Table of Contents:-
- What is Risk Management?
- Objectives of Risk Management
- Meaning of Risk Management
- Need for Risk Management
- Methods of Risk Management
What is Risk Management?
Though the term risk has different connotations from different angles, it can be defined as the potential that events, expected or unexpected may hurt a bank’s earnings or capital or both. Both the risks having a high probability of low impact and a low probability of high impact are covered under the definition. This working definition will prove useful throughout the discussion. It is useful to recall at this stage that risk and expected return are positively related; the higher the risk, the higher the expected return and vice versa. The scope of the risk management function in any organization is to ensure that systems and processes are set up by the risk management policy of the institution.
The risk management plan depends on the risk attitude of an organization and stakeholders, which refers to the extent to which the project manager and stakeholders are willing to take risks. There are different outlooks towards risk among organizations.
Risk-averse
Risk-averse organizations are cautious in situations involving large losses; they hesitate to make project decisions even if such decisions might offer the possibility of substantial gains associated with success. This behaviour is referred to as “risk-averse.” For these organizations, the fear of losing 1 million rupees outweighs the benefit of gaining 1 million rupees. They prefer lower returns instead of higher ones because lower-return investments have known risks. A risk-averse organization will not undertake a project if the chances are 50-50 between the two outcomes.
Risk Neutral
Risk-neutral organizations maintain a balance between utility and payoff. They carefully consider all pros and cons before deciding whether to take risks or not.
Risk Seeker
These organizations embrace and find dealing with risks challenging, viewing risk as a normal aspect of projects and business. However, this excessive optimism can sometimes result in losses as the potential impact of risks on achieving objectives is underestimated. Treating risk as a normal feature of the project may lead to inadequate management, both in terms of probability and impact.
Objectives of Risk Management
The very basic objective of the risk management system is to put in place and operate a systematic process to give a reasonable degree of assurance to the top management that the ultimate corporate goals that are vigorously pursued by it will be achieved most efficiently. In this manner, the risk management system would effectively handle all the risks that may impede the institution from achieving its set goals. Without such a system, no institution can endure in the long run without fulfilling the objectives for which it was established.
The objective of risk management is to enable project progress towards organisational goals and project objectives efficiently and effectively by maximising the use of available resources and delivering targets always in a sustainable manner. Thus, the discipline of project risk management has been recognised as critical for the success of every project. Project risk management seeks to increase the probability and impact of positive events and to decrease the probability and impact of negative ones. Project risks vary with the project type, industry, experience in managing similar projects, as well as scope and size of the project.
Meaning of Risk Management
Risk management aims to identify and address potential and unforeseen challenges that may arise during the implementation of the project. Risk management identifies as many potential risk events as possible (what can go wrong), minimizes their impact (what can be done about the event before the project begins), manages responses to those events that do materialize (contingency plans) and provides contingency funds to cover risk events that occur.
Projects are becoming increasingly complex, and the desired results are expected within a short timeframe and with a limited budget. Professional risk management is an absolute necessity to deal with this situation. Project risk management adds value to the project.
Need for Risk Management
The following are the needs of risk management in a project:
1) Tough Legislation: Legislation is getting more tougher, Risk assessment is growing more common in many areas of legislation.
2) In Response to Outside Factors: Companies tend to introduce risk management in response to outside factors such as scandals, legislation or regulation.
3) Quick Grasp of New Opportunities: A solid foundation of risk management plays a key role for qui grasping of new opportunities. There should be well-planned risk management in every organisation.
4) Fewer Sudden Shocks and Unwelcome Surprises: The contribution of risk management supports the selection of appropriate strategies. This helps to reduce sudden shocks and unwelcome surprises.
5) Avoid Cost: Risk management helps a project avoid cost and disruption in business operations.
6) Management Attitudes
i) Management has Learnt from Other Firms’ Disasters: Highly publicised disasters, from Bhopal and Exxon Valdez to Enron, Martha Stewart, Hollinger and Parmalat, have shown management that risks can be detrimental, and at times, even fatal, in terms of costs to the business.
ii) Companies are Becoming more Professional: As companies have started to manage their environmental impacts, they have increasingly discovered that preventing catastrophe is better than trying to cure it.
iii) Companies are more Global: Firms have had to learn how to manage their increasingly international operations. Often the solution lies in setting performance standards and policies while leaving local management to run the business.
iv) Growing Private-Sector Involvement in National Enterprises: Governments are withdrawing from the management of national enterprises, such as transportation, healthcare and energy. This implies that private enterprises are now engaged in high-risk businesses, and the government will not bear the costs of a catastrophe. These companies need to take risks more seriously.
Methods of Risk Management
Managers are not merely content with measuring risk. They want to explore ways and means of mitigating risks These risk reduction strategies have a cost associated with them and whether they are profitable in a given situation will depend on circumstances.
1) Fixed and Variable Costs
A common way to modify the risk of an investment is to change the proportion of fixed and variable costs. For example, in the early 1980s, Ford Motor Company restructured its various operations. Essentially it decided to buy most of its components from outside suppliers instead of facturing them in-house. This increased its variable costs and decreased its fixed costs. The net effect was a decline in its break-even level.
2) Pricing Strategy
Pricing strategy is used by many firms to manage risk. A lower price increases potential demand but also elevates the break-even level. This is the reason why publishers first release a hardcover edition at a higher price and then introduce a softcover edition at a lower price.
3) Sequential Investment
If one is not sure about the market response to his product or service, he may start small and later expand as the market grows. This strategy may entail higher capital costs per unit because capacity is created in stages. However, it reduces risk exposure. He can employ decision tree analysis to hammer out the optimal sequence of investment in the face of risk.
4) Improving Information
An African proverb says don’t test the depth of a river with both feet. One may like to gather more information about the market and technology before taking the plunge. Additional study often enhances the quality of forecasts but entails direct costs (the cost of the study) as well as opportunity costs associated with delayed action. He has to weigh the costs and benefits of further study and decide how much additional information should be gathered.
5) Financial Leverage
Reducing the dependence on debt lowers risk. Debt entails a specific contractual commitment, whereas equity carries no fixed burden. Hence, if the operating risk of the project is high, it makes sense to opt for a low level of financial leverage.
6) Insurance
An insurance cover against a variety of risks like physical damage, theft, loss of a key person and so on can mitigate risk. Insurance is a pure and complete antidote for such risks.
7) Long-Term Arrangements
One way to mitigate risk is to enter into long-term arrangements with suppliers, employees, lenders and customers. A long-term contract with suppliers ensures the availability of inputs at a predictable price; a long-term wage contract with employees removes uncertainty about employee cost; a long-term debt contract reduces risk about interest rate; and finally, a long-term sales contract with customers eliminates revenue risk.
Often long-term contracts are indexed. This means that prices are regularly adjusted based on the movement of an index, essentially reflecting inflation. For example, a supply contract may include an escalator clause that links the supply price to a price index, such as the Wholesale Price Index. Pride indexing protects both the buyer and the seller against inflation risk because indexing ensures that the real price (price in terms of purchasing power) is constant.
8) Strategic Alliance
When the resources required for a project or the risks inherent in a project are beyond the capacity of a single company, a strategic alliance may be the way out. A strategic alliance, also referred to as a joint venture, represents a partnership between two or more independent companies that join forces to achieve a common purpose. It is generally organized as a newly created company, although the partners may choose any other form of organization. Typically, the partners participate in the equity of the common enterprise, contribute resources (technology, facilities, distribution networks, brands, key manpower, and so on), and share management and control. The massive resource requirements and huge risks in modern enterprises have compelled many traditional rivals to work together. Competitors are beginning to co-operate leading to a phenomenon called ‘co-optition”.
9) Derivatives
Derivative instruments like options and futures can be used for managing risk. An option provides its owner with the right to buy or sell an underlying asset on or before a specified date at a predetermined price. An option to purchase is referred to as a call option. Options provide flexibility, which is very valuable in volatile markets. For example, A call option embedded in a debt instrument grants the issuing firm the right to redeem (buy back) the debt instrument prematurely at a specified price. Such an option is very valuable when interest rates fall.
A futures contract is an agreement between two parties to exchange an asset for cash at a predetermined future date, with a price specified today. Futures contracts help eliminate price risk. For example, A refinery may purchase an oil futures contract to meet its oil requirements. Doing so entitles the refinery to get delivery of oil at a specified future date at a price that is fixed today.
