Risk is all-pervasive. Wherever there is uncertainty, risk prevails. The concept of risk is omnipresent from the existence of mankind, but now it has become more relevant due to interdependence of economies throughout the globe. The recent financial crises in the developed economies not only affect domestic companies negatively, but are also capable of wiping of the entire net worth of companies. What appears to be safe for generations may not be safe now. The need of the hour is to look into these phenomena cautiously rather than suspiciously.

Risk management is the current favorite strategy, globally. It has helped global enterprises to face situations such as the Y2K problem or protecting against data loss in the aftermath of 9/11. It is impossible to predict all the incidents/events and their intensity in advance and to protect oneself against it. However, there is a well-laid procedure that can help predict possible threats and take remedial measures to reduce losses.

It is done in three stages.

Risk Identification: This is the first step towards mitigation/reduction of risk. The various sources of risk in today’s market place are interest rate risk, market risk, inflation risk, business risk, financial risk, liquidity risk, technology risk, political risk, sovereign risk, counterparty risk etc. Any of these risks can affect business adversely. Good knowledge of these sources can help to take appropriate action at the right times. One must try to understand the possible impact of these risks on the business and prepare a course of action to mitigate the adverse affect. Now regulators of many countries are making it mandatory to have a risk management committee that will understand the risk implications of existing or new products and suggest the measures required to be taken.

Risk Measurement: This is the second stage. One can choose from various risk-measurement models according to compatibility and the complexity of requirement. There are various risk measurement models available for different types of risk, such as VAR (delta normal method, historical simulation method, and Monte Carlo simulation method), stress testing, cash flow at risk, Merton model, credit scoring models, credit risk portfolio models, and so on. The most commonly used among these is the VAR.

The basic objective of all the models is to learn about the maximum loss a company can suffer in worst-case scenarios. Scenario analysis, stress test and the Monte Carlo simulation method gives enormous scope to management teams to use real time situations to get close-to-accurate results.

Risk Mitigation: Once an estimate of the risk is made, the next job is to mitigate that risk. This is crucial since it involves cost, effort, time, and resources.

There are a few risks that can not be mitigated like war, natural calamities, changes in economic policy, industrial recession etc.

However, many risks can be insured or protected.  Portfolio diversification in negatively correlated areas is one way to mitigate the impact of market risk. There are various derivative instruments available to reduce credit/counterparty risk; but in the current financial crisis it is difficult to rely on them. The recommendations of Counterparty Risk Management Policy Group II report further strengthens the global financial system by identifying private sector initiatives that will reduce the risk of global financial shocks and limit losses.

Liquidity risk can be addressed by matching the maturities of asset and liabilities in an organization. Further, investing a portion of an organization’s portfolio in highly liquid and sovereign bonds will support the organization in liquidity crises, besides earning regular returns.

Operational risk can be due to data loss, human failure, fraud and forgery etc. Operational risk can be avoided with proper precaution, comprehensive backup policy (including mirror image) at some remote area and foolproof management policy. To avoid frauds, policy makers put themselves in the shoes of person wants to commit fraud and make rules to plug the loopholes. One should always keep in mind that lack of proper checks and control may lead to financial disaster which could have been avoided in the cases like Barings Bank, Sumitomo, Daiwa Bank, and Allied Irish Bank.

Prabhat Varma works as General Manager (Finance), Sahara India Financial Corporation, Mumbai.