simple expected-profit decisions neglect the fact that managements abilities are not directly observable. Therefore, observed outcomes may influence owners perception of managerial talent. This would, in turn, favour reduced volatility or at least the protection of company profitability from large negative moves.
For all, or any one of these reasons, there appears to be ample justification for the view that managers will and should worry about risk.
The tax structure
Beyond managerial motives, firm-level performance and market value may be directly associated with volatility for a number of other reasons.
The first is the nature of the tax code, which both historically and internationally, is not strictly proportional. With a progressive tax structure, income-smoothing reduces the effective tax rate and, therefore, the tax burden shouldered by a company. By reducing the effective long-term average tax rate, activities which reduce the volatility in reported earnings will enhance shareholder value. However, two points are worth mentioning in this context.
First, with the advent of more proportional tax schedules, particularly in the US, the arguments here are somewhat mitigated. In fact, one should observe, other things being equal, a decline in the interest in risk management by American businesses over the past decade. No one, however, has suggested that such is the case.
Second, the tax argument rests on reported income not true economic profit. To the extent that generally accepted accounting principles permit tax planning, this argument may favour tax-motivated reporting and more careful management of the difference between the book and market value of profits.
Since there is significant discretion in tax reporting, tax consideration may not motivate actual decision-making nearly as much as this theory suggests. However, the argument here is that real economic decisions are affected by the tax code not just their reporting.
The cost of financial distress
Companies may also be concerned about earnings volatility because of the consequences of profits differing greatly from expectations and the implications of such negative news for corporate viability.
To the extent that a financial crisis or bankruptcy is associated with an increase in costs, a company will be forced to recognise this in its behaviour. In such cases, it will behave in a risk-averse manner because it is in its best interest to do so.
Numerous studies offer evidence of the cost associated with financial crisis. The first paper dates back to 1977 and presents empirical evidence of very high bankruptcy costs. More recent studies continue to reinforce the importance of these additional burdens on the company.
Expenses associated with bankruptcy proceedings legal costs and perhaps most importantly the diversion of management attention from creating real economic value are large and management correctly seeks to avoid them.
As a result, standard corporate finance training frequently refers to the cost of bankruptcy in the analysis of investment decisions. It is also worth noting that this cost is, perhaps, even more important in regulated industries.
In these cases, large losses may be associated with the withdrawal of a license or charter and the loss of a monopoly.
Capital market imperfections
The fourth explanation rests on the need for investment at the company level.
According to this view, volatility disrupts investment because it forces a business to both reduce the amount of capital devoted to new projects and seek external resources at times of low profitability.
However, external financing is more costly than internally generated funds due to capital market imperfections. These may include the transaction costs associated with obtaining external financing, imperfect information in the market about the risk of investment opportunities or the high cost of potential bankruptcy associated with a higher debt burden.
These added costs result in under-investment in low profitability periods.
Put another way, the volatility of profitability causes the company to seek external finance to exploit investment opportunities when profits are low.
The cost of such finance is higher than internal funds due to the markets higher cost structure associated with the factors enumerated above. This, in turn, reduces investment and expected profits.
The cost of volatility is the foregone investment or lowered earnings in each period that the company is forced to seek external funds. Recognising this, the company embarks upon volatility-reducing strategies, which reduce earnings vari-ability. Hence, risk management is optimal in that it allows the business to obtain the highest expected shareholder value.
Together, the stories work fairly well. Corporate managers are interested in both expected profitability and the risk, or the variability, of reported earnings. This conc-ern is explained by the costs that vary across the range of possible profit figures associated with any given expected performance.
Therefore, the company is led to treat the variability of earnings as a variable that it selects, subject to the usual constraints on management.
How it proceeds to manage its risk position is dealt with next.
How are risks being managed?
The question is easy enough but the answer is not so easy. Risk management can quickly be divided into three sub-fields of research. While there are overlaps, the questions, answers and open issues vary by area of discussion. It is, therefore, useful to address each of the following questions:
lHow should risks be managed?
lWhat have non-financial companies done by way of risk management?
lHow have financial companies addressed the issue?
The three areas can be seen as two separate problems: theory and application. However, in as much as financial company risk management has developed separately, it is useful to treat the application of risk- management techniques in the financial sector as a separate issue.
How should risk be managed?
This first question is the easiest to answer but hard to implement. When a manager is making the decision to further advance his or her own best interests the problem becomes the usual one of portfolio choice.
Projects and/or activities are selected using the standard risk-return trade-off that finance has long promulgated. Projects are selected according to their expected profitability, their variance and the covariance of their returns with other projects within the firm.
On the other hand, if the managers concern over risk is due to its effect on overall firm value, as discussed above, then managers must recognise the effect of volatility on market value. This will lead them to alter their decisions and encourage risk management and control.
In either case, implementing such a risk-management procedure requires a strategy that includes both risk identification and risk reduction. The former involves an analysis of the drivers of firm performance and the reasons for the volatility in earnings and/or market value. The latter is accomplished through the standard procedures of risk reduction, such as standard diversification procedures, and rules that limit potential extreme downside results.
Non-financial companies
From theory to practice, we move from the neat realm of concept into the difficult area of implementation. Here, little information exists on the practices employed by non-financial companies. General management practices to dampen the variability of cash flow and/or profitability are not documented in any systematic way.
Nonetheless, it is generally accepted that risk management can be conducted in two ways. Either a business can engage in activities that together result in less volatility than they would exhibit individually or it can use financial transactions to similar effect.
The first approach is to embark upon a diversification strategy in the portfolio of businesses operated by the firm: in short, engage in diversification by conglomerate merger.
However, conglomerate activity, while once a popular strategy, has fallen out of favour. Most companies have learned that they do not necessarily have value-added expertise in more than one area and have found it hard to prosper across industry lines. As a result, those concerned about the volatility of earnings have turned to the financial markets.
This is because these markets have developed more direct approaches to risk management that transcend the need to invest directly in activities that reduce volatility.
Financial risk management, using financial products such as swaps, options and futures, can accomplish the same ends and has thereby experienced explosive growth. Such derivative products have proved to be an important means of risk trading. The result of such use on shareholder value, however, is still an open question. The popular press has spotlighted the misuse and abuse of derivatives at Proctor and Gamble, Metallgesellschaft and Gibson Greetings.
Companies are, therefore, concerned that use of derivative products will hit their stock prices. At the very least, it is a public relations problem.
Financial companies
In many respects the story associated with risk management for industrial companies is transferable to their financial counterparts. However, the issue is more complicated for financial companies.
These companies deal in financial markets, as principals and agents, and have a long history of both hedging capability and taking positive risk positions. In fact, it could be argued that their franchise involves taking the financial risk from the non-financial sector.
However, taking financial risk does not imply keeping it. As corporate entities, these organisations, like their non-financial counterparts, must deal with the same issues that motivate the rest of the private sector.
They are run by managerial talent that must be concerned with risk for their own benefit. They face the same tax structure and are even more concerned by the cost of financial distress.
While it could be argued that regulatory oversight and its implicit guarantee makes them less risk averse, the existence of regulators that charter and sustain the institutions franchise makes risk a real concern.
Management, therefore, must find the correct place for risk management in a sector that has both a reason for taking financial risk and reasons for concern over doing so.
It is, therefore, useful to distinguish two ways of delivering financial services. These can be provided either as an agent or as a principal. In the former, risk is borne by the two sides of the transaction, with little remaining with the financial institution that facilitated it. In the latter, risk is absorbed by the financial institution itself because it places its balance sheet between the two sides of the transaction.
The choice between these two techniques seems to depend upon the institutions value-added or unique expertise in managing the associated risk. For some risks, the institution frequently finds itself absorbing risk associated with its asset services rather than transferring it, while for others the opposite is true.
The latter group, where financial transactions transfer risk to the buyer of assets, is growing more rapidly. As information and transaction costs have declined, the fraction of financial assets held by risk-transferring institutions, such as mutual funds, pension funds and unit trusts, has increased relative to those held in risk-absorbing institutions such as commercial banks and other depositories.
This is due to the decline in the returns offered to these institutions to bear such risks. Nonetheless, balance sheet risk management is still an important issue in the financial sector. Institutions that accept certain types of financial risk, because of their business strategy, require risk control and management procedures.
These should involve the same steps and obtain the same results as indicated above. The drivers of uncertainty must be identified and risk-reduction strategies outlined. The distinction here is that the risks are different from those faced by the non-financial sector.
Standard bank management texts, however, have long discussions on risk-identif-ication and risk-management strategies. In a recent review of risk techniques and their application in the financial sector, Babbel and Santomero (1997) and Santomero (1997) catalogue the procedures used, along with the compromises made along the way.
Where do we go from here?
The fact that risk matters is, perhaps, not news to senior managers.
However, the news is that there is a better understanding of why risk matters and how it should be managed.
Whether a company is in the manufacturing sector or financial services, it has risks that need to be managed. In todays business environment no organisation is immune from risk and none can be without a risk-management and control process.
To do so, however, requires a risk-management system that measures, controls and monitors these risks. In addition, it must hold accountable all those that are responsible for controlling the complex set of risks that impact upon firm performance. As a result of financial change and asset innovation, we have begun to develop a deep understanding of how to fashion an appropriate risk-manage-ment system. In fact, the implementation of broad risk-management systems has become big business indeed a growth area of management interest and consulting.
What does such a system involve?
As noted above, it begins with a careful identification of the causes of volatility the factors that lead to variation in performance. Next, the risks that have been so identified must be actively managed.
Recent research has shown how this is accomplished by standardised procedures that measure, monitor and limit the risk-taking activity in order to reduce the volatility of performance. Such systems usually include four parts:
lStandards and reports, which identify, measure and monitor the factors that cause volatility
lLimits and controls on each of the factors and on each member of the organisation that adds risk to a companys performance profile
lGuidelines and management recommen-dations concerning appropriate exposure to these same risks
lAccountability and compensation progr-ammes that lead mid-level managers to take the process seriously.
While still in the formative stage, such systems have proved valuable to organisations that have implemented them and are rapidly becoming a standard part of the managerial tool kit. This should not be a surprise.
Shareholders care about risk, the stock market cares and, as has been said, so should senior management. The challenge for these managers is to adopt a risk-control system that reduces the volatility of profitability and engenders a risk-control mentality throug-hout the organisation.
