Some of the world's leading financial institutions have suffered huge losses over the past few years. Many of them should really have been better at managing their financial risks effectively.
Financial risk can be split into three categories: market, credit and financing/ liquidity risk. Market risks are losses that can occur when there are changes to market prices or rates. This usually means movements in interest rates or foreign exchange rates, but it can include fluctuations in the cost of basic commodities.
Credit risks occur when customers fail to pay for goods or services supplied on credit. An organisation is particularly vulnerable to this type of risk when it relies heavily on small numbers of big customers to which it has given large amounts of credit. Credit risks are particularly serious in the financial services industry, where both short- and long-term lending is essential. They also exist where organisations are exposed to the credit risks of suppliers (supplier risk) or where a supplier or partner in a joint venture cannot obtain enough credit to continue trading (partner risk).
Financing risk covers an organisation's ability to obtain the funding it needs--for example, access to sufficient credit from its bank. Liquidity risk relates to its ability to fulfil its financial commitments, while cash flow risk relates to the volatility of the organisation's operating cash flow. The current challenges to liquidity posed by the credit crunch mean that organisations must revisit their financial risk management strategies regularly if they are to avert disaster. Northern Rock, for example, failed to conduct liquidity-related scenario analyses, even though it depended heavily on financing from the capital markets. The bank never anticipated that the markets' liquidity would dry up, which was a key reason for its collapse.
Perhaps the most important benefit of managing financial risk is that it safeguards an organisation's ability to run its core business and achieve its objectives. An effective policy encourages loyalty from equity investors, creditors, managers, workers, suppliers and customers. This increase in stakeholder goodwill can generate many other benefits, including:
* The enhancement of the organisation's reputation or brand.
* A reduction in earnings volatility.
* A reduction in average tax liabilities from greater earnings stability.
* The protection of cash flows.
* An improved credit rating and more secure access to financing.
* A possible reduction in capital costs
* An improvement in supply chain management and a more stable customer base.
* A stronger position from which to deal with mergers and acquisitions.
Before deciding how to respond to its financial risks, an organisation must understand their scale. The seriousness of different risks will vary from company to company. A multinational will be far more worried than a firm operating in one country about currency fluctuations, for example. Details about the quantification of financial risks--including methods such as regression analysis, value-at-risk analysis and scenario analysis--can be found in a Management Accounting Guideline published jointly by CIMA (see "Further information" panel).
Once a risk has been quantified, the organisation must choose whether to accept, reduce or avoid it. Various tools exist to help organisations make such choices for each type of risk. The table above summarises the options available.
Selecting the most appropriate tool depends on the organisation's appetite for risk, level of expertise and cost-effectiveness. The risk appetite is determined by the board, so it is important that directors fully understand the tools at their disposal.
Market risk tools include:
* Natural hedging, where different risk exposures may offset each other.
* Forwards--ie, contracts made today for the delivery of an asset at a specified date at an agreed price. …