The Huge Cost of Poor Risk Management
Many commodity trading / processing companies inadvertently end up relegating their Risk Management Function as just an obligatory process, unable to figure out how to measure its effectiveness on their bottom-line or margins. Many others invest in risk management by either developing their own in-house systems and processes, or by building teams to better support that function – but are still unable to clearly define whether all of this has resulted in better risk management or not. All these companies keep spending on Risk Management, thinking they’re doing what “should” be done, and are completely ignorant or drastically underestimate the cost of poor risk management.
In fact, some global surveys of commodity trading companies have shown that while most (> 70%) have initiated some sort of risk management process, the top management in most of those companies still rates earnings volatility as their biggest concern and poor Risk Management as a direct reason for that.
The problem is neither simple nor isolated. But there are tools and techniques available that can guide the companies towards measuring and managing their risks better. One of the ways is to measure and reduce the Cost of Risk that is being incurred by the organization currently.
The cost of risk management has the following 4 components:
- The cost of Retaining Risks (losses in trading)
- The cost of Transferring Risks (hedging)
- The cost of Internal Risk Management (People, systems, time)
- The cost of External Risk Management (Consultants, Solutions)
Every single organization incurs some cost of risk every year, only a few are aware of it. And the cost of poor risk management eventually shows through in either huge trading losses that could have been avoided, or un-optimized hedges, or huge internal spend on risk management – people, systems, processes, infrastructure – which does little other than obligatory reporting, or 3rd party spreadsheet based systems which take more people and time to maintain and update than it took to develop.
All of these factors result in volatility in earnings quarter on quarter, giving sleepless nights to top management and stakeholders and also reduce margins thereby impacting competitive edge. Companies that ignore the huge cost of poor risk management eventually see sustainability issues as well.
The way to think about this cost of risk is, it is not zero for an organization with extremely sophisticated Risk management function, but it’s optimal. Great organizations are not just aware of this cost, but constantly track it quarter on quarter, year on year, to see the trend of this cost – and invest judiciously at the right places so that, the cost, while it may increase marginally in the short term, will come down significantly over a period of 1 – 3 years. Moreover, there are several advanced ratios that can help determine the true nature of this cost and its movement over varied periods.
Companies that understand this, and act on this, grow consistently while others languish behind to become takeover targets or Chapter 11 filings. The multi-billion dollar question is – which category does your organization fall under?
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