Risk Management: Everyone's Business: The Terrorist Attacks in the US and Then Bali Have Highlighted That Good Risk Management Is Not Just a Corporate Luxury. It Should Be the Business of Everyone in the Organisation, Not Just the Chief Executive or Chief Finance Officer. (Risk Management)

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As businesses evolve and grow, the incorporation of a sound risk management culture into an organisation's business framework becomes crucial to ensure continued success.

A good company-wide risk management culture promotes productivity, because management and line managers can focus more on their primary responsibilities instead of being distracted into `fire-fighting' the problems that may arise due to the lack of such practices.

Risk management also strengthens the business planning processes by allowing decision makers to make contingency plans to avert possible `mishaps', thereby producing more realisable opportunities for the organisation.

There are therefore significant economic and commercial incentives for establishing sound and effective company-wide risk management control systems. Without such controls, an organisation could, at best, miss out on realisable opportunities, and at worst, be vulnerable to various risks that may even destroy the company.

The presence of sound and effective risk management and control systems also inspires confidence in the investing public and counterparties. Besides protecting and enhancing shareholder value, it can also serve to safeguard an organisation's credibility and goodwill and, in the broader context, help to promote stability in the entire financial and economic system.

There are several aspects of company-wide risk management relevant to banks. These include market risk, credit risk, operational risk and the less quantifiable forms of risks such as legal and political risks.

Market risk

Market risk, inherent in all financial instruments, is the risk of potential losses associated with the trading of financial instruments due to fluctuations in the underlying market measure(s).

Market risk involves the risk that prices, or rates of market measures, will adversely change due to economic forces. Such risks include effects of adverse movements in foreign exchange, interest rates, equity and commodity markets.

In recent times, market measures have also been developed in non-traditional markets; for example temperature derivatives in which the underlying market measure is the level of the temperature, or earthquake derivatives in which the underlying market measure is the strength of the earthquake.

Market risk can also include the risks associated with the cost of borrowing securities, dividend risk, and correlation risk.

Some of the recent widely publicised examples in which market risk have caused significant losses include:

* Orange County, US, December 1994. Orange County treasurer Bob Citron was entrusted with a $US7.5 billion investment pool. He invested a significant amount of the money in derivative securities, namely structured notes and `inverse floaters'.

When interest rates rose, the rates on these derivatives securities declined along with the market value of those notes (since they were at rates below those generally available in the market). This resulted in a $US1.7 billion loss to the Orange County investment pool.

* Around the same time, Gibson Greetings Inc. faced similar market risk when it began aggressively purchasing interest rate derivatives to take advantage of falling rates. When interest rates began to climb, Gibson sustained a $US20 million loss on its derivatives contracts.

* Likewise, pressured by demands from shareholders, Procter & Gamble's top management ordered its cash management division to become a profit centre. The division had to produce extraordinary returns and so turned to the derivatives markets, interest rate swaps in particular. This resulted in estimated leverage of a massive 100 to one.

By the end of 1994, P&G had to take a $US157 million charge to unwind interest rate derivative contracts that were tied to interest rates in Germany and the United States. When the interest rates rose in both countries above the derivative's contractual hurdle rate (which required P&G to pay interest rates that were 412 basis points above the then commercial paper rate), the leveraged derivatives became too costly for P&G. …