Towards integrated risk management: the three ways of managing risk

In a world of risk, it is important not only for banks but also for non banking corporations to manage risks strategically and holistically. Integrated risk management is all about the identification and assessment of the risks faced by a company as a whole, followed by the formulation and implementation of a companywide strategy to manage them. According to Lisa Melbroek[[“Integrated Risk Management for the firm: A senior Manager’s Guide,” Working Paper, Harvard Business School, 2002] companies must learn to use the best combination of three complementary approaches to risk management.

v The first is to modify the company's operations suitably.
v The second is to reduce debt in the capital structure.
v The third is to use insurance or financial instruments like derivatives to transfer the risk.

Take the case of the environmental risk that a heavy chemicals manufacturer faces. Modifying the company's operations could mean installation of sophisticated pollution control equipment. The company could also reduce debt and keep plenty of capital to deal with any contingencies arising out of environmental mishaps. The company can also achieve risk transfer by buying an insurance policy that would protect it in case an accident occurs.

An oil company needs a steady supply of petroleum crude to feed its refinery. Oil prices can fluctuate, owing to various social, economic and political factors. Indeed, they have done so in recent months. The company can set up, or at least tie up, with a large number of oilfields all over the world to insulate itself from volatility. This would limit the damage due to Opec actions, terrorist strikes or instability in Islamic countries. In case of a long recession, the best bet for a company would be to keep minimum debt and maintain huge cash reserves. The company may also resort to buying oil futures contracts that guarantee the supply of crude at predetermined prices.

A company like Walt Disney, which operates theme parks, is exposed to weather risks. If the weather is not sunny, people will not turn up. So, Disney took a decision to set up its second theme park in Florida. Today, the company can buy weather derivatives or an insurance policy to hedge the risks arising from inclement weather.

A similar argument may well apply to the Board of Control for Cricket in India (BCCI). These days, with big money involved, especially in the form of television rights, cricket matches are scheduled all through the year. So the threat of rain is real. If a match is washed off, the losses will be heavy. BCCI has two options. It can stick to the cities where there is little rain. In the long run, it can even explore the possibility of indoor stadia. This is the operational solution. Alternatively, BCCI can take insurance cover. This is the risk transfer approach.

The software giant, Microsoft, operates in an industry where technology risks are high. The company manages risk by maintaining low overheads and zero debt. But Microsoft also has organisational mechanisms to deal with risk. The capacity of a software company is effectively the number of software engineers on its payroll. Excess capacity can create serious problems during a downturn. Right from the beginning, Microsoft’s founder, Bill Gates was particular about not employing more persons than required. So, Microsoft has always maintained lean staffing, depending on temporary workers to deal with surges in workload from time to time. This not only reduces the risk associated with economic slowdowns but also results in greater job security for its most talented workers. In contrast, many Indian software services companies have traditionally maintained a huge “bench.” This has become a major liability during the current downturn.

India’s well known software services company, Infosys maintains plenty of cash. Infosys believes cash gives a lot of comfort in a volatile industry, characterised by swift changes in technology, and shifts in client spending patterns. To sustain operations under adverse conditions, and make investments in marketing and R&D, Infosys depends heavily on equity and keeps little debt on its balance sheet.

Airlines can manage their exposure to fluctuating oil prices by taking operational measures to cut fuel consumption. This might involve better maintenance of the air craft or purchase of more fuel-efficient engines. Another option is to buy financial instruments such as futures to hedge this risk. This is the risk transfer approach.

Various factors determine the choice of the approach to handling risk. Often a combination of these approaches makes sense. The choice between a financial and organisational solution varies from risk to risk. As we briefly mentioned earlier, strategic risks, which are core to the business and are critical to the generation of shareholder value have to be retained. So they invariably need organisational solutions. Where suitable financial instruments do not exist for risk transfer, organizational solutions may be unavoidable. In the case of some risks, organisational solutions may be too complicated, too expensive or may conflict with the company's strategic goals. In such situations, risk transfer solutions such as derivatives or insurance may be more efficient than organisational solutions.

The ultimate strategy for the rainy day is to keep overheads and debt low and hold plenty of cash to tide over uncertainties about which managers have little idea today. Indeed, equity is an all-purpose risk cushion. The larger the amount of risk that cannot be accurately measured or quantified, the more the equity component should be. It is no surprise that technology companies like Microsoft and Infosys keep little or no debt on the balance-sheet. Of course, equity is a more expensive source of funds. Equity holders expect a much higher rate of return, compared to debt providers. But that might well be a small price to pay in a volatile business environment. During a severe downturn, a comfortable capital position can give a company a major competitive advantage by allowing it to pursue an acquisition or a major investment that might well have had to be postponed otherwise.