Risk as a source of opportunity

Risk management in India has long been associated with mitigating adverse financial consequences. However, risks must also be seen as a source of opportunity

A 2012 study by FERMA globally found that firms with 'advanced' risk management practices exhibited stronger EBITDA and revenue results over five years than those with 'emerging' risk practices. This review of over 800 firms in 20 countries concluded that 75 per cent of firms with 'advanced' risk management practices had EBITDA growth of more than 10 per cent per annum.

To be able to understand how Indian companies can achieve this transformational focus, which would take corporate governance to the next level, let us first review the relationship between risk, risk management and governance and see how changing the positioning on risk can drive this change.

Relationship among risk, risk management and governance

RISK

• Risk is the potential for failure or harm or the missed opportunity for value creation or strategic competitive advantage
   
• Risk must be taken to seize opportunities and they must be managed not simply avoided

RISK MANAGEMENT

• Risk management is the discipline of improving one's chances of success by articulating, prioritising and managing risks
   
• Only by considering and managing risk, can an enterprise succeed in optimising its value and success

GOVERNANCE

• Governance is the 'management of risk management'. ie meeting stakeholder expectations while managing risks and ensuring compliance
   
• Value-creation requires governance mechanisms to be driven top-down

Perceiving risks as an opportunity
Risk management in India has long been associated with mitigating adverse financial consequences of "bad things happening" and organisational interest and reputation being impaired through natural calamities, business disruption, data loss, fines or regulatory enforcement action. However, the world continues to realise that risks must also be seen as a source of opportunity.

Governance, which is a higher-level process involving directing and managing risk management and related activities to address stakeholder expectations, is, therefore, globally reinventing itself to incorporate this bi-modal thinking of maximising the opportunity while also managing compliance and any downside of risk. In this new thinking, the explicit linkage of risk and strategy, starting at the Board and C-suite level of the organisation, is considered an integral part of the organisational strategy-setting process.

Management thinkers, including Michael Porter, have long advocated how strategically aligned governance can significantly enhance competitive advantage through differentiation. For instance, by enhancing its reputation that it is more resilient to risks than its peers. Nir Kossovsky, in his book Reputation, Stock Prices and You demonstrates, through the use of forward-looking big data, the business case of investing in this. "For the median company, the upside measure of success is an expected additional 4.3 per cent annual return on equity". In other words, when stakeholders can appreciate improvements in governance, controls and risk management that upgrade their long-term expectations, equity prices and, therefore, shareholder wealth will increase.

Articulating risk appetite
Risk appetite is one of the essential concepts that must be understood and consistently applied to be able to reap the strategic benefits out of this emerging perspective. COSO's Enterprise Risk Management Framework defines risk appetite as the amount of risk an entity is willing to accept in pursuit of value. Risk appetite is, thus, about establishing a strategic boundary between the amount of risk that a business is willing and able to take as an integral part of its business model/ profitability (risk seeking) on the one hand and the level at which it wants to expose itself to "bad things happening" on the other (risk aversion), together with a set of strategic, financial and operational risk parameters and related tolerances.

Consider the example of a consumer products company that aspires to increase market share by expanding to the MINT (Mexico, Indonesia, Nigeria, Turkey) countries through strategic alliances and leveraging newer sources of global supply for raw materials. Such a company may clearly articulate that it has absolutely no risk appetite for any reputational damage or erosion to shareholder wealth. However, it may have a high risk appetite with regard to new markets and franchisee networks and willing to accept higher losses in the pursuit of higher returns. The Board may define an expectation of say an 18 per cent return on investment in each of these growth initiatives over a one- to three-year horizon, but not willing to take more than a 25 per cent chance that the investment leads to a loss of more than 50 per cent of the capital investment in any new initiative.

With regard to its new sources of supply of raw materials, the Board may recognise the need for aggressive pricing to maintain its competitiveness. It may also set a higher risk appetite relating to product defects in accepting the cost savings from lower-quality raw materials. For instance, it may set a target for production defects of say, one flaw per 1,000 units and articulate that production staff may accept defect rates up to 50 per cent above this target if the cost savings from using lower-cost materials is at least 10 per cent.

Iterative discussion in the Boardrooms and C-suite of Indian companies is key to ensuring effectiveness. Boards should monitor this framework, given that the macro-economic environment is the foundation of business strategies and the impact of risks can radically change very quickly.

Sanjoy Sen
Doctoral Research Scholar, Aston Business School, UK