Why Does Risk Management Matter?
According to standard economic theory, firm managers should maximize expected profits
without regard to the variability of reported earnings. However, literature on the reasons
for managers’ concern about the volatility of financial performance dates back to 1984,
when Stulz offered a viable economic reason for firm managers’ concern.
Since then, there have been alternative theories and explanations; a recent review of the literature
presented four reasons to justify active risk management:
- Managerial self-interest
- Tax effects
- Cost of financial distress
- Capital market imperfections
In each explanation, the volatility of profit leads to lower value to at least some of the firm’s
stakeholders. In the first, it is noted that managers have limited ability to diversify their
investment in their own firm, due to limited wealth and the concentration of human capital
returns in the firm they manage. This fosters risk aversion and a preference for stability.
In the second, it is noted that, with progressive tax schedules, the expected tax burden is
lessened by reduced volatility in reported taxable income. The third and fourth explanations
focus on the fact that a decline in profitability has a more than proportional impact on the
firm’s fortunes. Financial distress is costly, and the cost of external financing increases rapidly
when a firm’s viability is in question. Any one of these reasons is sufficient to motivate
managers to be concerned about risk and carefully assess both the level of risk associated
with any financial product and potential risk-mitigation techniques.
How Can a Firm Mitigate Risk?
Managers can consider three generic risk-mitigation strategies
- Eliminate or avoid risks by simple business practices.
- Transfer risks to other participants.
- Actively manage risks at the firm level.
Risk avoidance involves reducing the chances of idiosyncratic losses by eliminating risks
that are superfluous to the institution’s business purpose. Common risk-avoidance activities
are underwriting standards, hedges or asset-liability matches, diversification, reinsurance or
syndication, and due diligence investigation. The goal is to rid the firm of risks that are unessential
to the financial service provided or to absorb only an optimal quantity of a particular risk.
What remains is some portion of systematic risk and the risks that are unique to an institution’s
business franchise. In both, risk mitigation is incomplete and can be enhanced. Any systematic risk
not required to do business can be minimized. Whether this is done is a business decision that the
firm can clearly indicate to stockholders. Likewise, in operational risk, the firm can address the risks
of providing service — including fraud, oversight failure, lack of control, and managerial limitations.
Aggressive risk-avoidance activities in both these areas will constrain risk, while reducing the
profitability from the business activity. Accordingly, the firm can communicate the level of
effort it makes to reduce these risks to shareholders and justify the costs.
The firm can eliminate some risks or at least substantially reduce them by transferring them.
Markets exist for the claims that many of these financial institutions issue and/or the assets
Individual market participants can buy or sell financial claims to diversify or concentrate the risk in
their portfolios. To the extent that the market understands the financial risks of the assets that the firm
creates or holds, the assets can be sold in the open market at their fair market value. If the institution has no comparative advantage in managing attendant risks, it has no reason to absorb or manage such risks rather than transfer them. In essence, for the firm, there is no value added associated with absorbing the risks.
However, the firm should absorb another class of assets or activities in which the risk is inherent.
In these cases, risk management must be aggressive, and there must be good reason for using further resources
to manage firm-level risk. These financial assets or activities have one or more of these characteristics:
- 1. The equity claimants, or others for whom the institution has a fiduciary interest, may own claims
- that the investors cannot trade or hedge easily themselves. For example, defined-benefit pension plan participants can neither trade their claims nor hedge them on an equivalent after-tax basis.
- This also applies to the policies of mutual insurance companies, which are complex bundles of insurance
- and equity.
- The nature of the embedded risk may be complex and difficult to reveal to nonfirm-level
- interests, such as banks, which hold complex, illiquid, and proprietary assets.
- Communication in such cases may be more difficult or expensive than hedging the underlying risk.
- Moreover, revealing information about customers or clients may give competitors an undue advantage.
- If moral hazard exists, it may be in the stakeholders’ interest to require risk management as part of
- standard operating procedures. For example, providers of insurance, e.g., the FDIC, can insist that
- institutions with insured claims follow appropriate business policies.
Written by Dr. Chao Yuang Shiang (趙永祥 博士)
Faculty, Dep. of Finance, Nan Hua university
21- August- 2017