Risk is where the business is

In his book Money: Master the Game, Tony Robbins nicely described the trend of happenings: "The Great Depression, the 1973 Oil Crisis, British Pound-sterling Crisis of 1976, Black Monday in 1987, Dotcom Bubble of 2000, Housing Bust in 2008, the 28 per cent 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. This we can be sure of." He 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. Yes, we are in uncharted waters." If doing one has to remember that business without risk is just akin to making omelettes without eggs!
Who thought that the airlines would 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 homeowners to borrow, but the real problem were rooted in the mortgage lending practices. Since the housing prices rapidly increased in the last decade, the mortgage lenders relaxed their lending standards. 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 world of business.    
What is risk? Most people vaguely consider risk to be an abstract notion that has a large impact in their stock market gamble or define it as a possibility that the value of the investment would decrease due to a variety of factors. Quantitative financial experts opine that 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 hi-tech company's stock during times of fluctuating consumer spending) the more risky it is considered to be.
Apparently, the business world today has become more complicated, so too the global financial markets. The global financial uncertainties were not entirely unanticipated. However, the intensity was not predicted nor was the duration expected. The outlook is uncertain than ever before due to the global situation - the global financial turmoil emanating from the US prime mortgage crisis and the increasingly-high prices of oil and gold. There is a strong need for guarding against uncertainties weighing properly the ability to absorb risk!
Consequently, a risk - derived from the Italian word risicare - is where the business is. It cannot be liquidated simply because tomorrow is a different day and we do not what will happen tomorrow. Yesterday is history and it cannot be changed. Today is a gift. We should plan, budget, fix and target for tomorrow as 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 Chinese dictionary, risk means danger and simultaneously an opportunity. A gain is always associated with a risk. What about high risk? Does it always indicate a high gain? No, it is the degree of risk that is important before the project is initiated or in operation.
Actually, the key to effective risk management is not necessarily to minimise all of the various types of risk. In the banking sector, lending operations have the inherent risk of possible loan losses (credit risk). But if they take risks, banks are able to charge a premium for their risk-taking activities and earn profits. Risk is also a source of profits. In managing various types of risk, it is necessary to divide them into two basic types, based on their inherent characteristics - risks that should be taken versus risks that should be minimised. While implementing risk management activities, departments in charge of various types of risks should respond promptly and simultaneously upgrade their capabilities. It is collectively essential for the institution to locate measures and manage risk volumes with centralised precision.
Hence, the crucial need is there for all the players - government or private enterprises - to identify, measure, price and exert all sorts of monitoring and control for ensuring that the financial health of the organisation does not suffer from any incurable disease. Naturally, early detection and degree assessment helps a lot to make it worthwhile. We know how to enter the market, but not the exact time to exit. While traditional tools are effective in terms of their universal application and compatibility, any omission of certain intangible risks - operational, social and political, regulatory, reputation and legal risks - may result in erroneous inferences or flawed business decisions.
As most of the activities and operations are driven by considerations of higher returns or better profitability, the search for returns exposes any business to higher risks. Banks should hold adequate capital and reserves so that solvency and stability are not threatened. The challenge is to turn cost into profit. Successful implementation of a sound mechanism for risk management can only be ensured through an active scrutiny by the top-level management. Besides, feasible policies, transparency, information systems, workable procedures, adequate risk management practices, internal control and sound risks are the preconditions. If institutions can properly manage risk by addressing these issues, we can avoid another damaging financial collapse in the future.

Dr BK Mukhopadhyay, a Management Economist, is attached to the West Bengal State University, India.
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