Description
Risk is the potential of loss (an undesirable outcome, however not necessarily so) resulting from a given action, activity and/or inaction. The notion implies that a choice having an influence on the outcome sometimes exists (or existed).
Risk reward matrix on corporate risk taking:
What are the essential issues in corporate risk taking?
Oliviero Roggi
Professor of Finance at University of Florence Academic Chairman of International Risk Management President of The Risk Banking and Finance Society
Colombo, Sri Lanka –July 7th, 2011
Summary
• The definition of risk governance • Managing risk in an active way: Enterprise Risk Management • Risk Management Vs Risk Taking • Sources of Risk advantage • The Risk Governance: When Corporate Strategy, Corporate Governance and Risk Management converge
Relevant questions for CEOs
• What is risk? • How does risk affect corporate performance? • How can I actively manage risk? • Which are the sources of competitive advantage in Risk Taking? • How can I exploit them in building an ERM system for increasing company value?
Before starting, here are some definitions
Governance is the managerial approach by which senior executives and their board direct and control the entire organization through management information systems and hierarchical management control structures Corporate governance refers to the values, goals, policies, institutions, and processes that affect the ways in which the corporation is directed, administrered, and controlled – often synonymous of good management/leadership Risk management is the identification, assessment, and handling of risks enacted through (coordinated) corporate actions to monitor, control, and minimize the adverse effect of unfortunate events or maximize the acheivement of opportunities
Combining the two aspects
Adapted from Torben Andersen IFC World Bank ©
Risk governance is the approache taken by senior executives and the board to ensure that the organization has adequate risk management practices in place Toward Strategic Risk Taking Governance, risk management, and compliance (GRC) is an integrated organization-wide approach to ensure that the organization ethically acts in line with its risk appetite and in accordance with its internal policies and external regulations
Lesson 1 You cannot hide from risk
«a risk negleted is a risk retained» Shimpi 2001
Lesson 2: Risk management ? Risk hedging..
• Scholars have abandoned the definition of terms of risk management to risk hedgers, who see the purpose of risk management as removing or reducing risk exposures. This has happened because
– the bulk of risk management products, which are revenue generators, are risk hedging products, whether they are insurance, derivatives or swaps. – it is human nature to remember losses (the downside of risk) more than profits (the upside of risk); we are easy prey, especially after disasters, calamities and market meltdowns for purveyors of risk hedging products. – the separation of management from ownership in most publicly traded firms creates a potential conflict of interest between what is good for the business (and its stockholders) and for its managers. Managers may want to protect their jobs by insuring against risks, even though stockholders may gain little from the hedging.
• The correct definition of Risk management has to look at both the downside of risk and the upside. It cannot just be about hedging risk.
Who and how to manage risk
Enterprise Risk Management Principles and Value Creation: Processes ,Tools and Techniques for Risk Management
The CEO’s duties in the Risk Management oversight
The CEO should assist the board of directors in matching the risk taking requirements: • Public legislation, e.g., Sarbanes-Oxley • Stock exchange requirements à IFRS 7 SFAS 157 and fair value • Credit rating agencies • Risk Common standards ISO 31000 Risk Management, COSO etc. The CEO is asked to establish corporate risk policies, implement effective risk management practices, conduct regular reviews of major risks and monitor the responses to them; • Enterprise risk management • Safety standards and ethics • Environmental impact assessment • Responsible management (CSR) • Sustainability reviews • Executive remuneration
Adapted from Torben Andersen IFC World Bank ©
Leading or being assisted by a: risk committee, audit committee, compensation committee, 6 ethics committee, environment assurance committee
Enterprise risk management (ERM)
“A comprehensive and integrated framework for managing credit risk, market risk, operational risk and economic capital and risk transfer in order to maximize firm value” (Lam 2003) “Dealing with uncertainty for the organisation” (Monhanan 2008) “Risk management is a central part of any organisation’s strategic management. It is the process whereby organisations methodically address the risks attaching to their activities with the goal of achieving sustained benefit within each activity and across the portfolio of all activities” AIRMIC 2010 (Risk Management Standard)
10
Determinants of Enterprise Risk Management
• ERM is strongly related to the firm’s corporate governance • All managerial levels are interested and involved in the definition and implementation of the RM strategy • It allows better planning and a more effective implementation of corporate strategy Does ERM contribute to value creation?
12
Corporate Finance and ERM objectives converge
SHAREHOLDER VALUE MAXIMIZATION MAXIMIZE EXPECTED CASH FLOWS ACTIVE RM generates incremental positive cash flow mainly through tax optimization and earning smoothing
MINIMIZE RISKS through ACTIVE RM à lowering cost of capital and default risk à default spread
SHAREHOLDERS VALUE MAXIMIZATION BY ACTIVE RM
11
The Risk Management Process
1
2 3
4
Setting Firm’s Risk Management goals and implementation on the CG structure
2A. Risk Analysis
2B. Risk Evaluation
Risk Identification/Description Estimation
Risk
1. Setting Firm’s Appetite on Risk Taking
• In this phase directors and senior management discuss and set the risk strategy (Top Management ) • Set, according to the specific firm risk aversion,the following: • Goals for CRO, CFO and Risk Management Officers (i.e.VaR and EML) • Resources available to run the RM process • Criteria for risk treatment
13
2. The Risk Assessment
2A. Risk Analysis i Identification: The company management identifies all sources of risk and prepares a risk description of potential upside and downside risks ii Estimation: Main goal is to quantify every risk’s probability and its economic consequences 2B. Risk Evaluation
14
2.A Risk assesment: quantitive or qualitive.. ? It doesn't matter as far as is effective:? i.e. The Matrix Probability-Impact
Likelihood Impact Insignificant Low Average High Catastrophic
Very Frequent (>50%) Frequent (%-50%) Moderate (5%-20%) Unlikely (1%-5%) Rare (<1%)
High Moderate Low Low Low
High High
Extreme High
Extreme Extreme Extreme Extreme Extreme Extreme High High Extreme High
Moderate High Low Low Moderate Moderate
15
Task 2: Risk in your organisation
List the five biggest risks that you see your firm organization) facing, and then categorize them.
Risk event Type (H/E/ Impact O/S) [$] Likelihood Severity [%] (Risk Score) [E, H, M, L]
1. 2. 3. 4. 5.
3. Risk Treatment
• Risk treatment is the process of selecting and implementing measures to modify the risk. Risk treatment includes as its major element: risk control/mitigation, risk avoidance, risk transfer, risk financing. • As consequence the Chief Risk Officer decides to:
Economic Impact Evaluation
Risk avoided Risk transferred
17
Risk retained
R
i
s
k
4. Risk Monitoring
During risk monitoring and control the following tasks are performed: • Identification, analyzation, and planning for new risks • Keeping track of identified risks and monitoring trigger conditions • Revision project performance information (such as progress/status reports, issues, and corrective actions) • Re-analyzation of existing risks to see if the probability, impact, or proper response plan has changed • Revision of the execution of risk responses and analyzation their effectiveness • Ensurement of the proper risk management policies and procedures that are being utilized
18
Risk Retention (Pass through to the suppliers of finance)
All the risks that are not avoided, mitigated or transferred are retained by the financial suppliers. Two different types of risks fall under this category:
–Risks explicitly retained by the firm (Core Business Risk and Upside risks) for which the company has to set an adequate capital structure (equity) in order to cover the expected loss; –All risks neglected by the risk managers Do you remember ? “ A risk neglected is a risk retained”
17
Tools for Risk Mitigation and Risk Transfer
In-Balance Out-Balance Sheet tools Sheet Tools
• Capital structure (mix of financial suppliers) is important in order to mitigate both market and firm specific risks • Insurance linked securities issued by the firm • Insurance is good for almost all types of risk but insurance cannot protect against core business risk à no risk, no return! • Forwards, Futures & Options are important mainly to mitigate commodities and currency risk • Swaps (interest rate swap, credit default swap, currency swap) address market risks • Contingent Capital
16
Firm’s Capital requirement (Paid up Capital) and expected loss
Scholars and practitioners identified three different reasons why equity should be collected:
–To finance operational investments à operational capital; –To protect the firm from expected and unexpected losses à risk capital; –To communicate to financial markets à signaling capital.
19
Traditional Financial Economics Perspective
The firm is neutral to risk
Risk generated = Risk retained (passed by financial suppliers)
How much equity should the firm raise?
Paid-up Capital = F (Risk retained)= F (Risk generated)
Investments= Paid-up Capital = Senior debt + junior debt + equity
20
Risk taking in Risk Neutral Firms
LOW
INVESTMENTS
HIGH
21
Risk Exposure
The Insurance Model + off balancesheet tools and contingent capital
LOW
Seniority
INVESTMENTS
HIGH
25
Risk Exposure
Optimizing Firm capital requirement (Equity)
The optimal capital requirement can be estimated applying the VAR methodology to the firm’s risk.
1) Aggregate all the risks retained by the firm 2) Compute the risk correlation matrix to estimate interactions 3) Estimate the Maximum Expected Loss (EML) = VAR 4) Adjust Raised Equity for the EML
Capital requirement (EQUITY)
EML
To avoid The Black
The firm Swan
Default
27
How do we create value from risk taking?
From Risk Hedging to Active Risk Taking: Exploiting the Upside Risk
The Individual Risk Treatment Decision Value
( Risk Treatment decision value = #
T t =0
E IHCFt " HC " + !MI t ( 1 + rj )
+
)
Where:
• E(IHCFt+) are the expected incremental positive cash flows generated by the hedging decision (i.e. tax advantage, greater efficiency in investing etc) • Rj is the cost of equity =risk free + B*equity premium (if Beta =1, Rj = Rm ) • HC- are the negative cash flow associated to the hedging decision (i.e. cost of insurance etc) • +/- ?MI market imperfections (Asymmetry of information, regulation, risk specific assets etc)
28
Risk Treatment affect firm value?
• For an action to affect value, it has to affect one or more of the following inputs into value:
Wequity
• • • •
CFt CFt +1 =# = t 1 + requity ) requity ! g t =0 (
"
Cash flows from existing assets Growth rate during excess return phase Length of period of excess returns Discount rate
Proposition : Risk hedging/management can increase value only if they affect cash flows, growth rates, discount rates and/or length of the growth period.
Risk Taking: Effect on Value
Evidence on risk taking and value..
• The most successful companies in any economy got there by seeking out and exploiting risks and uncertainties and not by avoiding these risks. • Across time, on average, risk taking has paid off for investors and companies. • At the same time, there is evidence that some firms and investors have been destroyed by either taking intemperate risks or worse, from the downside of taking prudent risks. • In conclusion, then, there is a positive payoff to risk taking but not if it is reckless. Firms that are selective about the risks they take can exploit those risks to advantage, but firms that take risks without sufficiently preparing for their consequences can be hurt badly.
Source of competitive advantage for Risk taking active risk exploitation
To exploit risk better than your competitors there are five possible advantages that successful risk taking firms exploit: a.Information Advantage: In a crisis, getting better information (and getting it early) can allow be a huge benefit. b.Speed Advantage: Being able to act quickly (and appropriately) can allow a firm to exploit opportunities that open up in the midst of risk. c.Experience/Knowledge Advantage: Firms (and managers) who have been through similar crises in the past can use what they have learned. d.Resource Advantage: Having superior resources can allow a firm to withstand a crisis that devastates its competition. e.Flexibility: Building in the capacity to change course quickly can be an advantage when faced with risk.
a. The Information Advantage
• Invest in information networks. Businesses can use their own employees and the entities that they deal with – suppliers, creditors and joint venture partners – as sources of information. • Test the reliability of the intelligence network well before the crisis hits with the intent of removing weak links and augmenting strengths. • Protect the network from the prying eyes of competitors who may be tempted to raid it rather than design their own.
b. The Speed Advantage
• Improve the quality of the information that you receive about the nature of the threat and its consequences. Knowing what is happening is often a key part of reacting quickly. • Recognize both the potential short term and long-term consequences of the threat. All too often, entities under threat respond to the near term effects by going into a defensive posture and either downplaying the costs or denying the risks when they would be better served by being open about the dangers and what they are doing to protect against them. • Understand the audience and constituencies that you are providing the response for. A response tailored to the wrong audience will fail.
c. The Experience/Knowledge Advantage
• Expose the firm to new risks and learn from mistakes. The process can be painful and take decades but experience gained internally is often not only cost effective but more engrained in the organisation. • Acquire firms in unfamiliar markets and use their personnel and expertise, albeit at a premium. The perils of this strategy, though, are numerous, beginning with the fact that you have to pay a premium in acquisitions and continuing with the postmerger struggle of trying to integrate firms with two very different cultures. Studies of cross border acquisitions find that the record of failure is high. • Try to hire away managers of firms or share (joint ventures) in the experience of firms that have lived through specific risks. • Find a way to build on and share the existing knowledge/ experience within the firm.
d. The Resource Advantage
• Capital Access: Being able to access capital markets allows firms to raise funds in the midst of a crisis. Thus, firms that operate in more accessible capital markets should have an advantage over firms that operate in less accessible capital markets. • Debt capacity: One advantage of preserving debt capacity is that you can use it to meet a crisis. Firms that operate in risky businesses should therefore hold less debt than they can afford. In some cases, this debt capacity can be made explicit by arranging lines of credit in advance of a crisis.
e. The Flexibility Advantage
• Being able to modify production, operating and marketing processes quickly in the face of uncertainty and changing markets is key to being able to take advantage of risk. Consequently, this may require having more adaptable operating models (with less fixed costs), even if that requires you to settle for lower revenues.
• In the 1990s, corporate strategists argued that as firms become more successful, it becomes more difficult for them to adapt and change.
Task 2: Risk actions
Take the five risks that you listed in task 1 and consider for each one, whether you will pass the risk through to your investors, hedge the risk or seek out and exploit the risk.
Risk Action (Hedge, Pass through or exploit) Why?
Build a successful risk taking organisation..
• While firms sometimes get lucky, consistently successful risk taking cannot happen by accident. • In particular, firms have to start preparing when times are good (and stable) for bad and risky times.
Align interests…
Pick the right people
• Good risk takers
– Are realists who still manage to be upbeat. – Allow for the possibility of losses but are not overwhelmed or scared by its prospects. – Keep their perspective and see the big picture. – Make decisions with limited and often incomplete information
• To hire and retain good risk takers
– Have a hiring process that looks past technical skills at crisis skills – Accept that good risk takers will not be model employees in stable environments. – Keep them challenged, interested and involved. Boredom will drive them away. – Surround them with kindred spirits.
Make sure that the incentives for risk taking are set correctly…
• You should reward good risk taking behavior, not good outcomes and punish bad risk taking behavior, even if it makes money.
Make sure the organisational size and culture are in tune..
• organisations can encourage or discourage risk based upon how big they are and how they are structured. Large, layered organisations tend to be better at avoiding risk whereas smaller, flatter organisations tend to be better at risk taking. Each has to be kept from its own excesses. • The culture of a firm can also act as an engine for or as a brake on sensible risk taking. Some firms are clearly much more open to risk taking and its consequences, positive as well as negative. One key factor in risk taking is how the firm deals with failure rather than success; after all, risk takers are seldom punished for succeeding.
Preserve your options..
• Even if you are a sensible risk taker and measure risks well, you will be wrong a substantial portion of the time. Sometimes, you will be wrong on the upside (you under estimate the potential for profit) and sometimes, you will be wrong on the downside. • Successful firms preserve their options to take advantage of both scenarios:
– The option to expand an investment, if faced with the potential for more upside than expected. – The option to abandon an investment, if faced with more downside than expected.
Task 3: Assess the “risk taking” capacity of your organisation
Dimension Your organisation’s standing
1. Are the interests of managers Aligned with stockholders aligned with the interests of capital Aligned with bondholders providers? Aligned with their own interests 2. Do you have the right people in place to deal with risk? 3. Is the incentive process designed to encourage good risk taking? 4. What is the risk culture in your organisation? 5. Have much flexibility is there in terms of exploiting upside risk and protecting against downside risk? Too many risk takers Too many risk avoiders Right balance Discourages all risk taking Encourages too much risk taking Right balance Risk seeking Risk avoiding No risk culture Good on exploiting upside risk Good in protecting against downside Good on both
Essential propositions about risk
1. Risk is everywhere 2. Risk is threat and opportunity 3. We (as human beings) are ambivalent about risk and not always rational in the way we deal with it. 4. Not all risk is created equal: Small versus Large, symmetric versus asymmetric, continuous vs. discrete, macro vs. micro 5. Risk can be measured 6. Risk measurement/assessment should lead to better decisions 7. The key to risk management is deciding what risks to hedge, what risks to pass through and what risks to take 8. To manage risk can generate new shareholder value
And here is the most important ingredient in risk management: Be lucky…
•There is so much noise in this process that the dominant variable explaining success in any given period is luck and not skill. Proposition 1: Today’s hero will be tomorrow’s goat (and vice verse) There are no experts. Let your common sense guide you. Proposition 2: Don’t mistake luck for skill: Do not over react either to success or to failure. Chill. Proposition 3: Life is not fair: You can do everything right and go bankrupt. You can do everything wrong and make millions.
Thanks for your attention!
doc_543452315.pdf
Risk is the potential of loss (an undesirable outcome, however not necessarily so) resulting from a given action, activity and/or inaction. The notion implies that a choice having an influence on the outcome sometimes exists (or existed).
Risk reward matrix on corporate risk taking:
What are the essential issues in corporate risk taking?
Oliviero Roggi
Professor of Finance at University of Florence Academic Chairman of International Risk Management President of The Risk Banking and Finance Society
Colombo, Sri Lanka –July 7th, 2011
Summary
• The definition of risk governance • Managing risk in an active way: Enterprise Risk Management • Risk Management Vs Risk Taking • Sources of Risk advantage • The Risk Governance: When Corporate Strategy, Corporate Governance and Risk Management converge
Relevant questions for CEOs
• What is risk? • How does risk affect corporate performance? • How can I actively manage risk? • Which are the sources of competitive advantage in Risk Taking? • How can I exploit them in building an ERM system for increasing company value?
Before starting, here are some definitions
Governance is the managerial approach by which senior executives and their board direct and control the entire organization through management information systems and hierarchical management control structures Corporate governance refers to the values, goals, policies, institutions, and processes that affect the ways in which the corporation is directed, administrered, and controlled – often synonymous of good management/leadership Risk management is the identification, assessment, and handling of risks enacted through (coordinated) corporate actions to monitor, control, and minimize the adverse effect of unfortunate events or maximize the acheivement of opportunities
Combining the two aspects
Adapted from Torben Andersen IFC World Bank ©
Risk governance is the approache taken by senior executives and the board to ensure that the organization has adequate risk management practices in place Toward Strategic Risk Taking Governance, risk management, and compliance (GRC) is an integrated organization-wide approach to ensure that the organization ethically acts in line with its risk appetite and in accordance with its internal policies and external regulations
Lesson 1 You cannot hide from risk
«a risk negleted is a risk retained» Shimpi 2001
Lesson 2: Risk management ? Risk hedging..
• Scholars have abandoned the definition of terms of risk management to risk hedgers, who see the purpose of risk management as removing or reducing risk exposures. This has happened because
– the bulk of risk management products, which are revenue generators, are risk hedging products, whether they are insurance, derivatives or swaps. – it is human nature to remember losses (the downside of risk) more than profits (the upside of risk); we are easy prey, especially after disasters, calamities and market meltdowns for purveyors of risk hedging products. – the separation of management from ownership in most publicly traded firms creates a potential conflict of interest between what is good for the business (and its stockholders) and for its managers. Managers may want to protect their jobs by insuring against risks, even though stockholders may gain little from the hedging.
• The correct definition of Risk management has to look at both the downside of risk and the upside. It cannot just be about hedging risk.
Who and how to manage risk
Enterprise Risk Management Principles and Value Creation: Processes ,Tools and Techniques for Risk Management
The CEO’s duties in the Risk Management oversight
The CEO should assist the board of directors in matching the risk taking requirements: • Public legislation, e.g., Sarbanes-Oxley • Stock exchange requirements à IFRS 7 SFAS 157 and fair value • Credit rating agencies • Risk Common standards ISO 31000 Risk Management, COSO etc. The CEO is asked to establish corporate risk policies, implement effective risk management practices, conduct regular reviews of major risks and monitor the responses to them; • Enterprise risk management • Safety standards and ethics • Environmental impact assessment • Responsible management (CSR) • Sustainability reviews • Executive remuneration
Adapted from Torben Andersen IFC World Bank ©
Leading or being assisted by a: risk committee, audit committee, compensation committee, 6 ethics committee, environment assurance committee
Enterprise risk management (ERM)
“A comprehensive and integrated framework for managing credit risk, market risk, operational risk and economic capital and risk transfer in order to maximize firm value” (Lam 2003) “Dealing with uncertainty for the organisation” (Monhanan 2008) “Risk management is a central part of any organisation’s strategic management. It is the process whereby organisations methodically address the risks attaching to their activities with the goal of achieving sustained benefit within each activity and across the portfolio of all activities” AIRMIC 2010 (Risk Management Standard)
10
Determinants of Enterprise Risk Management
• ERM is strongly related to the firm’s corporate governance • All managerial levels are interested and involved in the definition and implementation of the RM strategy • It allows better planning and a more effective implementation of corporate strategy Does ERM contribute to value creation?
12
Corporate Finance and ERM objectives converge
SHAREHOLDER VALUE MAXIMIZATION MAXIMIZE EXPECTED CASH FLOWS ACTIVE RM generates incremental positive cash flow mainly through tax optimization and earning smoothing
MINIMIZE RISKS through ACTIVE RM à lowering cost of capital and default risk à default spread
SHAREHOLDERS VALUE MAXIMIZATION BY ACTIVE RM
11
The Risk Management Process
1
2 3
4
Setting Firm’s Risk Management goals and implementation on the CG structure
2A. Risk Analysis
2B. Risk Evaluation
Risk Identification/Description Estimation
Risk
1. Setting Firm’s Appetite on Risk Taking
• In this phase directors and senior management discuss and set the risk strategy (Top Management ) • Set, according to the specific firm risk aversion,the following: • Goals for CRO, CFO and Risk Management Officers (i.e.VaR and EML) • Resources available to run the RM process • Criteria for risk treatment
13
2. The Risk Assessment
2A. Risk Analysis i Identification: The company management identifies all sources of risk and prepares a risk description of potential upside and downside risks ii Estimation: Main goal is to quantify every risk’s probability and its economic consequences 2B. Risk Evaluation
14
2.A Risk assesment: quantitive or qualitive.. ? It doesn't matter as far as is effective:? i.e. The Matrix Probability-Impact
Likelihood Impact Insignificant Low Average High Catastrophic
Very Frequent (>50%) Frequent (%-50%) Moderate (5%-20%) Unlikely (1%-5%) Rare (<1%)
High Moderate Low Low Low
High High
Extreme High
Extreme Extreme Extreme Extreme Extreme Extreme High High Extreme High
Moderate High Low Low Moderate Moderate
15
Task 2: Risk in your organisation
List the five biggest risks that you see your firm organization) facing, and then categorize them.
Risk event Type (H/E/ Impact O/S) [$] Likelihood Severity [%] (Risk Score) [E, H, M, L]
1. 2. 3. 4. 5.
3. Risk Treatment
• Risk treatment is the process of selecting and implementing measures to modify the risk. Risk treatment includes as its major element: risk control/mitigation, risk avoidance, risk transfer, risk financing. • As consequence the Chief Risk Officer decides to:
Economic Impact Evaluation
Risk avoided Risk transferred
17
Risk retained
R
i
s
k
4. Risk Monitoring
During risk monitoring and control the following tasks are performed: • Identification, analyzation, and planning for new risks • Keeping track of identified risks and monitoring trigger conditions • Revision project performance information (such as progress/status reports, issues, and corrective actions) • Re-analyzation of existing risks to see if the probability, impact, or proper response plan has changed • Revision of the execution of risk responses and analyzation their effectiveness • Ensurement of the proper risk management policies and procedures that are being utilized
18
Risk Retention (Pass through to the suppliers of finance)
All the risks that are not avoided, mitigated or transferred are retained by the financial suppliers. Two different types of risks fall under this category:
–Risks explicitly retained by the firm (Core Business Risk and Upside risks) for which the company has to set an adequate capital structure (equity) in order to cover the expected loss; –All risks neglected by the risk managers Do you remember ? “ A risk neglected is a risk retained”
17
Tools for Risk Mitigation and Risk Transfer
In-Balance Out-Balance Sheet tools Sheet Tools
• Capital structure (mix of financial suppliers) is important in order to mitigate both market and firm specific risks • Insurance linked securities issued by the firm • Insurance is good for almost all types of risk but insurance cannot protect against core business risk à no risk, no return! • Forwards, Futures & Options are important mainly to mitigate commodities and currency risk • Swaps (interest rate swap, credit default swap, currency swap) address market risks • Contingent Capital
16
Firm’s Capital requirement (Paid up Capital) and expected loss
Scholars and practitioners identified three different reasons why equity should be collected:
–To finance operational investments à operational capital; –To protect the firm from expected and unexpected losses à risk capital; –To communicate to financial markets à signaling capital.
19
Traditional Financial Economics Perspective
The firm is neutral to risk
Risk generated = Risk retained (passed by financial suppliers)
How much equity should the firm raise?
Paid-up Capital = F (Risk retained)= F (Risk generated)
Investments= Paid-up Capital = Senior debt + junior debt + equity
20
Risk taking in Risk Neutral Firms
LOW
INVESTMENTS
HIGH
21
Risk Exposure
The Insurance Model + off balancesheet tools and contingent capital
LOW
Seniority
INVESTMENTS
HIGH
25
Risk Exposure
Optimizing Firm capital requirement (Equity)
The optimal capital requirement can be estimated applying the VAR methodology to the firm’s risk.
1) Aggregate all the risks retained by the firm 2) Compute the risk correlation matrix to estimate interactions 3) Estimate the Maximum Expected Loss (EML) = VAR 4) Adjust Raised Equity for the EML
Capital requirement (EQUITY)
EML
To avoid The Black
The firm Swan
Default
27
How do we create value from risk taking?
From Risk Hedging to Active Risk Taking: Exploiting the Upside Risk
The Individual Risk Treatment Decision Value
( Risk Treatment decision value = #
T t =0
E IHCFt " HC " + !MI t ( 1 + rj )
+
)
Where:
• E(IHCFt+) are the expected incremental positive cash flows generated by the hedging decision (i.e. tax advantage, greater efficiency in investing etc) • Rj is the cost of equity =risk free + B*equity premium (if Beta =1, Rj = Rm ) • HC- are the negative cash flow associated to the hedging decision (i.e. cost of insurance etc) • +/- ?MI market imperfections (Asymmetry of information, regulation, risk specific assets etc)
28
Risk Treatment affect firm value?
• For an action to affect value, it has to affect one or more of the following inputs into value:
Wequity
• • • •
CFt CFt +1 =# = t 1 + requity ) requity ! g t =0 (
"
Cash flows from existing assets Growth rate during excess return phase Length of period of excess returns Discount rate
Proposition : Risk hedging/management can increase value only if they affect cash flows, growth rates, discount rates and/or length of the growth period.
Risk Taking: Effect on Value
Evidence on risk taking and value..
• The most successful companies in any economy got there by seeking out and exploiting risks and uncertainties and not by avoiding these risks. • Across time, on average, risk taking has paid off for investors and companies. • At the same time, there is evidence that some firms and investors have been destroyed by either taking intemperate risks or worse, from the downside of taking prudent risks. • In conclusion, then, there is a positive payoff to risk taking but not if it is reckless. Firms that are selective about the risks they take can exploit those risks to advantage, but firms that take risks without sufficiently preparing for their consequences can be hurt badly.
Source of competitive advantage for Risk taking active risk exploitation
To exploit risk better than your competitors there are five possible advantages that successful risk taking firms exploit: a.Information Advantage: In a crisis, getting better information (and getting it early) can allow be a huge benefit. b.Speed Advantage: Being able to act quickly (and appropriately) can allow a firm to exploit opportunities that open up in the midst of risk. c.Experience/Knowledge Advantage: Firms (and managers) who have been through similar crises in the past can use what they have learned. d.Resource Advantage: Having superior resources can allow a firm to withstand a crisis that devastates its competition. e.Flexibility: Building in the capacity to change course quickly can be an advantage when faced with risk.
a. The Information Advantage
• Invest in information networks. Businesses can use their own employees and the entities that they deal with – suppliers, creditors and joint venture partners – as sources of information. • Test the reliability of the intelligence network well before the crisis hits with the intent of removing weak links and augmenting strengths. • Protect the network from the prying eyes of competitors who may be tempted to raid it rather than design their own.
b. The Speed Advantage
• Improve the quality of the information that you receive about the nature of the threat and its consequences. Knowing what is happening is often a key part of reacting quickly. • Recognize both the potential short term and long-term consequences of the threat. All too often, entities under threat respond to the near term effects by going into a defensive posture and either downplaying the costs or denying the risks when they would be better served by being open about the dangers and what they are doing to protect against them. • Understand the audience and constituencies that you are providing the response for. A response tailored to the wrong audience will fail.
c. The Experience/Knowledge Advantage
• Expose the firm to new risks and learn from mistakes. The process can be painful and take decades but experience gained internally is often not only cost effective but more engrained in the organisation. • Acquire firms in unfamiliar markets and use their personnel and expertise, albeit at a premium. The perils of this strategy, though, are numerous, beginning with the fact that you have to pay a premium in acquisitions and continuing with the postmerger struggle of trying to integrate firms with two very different cultures. Studies of cross border acquisitions find that the record of failure is high. • Try to hire away managers of firms or share (joint ventures) in the experience of firms that have lived through specific risks. • Find a way to build on and share the existing knowledge/ experience within the firm.
d. The Resource Advantage
• Capital Access: Being able to access capital markets allows firms to raise funds in the midst of a crisis. Thus, firms that operate in more accessible capital markets should have an advantage over firms that operate in less accessible capital markets. • Debt capacity: One advantage of preserving debt capacity is that you can use it to meet a crisis. Firms that operate in risky businesses should therefore hold less debt than they can afford. In some cases, this debt capacity can be made explicit by arranging lines of credit in advance of a crisis.
e. The Flexibility Advantage
• Being able to modify production, operating and marketing processes quickly in the face of uncertainty and changing markets is key to being able to take advantage of risk. Consequently, this may require having more adaptable operating models (with less fixed costs), even if that requires you to settle for lower revenues.
• In the 1990s, corporate strategists argued that as firms become more successful, it becomes more difficult for them to adapt and change.
Task 2: Risk actions
Take the five risks that you listed in task 1 and consider for each one, whether you will pass the risk through to your investors, hedge the risk or seek out and exploit the risk.
Risk Action (Hedge, Pass through or exploit) Why?
Build a successful risk taking organisation..
• While firms sometimes get lucky, consistently successful risk taking cannot happen by accident. • In particular, firms have to start preparing when times are good (and stable) for bad and risky times.
Align interests…
Pick the right people
• Good risk takers
– Are realists who still manage to be upbeat. – Allow for the possibility of losses but are not overwhelmed or scared by its prospects. – Keep their perspective and see the big picture. – Make decisions with limited and often incomplete information
• To hire and retain good risk takers
– Have a hiring process that looks past technical skills at crisis skills – Accept that good risk takers will not be model employees in stable environments. – Keep them challenged, interested and involved. Boredom will drive them away. – Surround them with kindred spirits.
Make sure that the incentives for risk taking are set correctly…
• You should reward good risk taking behavior, not good outcomes and punish bad risk taking behavior, even if it makes money.
Make sure the organisational size and culture are in tune..
• organisations can encourage or discourage risk based upon how big they are and how they are structured. Large, layered organisations tend to be better at avoiding risk whereas smaller, flatter organisations tend to be better at risk taking. Each has to be kept from its own excesses. • The culture of a firm can also act as an engine for or as a brake on sensible risk taking. Some firms are clearly much more open to risk taking and its consequences, positive as well as negative. One key factor in risk taking is how the firm deals with failure rather than success; after all, risk takers are seldom punished for succeeding.
Preserve your options..
• Even if you are a sensible risk taker and measure risks well, you will be wrong a substantial portion of the time. Sometimes, you will be wrong on the upside (you under estimate the potential for profit) and sometimes, you will be wrong on the downside. • Successful firms preserve their options to take advantage of both scenarios:
– The option to expand an investment, if faced with the potential for more upside than expected. – The option to abandon an investment, if faced with more downside than expected.
Task 3: Assess the “risk taking” capacity of your organisation
Dimension Your organisation’s standing
1. Are the interests of managers Aligned with stockholders aligned with the interests of capital Aligned with bondholders providers? Aligned with their own interests 2. Do you have the right people in place to deal with risk? 3. Is the incentive process designed to encourage good risk taking? 4. What is the risk culture in your organisation? 5. Have much flexibility is there in terms of exploiting upside risk and protecting against downside risk? Too many risk takers Too many risk avoiders Right balance Discourages all risk taking Encourages too much risk taking Right balance Risk seeking Risk avoiding No risk culture Good on exploiting upside risk Good in protecting against downside Good on both
Essential propositions about risk
1. Risk is everywhere 2. Risk is threat and opportunity 3. We (as human beings) are ambivalent about risk and not always rational in the way we deal with it. 4. Not all risk is created equal: Small versus Large, symmetric versus asymmetric, continuous vs. discrete, macro vs. micro 5. Risk can be measured 6. Risk measurement/assessment should lead to better decisions 7. The key to risk management is deciding what risks to hedge, what risks to pass through and what risks to take 8. To manage risk can generate new shareholder value
And here is the most important ingredient in risk management: Be lucky…
•There is so much noise in this process that the dominant variable explaining success in any given period is luck and not skill. Proposition 1: Today’s hero will be tomorrow’s goat (and vice verse) There are no experts. Let your common sense guide you. Proposition 2: Don’t mistake luck for skill: Do not over react either to success or to failure. Chill. Proposition 3: Life is not fair: You can do everything right and go bankrupt. You can do everything wrong and make millions.
Thanks for your attention!
doc_543452315.pdf