Developing a Risk Management Action Plan to counteract against Financial and Business Risks is very important for survival of all organizations. However it is of utmost importance for FIs (Financial institutions) to develop a concrete risk management action plan, which they can put into use once a situation demands of them to do so.
Basically they are SIX Types of Risk Management Actions which an organization may undertake on as is and when required basis. These are listed in the order below:
- Risk Acceptance
- Risk Reduction
- Risk Avoidance
- Risk Transfer (via Hedging)
- Risk Ignorance
- Risk Exploitation
1. Risk Acceptance is the first form of action which an organization such as a bank may undertake in order to process transactions. No reward can be earned without accepting risk. If for e.g. an IB – (Investment Bank) wants to earn a desirable Rate of Return on shareholder equity funds, then they should invest in financial markets such as Money Markets, Bond markets, Currency (FX) Markets and so on etc. That’s a normal IB Treasury Practice the world over.
So there will be no rewards without accepting risk and vice -versa. Period.
How much should an organization accept?
For that very reason, firms need to develop a well planned out RAC – Risk Acceptance Criteria under various set of scenarios!! Well that’s “ALWAYS” a must!!
Hence don’t forget to implement this cardinal principle before undertaking business and / or financial transactions in markets.
2. Risk Reduction is the second form of action that an organization may undertake. For E.g. a mutual fund may not accept funds from those who are involved in money laundering activities. Hence it is important for such such asset management firms to develop proper KYC – (Know Your Customer) Internal Controls.
Another example may be of a bank with a large branch network . Such a bank has to have a proper MIS – (Management Information System) in order to process transactions. However the bank must have a data link and data base recovery system in place during a system breakdown or in any other eventuality that may cause a calamity such as an Earth Quake. In this case a bank should have a risk reduction strategy that can be executed by applying both the DRP – Disaster Recovery and BCP – Business Continuity Plans.
Remember no firm such as a financial institution can make money without accepting risk. However blind acceptance of risk is not on! I hope Wall Street Professionals will be reading my blog once it goes online 😉 .
So this is self explanatory. Lets move on to the third category.
3. Risk Avoidance is the third form of action that an organization may undertake. How can an organization avoid risk/s? well this is probably the best answer to not taking on any kind of Business and / or Financial Risks at all.
Just avoid them!! ….
However in my opinion such a proposition may not be feasible all the time. For E.g. an Insurance firm is in the business market to take on risks (which others transfer onto them) .
What If they start avoiding certain types of risks, than what shall be the consequences for the entire economic system and it’s economic agents ?
The answer to the above question is that certain segments of the financial, commodity and producer markets may collapse and economic activity may come to a stand still.
But Risk Avoidance to an extent may be desirable for Investment Companies that deal in derivatives and other structured products which have exotic pay -off structures and accompanied by higher forms of market volatility. A point comes when such an institution has to say that “enough is enough”.
Unfortunately Global Banks, Insurance Firms such as (AIG), Brokerage Houses and Hedge Funds that were underwriting contingent claims and investing in various complex transactions didn’t have the guts to avoid RISKS!!
Bad for them, they went out of business.
You know what happened afterwards………..
4. Risk Transfer is the fourth form of action that an organization may undertake. Very popular these days and used by organizations for e.g. such as Investment Banks and Hedge Funds to transfer risk onto other economic agents within the system using derivative products and Insurance schemes of different types.
This helps the firm to stay viable under duress. For e.g. a Balanced Fund that trades in both stocks and bonds may short forward and future contracts to hedge against incoming Market Risks in Capital Markets (provided SEC regulations allow them to do so).
But do Note: that if all agents in a system adopt “risk transfer” methods at the same time, than such actions can bring about a bigger systemic risk which in return may instigate panic and collapse of confidence within the entire economic system.
Hence the question arises that should all speculators be welcomed or discouraged in financial markets. We shall pick this issue up in some other blog.
5. Risk Ignorance is the fifth form of action that an organization may undertake. I believe a certain element of risk ignorance exists in all economic and business transactions that we undertake from time to time. Its not humanly possible to react or hedge against all forms of risk. For e.g. in certain business contracts a clause clearly mentions that the firm XYZ shall not be responsible for paying damages and compensation if an earth quake takes place.
Such a risk is described as FORCE MAJEURE RISK , implies => “chance occurrence, unavoidable accident”
Also in Islamic Finance certain investors tend to ignore certain aspects of positive business risk which makes a business contract legally viable in shariah compliant terms.
For e.g. in the Hanafi school of thought, it is necessary for an investor to ignore acceptable forms of market risk and performance risk as long as they don’t invoke Gharar- (excessive risk taking activities such as derivative trading) and Maysir – (speculation driven activities such as gambling in casino’s etc).
Hence “Hanafi” Sunni Moslems cannot invest in Capital Protected Funds etc. Such class of investors have to ignore legitimate financial risks which removes the possibility of incurring a loss in business operations and investments.
So risk ignorance may also become an implicit way of sharing risks between two commercial entities in Islamic Finance and Banking!
We shall Inshallah discuss these issues in some other blog in much more detail.
6. Risk Exploitation is another form of action that an organization may undertake. I am sure those who want to do this are traders working for some High profile “Hedge Fund” on the Wall Street or Lombard Street in the City of London! haha 😉
No Offense! ….lets move on.
In fact modern financial economics teaches us to exploit risk intelligently in order to maximize profits/returns.
what else is High Frequency Trading Economics?
Don’t we see trader/ dealers glued to their Reuters Screen.
Why would they be doing that? well…..
They are waiting for the right moment when a “Risk Exploitation” opportunity may arise from somewhere and this gives the dealing room blokes an opportunity to make money by executing transactions across markets and over time.
Its all done in a well planned manner using market intelligence systems and automated trading platforms.
For e.g. in stock markets, the fund managers may “sell- short” / “buy-long” stock futures when the Required returns exceed expected returns for a given underlying. So they have turned a forthcoming risk into an opportunity to make “arbitrage gains” using Equity Derivatives.
Hope I have covered the essence of all basic Risk Management Actions (which can be distinctly translated into plans) by organizations such as financial institutions under normal circumstances.
You feedback is welcomed.