Study Notes - Chapter 1 - The Global Risk Environment Flashcards
Explain how risk is both an input and output of the strategic decision making process.
Risk is both an input into the strategic decision-making process and an output.
From an input perspective, the risk exposures that exist will influence the types of strategy that are chosen. For example, an organisation might launch
a new product to exploit a new market, or choose to merge to help address an increase in the cost of regulation or to survive in a competitive marketplace.
From an output perspective, strategic decisions may create risks that need to be managed (such as health and safety risks or environmental risks).
Identify the key risks that the following stakeholder groups will wish to have managed effectively:
* creditors, customers & employees
Creditors are primarily exposed to the risk that an organisation will default on its loan repayments. This will mean a loss of some or all of the entire loan amount, plus the loss of interest payments.
Customers face three possible risks – the risk of INJURY as a result of their use of products or services;
the FAILURE OF PRODUCT OR SERVICE (such as a breakdown);
and the LOSS OF GUARANTEE OR WARRANTY. Guarantees and warranties may be lost if an organisation goes bankrupt.
Employees face HEALTH AND SAFETY-related risks, plus the LOSS OF THEIR ECONOMIC LIVLIHOOD in the event that an organisation becomes bankrupt or has to make staff redundant due to unforeseen losses.
What are the three reasons that Shareholders may not behave in a risk averse way?
1.ASYMMETRIC RETURNS: shareholders may receive dividends and they may benefit from an increase in the value of the shares that they hold, allowing them to be sold for a profit. There is no theoretical limit on the size of these returns, meaning that they could be 100%, 1,000% or more. Generally, risk and return are positively correlated. The more risk an organisation takes, the more return it can generate: a return that should translate into increased dividends and share values. Shareholders may value an increase in risk, providing that there is the prospect of higher returns.
Such an increase in risk may result in a higher chance of bankruptcy, but shareholders are often protected from this because of their limited liability.
6 cgi.org.uk
- LIMITED LIABILITY: the shareholders of most companies, whether public or private limited companies, have limited liability. In the event that the company becomes insolvent or goes bankrupt, shareholder liability is limited to the value of their investment stake. Limited liability shareholders cannot be forced to provide additional funds once they
have invested in a company, as would be the case if shareholders had unlimited liability. - THE DIVERSIFICATION OF RISK: shareholders often choose to create diversified portfolios of investments. They purchase shares in multiple companies or some other form of investment asset (for example, bonds, commodities or property). Through diversification, shareholders can insulate their investment portfolio from company-specific risk events such as fires, frauds or a decline in sales. Diversification can be understood via the well-known proverb ‘do not put all your eggs in one basket’.
Although there are reasons why shareholders may be risk-neutral or even risk-preferring, in practice most will value effective risk-management. Why would this be?
This may be because of
Ethical concerns
A desire to protect employees, third parties or
customers from harm.
Concerns about bankruptcy costs
The effect of cash-flow fluctuations on opportunities for growth.
Explain why Shareholders may have concerns about Bankruptcy costs.
High levels of risk-taking may result in financial distress and ultimately bankruptcy. In theory, shareholders should be indifferent to bankruptcy, providing that the organisation can be sold and they receive back their investment stake.
In practice, shareholders rarely get back the money they have invested and almost certainly will not receive any of the appreciation they may have received on this investment (though well-informed investors may be able to sell their shares before they start to fall in value).
When an organisation becomes bankrupt it can incur a range of costs. These may include
legal costs, other administration costs and legal-liability claims.
In addition, the organisation will lose the value of any goodwill (such as brand value) that has been built up over time.
It also may have to sell assets at far below their market value.
Bankruptcy costs significantly decrease the chance that shareholders are repaid the capital that they have invested in a company. While they may have limited liability, they will still want to get back the funds that they have invested.
Shareholders will typically value risk-management activity that can help to prevent the costs associated with bankruptcy.
Explain why Shareholders may have concerns about Cash Flow Fluctuations.
Almost all risks will affect an organisation’s cash flows.
Gains from risk-taking will help to increase the level of cash flowing into an organisation. In contrast, losses from risk-taking will result in cash flowing out of the organisation.
Fluctuations in cash flows can be very disruptive. A large, unexpected loss – such as from a fire or major fraud – could mean that there are insufficient funds to invest in profitable opportunities such as new product development or process efficiencies via the purchase of a new IT system.
From a cost perspective, large and unexpected losses may necessitate high-cost debt finance or lead to other financing and contractual costs, such as late-payment charges.
In contrast, companies with stable cash flows will be able to invest for the future and control their costs, generating higher profits and dividends for shareholders over the long term.
Shareholders will typically require much higher rates of expected return from organisations with less stable cash flows. This is known as the risk premium or ‘cost of risk’. The extra return is required to compensate for the higher level of cashflow volatility associated with increased risk. This is why venture capital organisations may choose to invest in high-risk
start-up companies, because they estimate that the level of return they should receive is sufficient to compensate them for the greater degree of cash-flow volatility.
Give examples of how different Shareholders may have different risk objectives.
Shareholders look to maximise their dividends and the share price.
Creditors want the security of knowing that their loan will be repaid with the agreed level of interest, and consumers will prioritise safe, reliable products and
services.
Conflicts regarding the preferred type and level of risk exposure may arise even in the case of organisations
that do not have shareholders. For example, employees may be less concerned about the health and safety of the organisation’s customers than their own health and safety, and vice versa.
Howe does effective risk management assists with Shareholders risk objectives?
Effective risk management is needed to help balance the conflicting interests of different stakeholder groups, weighing up different priorities and assessing the costs and benefits of different risk-management decisions and risk-exposure levels.
The board and senior management make these difficult decisions. These decisions will influence the riskiness of the strategy that the board chooses for the organisation, along with the level of investment in risk-management to help ensure that organisational objectives are met.
What is the Cosec role in balancing risk decisions at Board level?
Company secretaries and other governance professionals (as well as an organisation’s specialist risk-management staff, where present) have a
role to play in supporting these decisions to ensure that any legal, regulatory or ethical concerns are considered.
What is a self regulating system, and what problems does this face?
A self regulating system is where a group of organisations or professionals agree to
set and enforce specific risk-management standards. Co-ordination and enforcement may be managed by a trade association or institute to help prevent the collapse of the self-regulatory agreement.
Professional regulation in areas such as law and medicine often include an element of self-regulation that may cover aspects of risk-management practice by these professionals. Risk-management activities such as customer complaint handling can be self-regulatory in some countries, such as the Advertising Standards Authority in the UK.
ADVANTAGES
Regulation is agreed and enforced by those being regulated.
Ensures that the regulation is appropriate and proportionate, cutting down on the costs of compliance.
DISADVANTAGES
Hard to sustain because of the limited incentives to enforce such an agreement.
Organisations may be reluctant to punish their contemporaries because they may be next to receive enforcement action.
FAILURES
Many self regulatory systems fail – such as financial services self-regulation in the UK in the 1980s and early 1990s – and are replaced by statutory regulation, enforced by a government-appointed regulatory body.
HYBRID
The current UK governance code, issued by the Financial Reporting Council (FRC), has elements of self-regulation, though the FRC board members are appointed by the Department for Business, Energy & Industrial Strategy (BEIS), the FRC is an independent regulator and is not directly accountable to the UK government (such non-governmental organisations with regulatory power are sometimes called ‘quangos’ – quasi-autonomous non-governmental
organisations). However, this is expected to change. As the UK government is consulting on replacing the
FRC with a new government regulator, the ‘Audit, Reporting and Governance Authority’ (ARGA).
What is the asymmetric information problem?
Stakeholders need to know the types and degrees
of risk to which they will be exposed in order to generate market incentives for effective risk-management. This can be hard to achieve in practice. Customers are unlikely to know how safe or reliable a product is before they purchase it, whereas the organisation manufacturing the product will have a much better understanding of the product’s safety and
reliability. This is known as the asymmetric information problem.
What dangers can arise from an asymmetric information problem?
OPPPORTUNISM AND PUBLIC GOODS PROBLEMS
Opportunism - It may be that an organisation exploits a customer’s lack of prior safety information by making a product less safe or reliable than it could be, thus saving the organisation money but exposing the customer to an unacceptable level of risk.
Public Goods Problems - Public goods are products, services or other benefits that are enjoyed on a non-exclusive basis by all the members of a society. From
a risk-management perspective, key public goods are the ENVIRONMENT and the protection of SHARED SYSTEMS such as the global financial system.
The problem with these public goods is that individuals or organisations may make risk management decisions that benefit them, but which do not protect the wider environment or financial system.
In the case of the environment, an organisation may not invest as much in preventing pollution as required by society to preserve public health and wellbeing. This is because the organisation may only consider the costs and benefits to itself from managing pollution risks, not those to society as a whole.
The same can also be the case in financial organisations, which, left to their own devices, may not do enough to protect the financial system as a whole.
What is the primary benefit of risk-management regulation?
The primary benefit of risk-management regulation is that it intends to help mitigate market failures and to protect the consequences of excessive risk exposures.
What is the risk of over regulation or ineffective regulation?
COSTS of regulation come from over-regulation or ineffective regulation, where organisations are required to reduce risk below the optimum level that balances the needs of different stakeholder groups or where organisations face excessive costs related to compliance and enforcement, without much benefit.
Over-regulation is relatively rare, but
different groups of stakeholders have conflicting opinions on this. In all cases compliance costs can be considerable and these costs may both decrease the profitability of an organisation and increase the price of goods and services.
Compliance costs include the cost of maintaining a compliance function or providing information to regulators. This means that the stakeholder groups that regulation is designed to protect may end up paying some or all of the associated costs of compliance.
What is the role of Compliance Management?
Compliance management ensures that an organisation’s risk-management arrangements and decisions are consistent with all applicable laws and regulations. This will often include ensuring that the organisation does not expose vulnerable
stakeholders to excessive levels of risk.
