The benefits of risk management

What is the rationale for risk management? Ultimately, risk management must benefit the shareholders. After all many of the risks a company faces, are specific to it. Portfolio theory argues that shareholders are rewarded only for systematic risk. Unsystematic risk, i.e., risk specific to a company can be diversified away by purchasing shares in a reasonably large number of companies. If shareholders can manage risk more efficienty on their own, by buying shares in various corporations, should companies really manage risk? The answer is an emphatic yes.

For starters, shareholders do not have all the information needed to manage the risks a company faces. Moreover, even if they had, individual shareholders would find it inefficient and expensive to manage risks on their own. The transaction costs would be too high if a large number of small hedging transactions are undertaken. Finally, distress situations are eminently avoidable. During such situations, significant value destruction takes place as the assets of the company trade at unrealistically low prices. Recall the collapse of Bear Stearns in March 2008 and Lehman in September 2008.

Prudent risk management ensures that the firm’s cash flows are healthy so that the immediate obligations and future investment needs of the firm are both adequately taken care of. Firms typically run into cash flow problems because they fail to anticipate or handle risks efficiently. These risks include market risks such as vulnerability to interest rate, stock index and exchange rate movements. Then there are credit risks which arise because of excessive investments in the same asset class or lending to the same customer segment. They also include liquidity risks such as liquidity black holes, which result when the entire market shifts to one side, with sellers finding it difficult to find buyers. Firms may also fail to anticipate business risks when the demand suddenly falls or a rival starts taking away market share aggressively with a new business model or technological innovation. Then there are various examples of companies failing to manage operational risk effectively because of poor systems and processes.

Risk management helps in sustaining the staying power of an organization. In 1993, Metallgesellschaft which tried to cover the risk associated with its long term contracts through oil futures ended up losing a huge amount. The star studded team at hedge fund, Long Term Capital Management could do little as unexpected interest rate and currency movements brought the fund to the edge of bankruptcy in 1998. In both the cases, the positions taken were fundamentally sound. But there were serious doubts about their ability to tide through the crisis. Indeed, much of the sub prime crisis has been about liquidity. Under the circumstances, liquidity has become the most potent weapon in many sectors. Liquidity gives the comfort to sustain day-to-day operations and more importantly make those vital investments that are needed to sustain the company’s competitiveness in the long run. Sound risk management goes a long way in ensuring that the organization has the required liquidity to function effectively even in bad times.