Deciding on a strategy

High concentrations of risk aren’t necessarily bad. Everything depends on the company’s appetite for it. Unfortunately, many companies have never articulated a risk strategy.

Formulating such a strategy is one of the most important activities a company can undertake, affecting all of its investment decisions. A good strategy makes clear the types of risks the company can assume to its own advantage or is willing to assume, the magnitude of the risks it can bear, and the returns it demands for bearing them. Defining these elements provides clarity and direction for business-unit managers who are trying to align their strategies with the overall corporate strategy while making risk-return trade-offs.

The CEO, with the help of the board, should define the company’s risk strategy. But more often than not, it is determined inadvertently, every day, by dozens of business and financial decisions. One executive, for example, might be more willing to take risks than another or have a different view of a project’s level of risk. The result may be a risk profile that makes the company uncomfortable or can’t be managed effectively. A shared understanding of the strategy is therefore vital.

A company’s particular skills determine the types of risks it assumes. While it might seem obvious that a company should take on only those risks it can understand and manage, this isn’t always what happens. Many telecom-equipment companies, for example, financed customers during the Internet boom without possessing solid credit skills—and suffered as a result.

As for defining the level of risk companies will accept, one common approach for them is to decide on a target credit rating and then assess the amount of risk they can bear given their capital structure. Credit ratings serve as a rough barometer, reflecting the probability that companies can bear the risks they face and still meet their financial obligations. The greater the level of risk and the lower the amount of capital and future earnings available to absorb it, the lower the credit ratings of companies and the more they will need to pay their lenders. Companies that have lower credit ratings than they desire will likely need to reduce their risk exposure or to raise costly additional capital as a cushion against that risk.

The level of returns required will vary according to the risk appetite of the CEO and the board. Some might be happy taking higher risks in pursuit of greater rewards; others might be conservative, setting an absolute ceiling on exposure regardless of returns. At a minimum, the returns should exceed the cost of the capital needed to finance the various risks.

As with any strategy, a company’s risk strategy should be "stress-tested" against different scenarios. A life insurance company, for example, should examine how its returns would vary under different economic conditions and ensure that it felt comfortable with the potential market and credit losses (or with its ability to restructure the portfolio quickly) in difficult economic times. If it isn’t comfortable, the strategy needs refining.

The heat map gives a top-level indication of whether a company is sticking to its strategy and provides for corrective action. But both depend upon the next two elements of this risk-management program.

Date: 2015-12-24; view: 780