By: Dr. Panagiotis Avramidis, Adjunct Assistant Professor of Finance and Quantitative methods & Academic Director of the MSc in Risk Management
During the last five years, the world has witnessed a series of financial crisis with significant reverberations on investments and businesses. An extended period of high liquidity combined with loose regulation and political interference were the key ingredients of an unprecedented rise of financial leverage, which ultimately came to an end in 2008 through the US-subprime loan market.
If anything, those turbulent times have revealed the benefits of prudent management and highlighted the necessity of risk awareness. Although portfolio theory has long established the role of risk as the second dimension for the optimal investment selection, the late events reveal that it has been consistently underestimated in favor of the more “rewarding” dimension of return. The lagging interest could also be attributed to the difficulty to define, let alone measure and manage, what exactly risk is.
If we assume that markets and businesses are informationally efficient then the emergence of risk profession comes as no surprise in the aftermath of a challenging period. Indeed, businesses increasingly come to terms with the idea that their long term existence depends on their ability to monitor and manage the risks of their balance sheet and income statements. At the same time, risk has emerged as a separate area of expertise. Professional global communities have taken the initiative to promote the objective of a risk aware business community through knowledge sharing and specialized training programs. Academic institutions have introduced new educational programs, primarily on a graduate level, that focus on shaping successful risk professionals by providing the required skills and knowledge.
Although this transformation is currently taken place, the progress so far may not seem satisfactory. The slow progress can be attributed to two misconceptions about managing risks, (a) it should concern only the financial institutions and (b) it is too expensive.
Risk management has traditionally been linked to financial institutions mainly due to the nature of their business and to their regulatory requirements that emphasized on risk management techniques. However, all businesses are to a lesser or higher degree exposed to some types of financial and operational risks. Depending on their credit policies, corporations can be significantly exposed to credit risk through their trade receivables. Companies using debt to finance part of their assets are exposed to interest rate risk, while the uncertainty of cash flows in periods of dry market liquidity implies a funding liquidity risk for the organization. Furthermore, companies that use commodities as raw materials or sell them as their main products are exposed to volatile price movements that can substantially impair their profitability. Finally, fraud, system break-down and procedures failure are common themes of operational risks shared across sectors.
The value of risk mitigation is most of the time unobservable because it relates to unrealized losses. Hence, when growth is peaking and losses are declining, companies are reluctant to hold back and allow an opportunity go wasted even if the incremental risk is negative for the company. Instead, it is during the storm that one evaluates the importance of prudent management and the need for risk mitigation. If anything, the recent crisis and the losses recorded by businesses globally prove that unhedged risk can be more expensive than hedging risks. Moreover, risk management can be proactive rather than passive by helping the organization to spot the “profitable” low risk customers, a method that can boost turnover without jeopardizing the viability of the organization.
Will the establishment of risk profession mean the end of financial crisis? This is highly unlikely for two reasons. First because uncertainty is part of the nature and it can be diversified away up to a limit. For example, a bank can issue loans and manage the specific risk from each loan, but it cannot eliminate the systematic risk of a raise in default rates due to an economic recession. Furthermore, there are particular hazards that cannot be predicted. For instance there are event driven risks, frequently termed among practitioners as black swans, with catastrophic consequences that cannot be predicted or pre-assessed with acceptable accuracy.
Then, what are the prospects to the corporation from introducing risk management processes? The strategy should be to reduce the uncertainty of the organizations future cash flows by removing the risks that can be diversified and immunize dynamically against the non-diversifiable risks. Ultimately, the goal of effective risk management is to make the organization more resilient against market uncertainty. Such an achievement will reflect positively not only to the creditors of the business but also to the shareholders and customers.