Thursday, March 29, 2012

Corporate Risk Management

Corporate risk management emerged as a catch-all phrase for practices that serve to optimize risk taking in a context of book value accounting. Generally, this includes risks of non-financial corporations, but also those of business lines of financial institutions that are not engaged in trading or investment management.

Risks vary from one corporation to the next, depending on such factors as size, industry, diversity of business lines, sources of capital, etc. Practices that are appropriate for one corporation are inappropriate for another. For this reason, corporate risk management is a more elusive notion than is financial risk management. It encompasses a variety of techniques drawn from both FRM and ALM. Corporations pick and choose from these, adapting techniques to suit their own needs. 

Operational risk largely doesn't apply to corporations. It includes such factors as model risk or back office errors. Some aspects do affect corporations—such as fraud or natural disasters—but corporations have been addressing these with internal audit, facilities management and legal departments for decades. Also, corporations face risks that are akin to the operational risk of financial institutions but are unique to their own business lines. An airline is exposed to risks due to weather, equipment failure and terrorism. A power generator faces the risk that a generating plant may go down for unscheduled maintenance. In corporate risk management, these risks—those that overlap with the operational risks of financial firms and those that are akin to such operational risks but are unique to non-financial firms—are called operations risks.

The real challenge of corporate risk management is those risks that are akin to market risk but aren't market risk. An oil company holds oil reserves. Their "value" fluctuates with the market price of oil, but what does this mean? The oil reserves don't have a market value. A chain of restaurants is thriving. Its restaurants are "valuable," but it is impossible to assign them market values. Something that doesn't have a market value doesn't pose market risk. This is almost a tautology. Such risks are business risks as opposed to market risks.

In the realm of corporate risk management, we abandon the division of risks into market, credit and operational risks and replace it with a new categorization: market risk, business risk, credit risk and operations risk.

Corporations do face some market risks, such as commodity price risk or foreign exchange risk. These are usually dwarfed by business risks. In a nutshell, the challenge of corporate risk management is the management of business risk.

Techniques for addressing business risk take two forms"
1. Those that treat business risks as market risks, so that techniques of FRM can be directly applied 2.Those that address business risks from a book value standpoint, modifying or adapting techniques of FRM and ALM as appropriate.

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