Identifying & managing business risks

Dr B K Mukhopadhyay

(The author is a Professor of Management and Economics, formerly at IIBM (RBI) Guwahati. He can be contacted at m.bibhas@gmail.com)

Dr. Boidurjo Rick Mukhopadhyay

(The author, international award-winning development and management economist, formerly a Gold Medalist in Economics at Gauhati University)

Financial risks are uncertainties resulting in adverse variations of profitability or outright loss. Hence the crucial need is there for all the players – government controlled or privately/ jointly controlled – to identify, measure, price and exert all sorts of monitoring and control so as to ensure that the financial health of organizations do not suffer from incurable disease.

Whether to adapt or mitigate risk, an early detection and degree assessment can help in setting right the entire going. Naturally, the question arises to what extent our corporate sector is really ready for this departure and at the same time what steps do individuals need to take so far as capital management, compliance and risks are concerned.

With volatile markets coupled with high employee turnover it gets really critical to effectively contain risks – political, country, currency, foreign exchange, operational and market. The cost of compliance oversight in today's business environment is colossal.

In fact, while traditional tools are not fully ineffective in terms of their universal application and comparability, the very omission of certain intangible risks – operational, social and political, regulatory, reputation and legal risks - may result in erroneous inferences or flawed business decisions.

Examples are not far to seek: The need is there to become double cautious about the very risk - concentration risk inasmuch as concentration may arise in a particular market, industry, region, tenor or trading strategy. Again, organizations have to rely on continuous feed back in order to repair any damage at the earliest – before one makes mountain on a mole hill!

At the same time, reputation risk should not be lost sight of: accusations and the negative media attention can seriously damage a multinational's brand and expose a foreign firm to popular demonstrations and even legal actions.

The way the risks are managed in any particular institution actually reflects its very position in the market place, the range of products or services it delivers and truly at the top of it - its culture and unfailingly effective risk management ultimately decides the ability to withstand the pressure of futuristic challenges mainly emanating from ever increasing intense competition. With each line of business, the sub-groups are there and each sub-group, in turn, has to deal with variety of financial activities. While carrying all such business operations, any mismatch between assets and liabilities results in different types of risks.

It is well known that diversification is one of the cornerstones of risk management. A professional risk-taking enterprise has to limit the concentration of their exposures to prevent any one event having significant impact on their capital base. Unfortunately, there remains a natural tension between pursuit of an institution's core competencies and competitive advantages into profitable market segments or niches that produces concentration, and their desire to diversify and exposures!

In fact, the growing risk that the executives almost globally, face is the over dependence on traditional methods of risk measurement – ROA [Return on Assets] and ROE [Return on Equity] – which may not be quietly effective for significant business risks addressing. As per Fortune 500 evaluation, almost 80 per cent of the companies assess the existing and proposed business activities using these methods.

Risk is intricately related to loss that is expected to be there due to the happening or non-happening of certain events or activities. Here the cost of capital arises from the need to pay investors in bank's equity and internal generation of capital necessary for business growth. Capital efficiency is a core imperative for the banking sector and will definitely come into focus given numerous growth opportunities that will drive need for capital. Clearly, any business will not be able to participate in growth opportunities if it is not able to raise capital due to either performance issues or regulatory issues. While ensuring capital efficiency, ensuring compliance and managing risks, business enterprises are bound to tap the high growth opportunities.

In banking transactions, risks impact in two ways – banks have to maintain necessary capital as per regulatory requirements and then there is always a probability of incurring loss associated with all risks which need to be factored into pricing. It is more crucial today as the banking industry has to discharge a wide range of functions – commercial banking [advances, deposits, borrowings], corporate finance, retail banking, trading [all the assets that are marketable], investment banking and other financial services [off balance sheet exposures that are contingent in nature like guarantees, committed or back up credit lines, letter of credit, etc.].

Especially, the crucial need is there as to examining adequacy of risk management system followed. Detailed particulars on the vibrant areas are to be looked into so that early detection system could be there in the true sense. For example: credit risk management systems followed call for adequate scrutiny especially considering the main activity of the banks / financial institutions hover around this specific field. The credit appraisal, monitoring systems and the credit recovery systems are the pillars and as such any big gap or inadequacy on these scores capsizes the growth process. Simultaneously, the adequacy of policies and procedure for write off of Loans, adequacy of policies, guidelines and controls over off Balance Sheet items call for detailed scanning. Concentrations in the credit and investment portfolio are another important area that should be considered. Effectiveness of risk management committee is to be assessed along with overall audit opinion on credit risk management.

A closer scrutiny of market risk - interest rate, liquidity and foreign exchange - management systems including adequacy of policies, procedures and guidelines for the market risk management as well as the adequacy of the system for measuring, monitoring and mitigation of market risk – are expected to be there along with assessing the functioning of risk management committees and their effectiveness. Overall audit opinion on market and liquidity risk management is required to be incorporated.

So far as operational risk management system that are being followed calls for intensive look at adequacy of policies, procedures and guidelines for the operational risk management plus adequacy of the system for measuring, monitoring and mitigation of operational risk are to be analysed inclusive of assessing effectiveness of risk management Committees in order to thus arriving at overall audit operational risk management level.

Undoubtedly, in such a context the ultimate area is to ensure effectiveness of risk-conscious internal control system. This arena, in turn, also calls for assessment of the related aspects - effectiveness of the audit committee; effectiveness of the internal audit function; rectification of the deficiencies identified in the audit reports; adequacy of the controls in credit operation/ controls exercised; adequacy of the controls in treasury operations, adequacy of the controls in operation of distribution channels; adequacy of the controls in procedures related to expenditure as well as adequacy of the control over fixed assets.

Adequacy of the controls to prevent and/or minimize fraud and forgeries, specific instances of fraud and forgery in the review period and other control issues, if any, are to be furnished by Auditors while arriving at overall assessment of the internal control system. No less important is the area of investments in shares and debentures - investments in unlisted companies, investment in companies with financial interest, investment in shares of other bank/Fls, investments arising out of underwriting commitments, and investment in shares and debentures exceeding the limits must be examined. Review of the investment portfolio, adequacy of provisioning requirements is thus very vital.

Therefore, reporting requirements demand utmost attention: The reliability of mechanism used for reporting and the accuracy of returns. Comments are to be there on the compliance with the prevailing Statute, Act, Directive and Regulations, especially in vital areas like: profit appropriation to General Reserve: appropriation to Exchange Fluctuation Reserve, Distribution of Dividend, whether prohibited activities are pursued and control/ notification of dormant deposit, among others.

Finally, it is the degree of risk that is important to be critically assessed before a project is taken up / in operation. A stitch in time saves nine indeed! That is why one has to locate the risk factors, measure it, control the same and finally go for appropriate risk management processes.