Having established that risks, from a vast variety of sources, can incur costs for an organisation, it is important to consider exactly how, in a limited company, risk is a source of cost to the owners (shareholders).
Finance theory, using the Capital Asset Pricing Model, leads us to believe that any risk that is firm specific (i. e. has a zero beta value) can be borne most effectively by a shareholder as they can diversify their portfolio at no extra cost.Even when a firm has a risk that is in someway correlated with the market portfolio, and is hence worth ‘hedging’ it is likely that a shareholder will be able to ‘hedge’ their risk for a lower price than that incurred by the firm through dealing with an insurer. Hence, according to conventional finance theory, shareholders should have no interest in managing risk.
However, “It turns out that risk is important to shareholders, not because the risk per se is a problem to the firm’s owners but because risk can have indirect effects that will reduce expected shareholder income.” (Doherty, 2000, p198. ) The indirect effects of risk act as motivation for risk management. The sources of motivation can be split into to two categories, those focused on maximising shareholder value and those focused on maximising managers’ private utility. Risk management can increase shareholder value in three ways, by reducing tax costs, by reducing dysfunctional investment and by minimising the costs of financial distress. Tax schedules are usually convex, but including a certain tax free allowance for initial corporate earnings and certain expenditures such as depreciation.By using risk management to fix the level of taxable earnings at a steady rate (x) a firm will have a lower expected tax burden than if their income was to fluctuate around the convex schedule but still maintain the same average earnings (x). Investment policies are crucial to the ongoing success of a firm.
Risk management can help to prevent firms from being forced to pursue sub optimal investment policies. Froot et al (1993) state “If external sources of finance are more costly to corporations than internally generated funds, there will typically be a benefit to hedging.” Hedging aids the organisation by ensuring sufficient internal funds exist for the continued funding of investment plans. Hedging strategies may be affected by market factors and can take many forms. The costs of financial distress can be both direct, when a bankruptcy occurs, and indirect, costs incurred simply by the possibility of bankruptcy and the possibility that the limited liability shareholders of the firm will exercise their right to default. Bankruptcy costs can fall on both the shareholders in the form of legal and administrative fees and on creditors in the form of monetary losses.Indirect costs stemming from the fear of a bankruptcy include increased inefficiency, agency costs and transaction costs due to a conflict of interest between the firm and it’s creditors, forced sale of assets, loss of customers, an impact on managerial behaviour and a diminished bargaining power with both suppliers and customers.
Hence, a risk management strategy that reduces the probability of a bankruptcy, or persuades investors and creditors that the probability is reduced, should prevent the costs listed above and even cause an increase in the stock market value of the firm.As a caveat to all of the above possible motivations for a firm to pursue risk management, it is important to note that a risk management policy should only be pursued if it imposes a cost of less value than the expected gain to the shareholders. As previously mentioned, the second category of incentives for risk management stem from managerial attempts to maximise their personal utility. Managerial risk aversion can drive a firm’s risk management strategy.”Managers whose human capital and wealth are poorly diversified strongly prefer to reduce the risk to which they are exposed. If managers judge that it will be less costly (to them) for the firm to manage this risk than to manage it on their own account, they will direct their firms to engage in risk management. ” (Tufano, 1996, p1109). As a manager’s pay is usually a large proportion of their total wealth, a risk averse manager is likely to want their pay to contain as little risk as possible, and hence favour risk management.
Management remuneration schemes can have an impact on the behaviour of the manager. A flat salary provides no risk to the manager’s income, assuming that their effort cannot be measured, a manager will be indifferent to risk management. A remuneration package containing shares, or one linked to profit, is likely to encourage hedging, as the manager will want to reduce the risk they are exposed to by obtaining an average expected income from the linear pay schedule formed.However, if a manager is incentivised via stock options, then his pay schedule is convex and unless stock prices rise over his stated exercise price, his options will be worthless. Hence, the manager is now unlikely to favour risk management as he wishes to take risk to raise the share price over his exercise price. The second way in which managers may influence risk management in a quest to maximise their utility is through an attempt to ‘signal’ their ability to investors, shareholders and the labour market.
Consider that a firm’s performance is largely based on management skill but is also subject to some random external factors. If a manager can employ risk management to reduce these random influences, then some of the ‘noise’ in the firm’s results is removed, leaving a clearer ‘signal’ of the management’s ability. In contrast to the shareholder value maximisation theories, when risk management is pursued for the manager’s own personal gain it does not have to satisfy the condition of being less costly to the firm than the expected gain to the manager.The empirical evidence relating to these theories is mixed. Doherty (2000, p227) highlights two studies of the insurance industry that find support for the theories of financial distress and dysfunctional investment as motivators.
Whilst, Tufano (1996, p1129) finds that “Risk management practices in the gold mining industry appear to be associated with both firm and managerial characteristics, although theories of managerial risk aversion seem more informative than those of shareholder value maximisation. ” Finally, I must consider an additional source of motivation for risk management.Moral, Ethical and Environmental factors are all likely to have an emotional impact on shareholders and managers and indeed they can lead to financial costs that will further alert the attention of a firm’s owners. Shirivastava (1995) highlights the need for ‘ecocentric’ management by firms and an increased level of environmental awareness.
Industrial crises in the vein of the Bhopal and Chernobyl disasters are striking examples of the strength of motivation that safety and environmental issues should provide.Furthermore there are millions of more minor examples of environmental risks that are not dealt with satisfactorily. However, we are seeing a striking rise in the profile of ‘corporate social responsibility’ and an increase in society’s overall awareness of risk, catalysed by recent terrorist attacks and the increasing cost of natural disasters (Kleindorfer & Kunreuther, 2000).
Contemporary examples of this fact include new degree courses in ‘disaster risk management’ (www. guardian. co.
uk). To conclude, in this essay I have stated that risk from a variety of sources can impact on an organisation in a number of different ways. I have examined how risk can impose a cost on an organisation and seen how minimising this cost to maximise shareholder value can be a motivation for risk management practices. I have also shown how managers can pursue risk management to maximise their own utility and how risk management can be prompted by social, ethical and environmental issues.