Tony Robbins in his well known book ‘Money: Master the Game” nicely described the trend of happenings – ‘The Great Depression, the 1973 oil crisis, the rapid inflation of the late ’70s, the British sterling crisis of 1976, Black Monday in 1987, the dotcom bubble of 2000, the housing bust in 2008, the 28% drop in gold prices in 2013 – all of these surprises caught most investment professionals way off guard, And the next surprise will have them on their heels again. That we can be sure of’.
In the financial world, [hedge fund manager] Ray Daliobe rightly observed “What kind of investment portfolio would one need to have to be absolutely certain that it would perform well in good times and in bad-across all economic environments?” Tony Robbins added – all the fancy software that the industry uses -the Monte Carlo simulations that calculate all sorts of potential scenarios in the future -didn‘t predict or protect investors from the crash of 1987, the collapse of 2000, the destruction of 2008, the list goes on. If you remember those days back in2008, the standard answers were; “This just hasn’t happened before. Yes, we are in uncharted waters. When one is in business one has to remember that business without risk is just akin to making omelets without eggs!
Who thought that the airlines could compete with the railways? Nothing happens overnight. The overexpansion of credit in the US housing market did not happen overnight – the low Federal Funds rate between 2002 and 2005 allowed many home owners to borrow, but the real problem were rooted in the mortgage lending practices in as much as the mortgage lenders mistakenly believed that they were taking on manageable risk during the period of low interest rates, because the values of the collateral underlying the loans were appreciating quickly. More specifically, the housing prices rapidly increased in the last decade, and the mortgage lenders relaxed their lending standards as they believed that the seemingly ever-appreciating values of these homes would be viable collateral in case of default. The result is well known today.
The real learning from these experiences led to at least one accrued benefit – men in the business have become more risk conscious. Wild shots are not attempted in today’s learned business world indeed.
What exactly is risk? Very often it is interpreted in the vague sense – consider risk to be an abstract notion that has a large impact in their stock market gamble: the possibility that the value of the investment would decrease due to a variety of factors. Quantitative financial experts opine – variance is a commonly used proxy for risk. Risk is essentially the standard deviation of return on an asset of portfolio. When examining a security, the more volatile it is (for example, a technology company’s stock during times of fluctuating consumer spending) the more risky it is considered to be.
The business world today has become more complicated – so also global financial markets -much more uncertain than ever before. The global financial uncertainties were not entirely unanticipated, but, yes, the intensity was not predicted nor was the duration expected – the outlook is far more uncertain now for global situation than before – the recession menace and the global financial turmoil emanating from the U S sub prime mortgage crisis; oil prices skyrocketing; gold prices ruling at three decades high – a few instances out of a good equilibrium / peace disturbing number clearly show the need for guarding against uncertainties weighing properly the ability to absorb risk!
So, risk – derived from the Italian word risicare – is where the business is. It cannot be liquidated altogether simply because tomorrow is another day and we do not what will happen tomorrow. Yesterday is a history – it cannot be changed. Today is a gift. We plan, budget, fix target for tomorrow when the past experience plays a great role – the gains are noted and the failures are guarded against repetition. Risk can be hedged, whereas uncertainties are to be insured against. In Webster dictionary risk means danger; in Chinese dictionary risk means a danger and simultaneously an opportunity. No gain is associated with no risk; but what about high risk – does it always indicate high gain! No. It is the degree of risk hat is important before the project is taken up / in operation. A stitch in time saves nine indeed!
In fact, the key to effective risk management, however, is not necessarily to minimize all of the various types of risks. For example, in the banking sector, lending operations have the inherent risk of possible loan losses (credit risk), but by taking risk, banks are able to charge a premium for their risk-taking activities and earn profits. Risk is, clearly, a source of profits. Of course in managing various types of risk, it is essential to divide them into two basic types, based on their inherent characteristics [viz. risks that should be taken and risks that should be minimized]. In implementing risk management activities, departments in charge of various types of risks must respond appropriately in time and at the same time work to constantly upgrade capabilities. It is essential for the institution as a whole to locate measure and manage risk volumes accurately and that too from a centralized perspective practically and realistically.
Hence the crucial need is there for all the players – government controlled or privately controlled – to identify, measure, price and exert all sorts of monitoring and control so as to ensure that the financial health of the organization does not suffer from incurable disease. And naturally early detection and degree assessment helps set right the entire going. We knew how to enter the market, but little did we know the exact time to exit.
While traditional tools are effective in terms of their universal application and comparability, any omission of certain intangible risks – operational, social and political, regulatory, reputation and legal risks – may result in erroneous inferences or flawed business decisions
The upshot – the need is there to improve on the risk management models by having a risk measure that will quantify risk on a monetary scale, being sensitive to large losses, while encouraging diversification, taking into account the variety of macro-effects that occurs in the dynamic and constantly changing business world.
As most of the activities and operations are driven by considerations of higher returns or better profitability the search for returns exposes the businesses to higher risks. Banks have to ensure that they hold adequate capital and reserves so that solvency and stability are not threatened. The challenge is to turn cost centre into profit centre. Successful implementation of sound risk management mechanism only can be ensured through an active scrutiny by the board of directors / senior management, backed by adequate policies, systems and procedures , adequate risk management practises, transparent monitoring and information system, internal control and sound risks aware human resource pool . And if institutions can properly manage risk by addressing these issues, we can avoid another damaging financial collapse in the future.
Dr B K Mukhopadhyay, a noted Management Economist and an International Commentator on Business and Economic Affairs, attached to the West Bengal State University, can be reached at m.bibhas@gmail.com