Environmental Factors that Cause Risk
Business is a complicated phenomenon that is regulated by its own rules and laws. Accordingly, when business decisions are made, they are adjusted to the reality of the business environment and potential developments of the markets. Forecasting and prediction of future thus play an important role in financial decision making. However, the situations when the forecast are not precise or failing on the whole are rather often, and such situations make business companies think of both the factors that expose them to financial risks and the ways to manage risk and uncertainty in the market. The major environmental factors that cause risk to business companies include:
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- Global economic conditions;
- Supply and demand in the market;
- Competition conditions;
- Political situation in a country and globally;
- Degree of governmental regulation of business.
Examples from the Industry
Carrying out a research of financial risk factors and risk management techniques, one can observe that the bulk of even the most historically successful companies, let alone ordinary or underperforming business entities, have faced risks in their work and had to deal with those risks through specific methods. In the light of the current global economic recession, the majority of companies faced risks of bankruptcy or income downturn. The examples of such companies include the large banks like Lloyds, industrial companies like General Motors, General Electric, Deimler-Chrysler, etc (Winston, 2008, p. 112). Companies like Sony and British Petroleum currently face the risks associated with the change of supply and demand market conditions and global economic development (Nadler and Slywotzky, 2009, pp. 43 – 44).
Even the Coca-Cola Company, the giant of the international beverage market, has faced risks associated with competition conditions in the global marketplace, and only successful risk-handling techniques, discussed further, allowed the company to overcome its troubles (Sharma, 2009, p. 43). Finally, General Motors and a number of American and British banks have faced considerable risks of failure conditioned by the complicated political situations in the countries and increased degree of governmental regulation as the reaction to the developing worldwide economic recession (Fletcher, 2009, p. 17). Thus, let us examine in more detail what are the decisions that expose companies to risk and exemplify the argument with real-life situations experienced by Sony, General Motors, Coca-Cola, and other companies.
Nature of Risk
Anyway, before the risk management in finance and business is considered and exemplified, it is necessary to realize what risk is, how scholars define it, and what types of risk they associate with business activities. Thus, for Vance (2002), the notion of risk is “the term for deviations from a plan” (p. 67). As in the sphere of business the concept of risk is associated mainly with the expected outcomes of a planned business activity, Vance (2002, pp. 67 – 68) and Allen (2003, pp. 33 – 34) distinguish 3 major categories of risk and six main subcategories of business risks, and argue that there are two main ways for a business company to forecast financial risks.
Thus, the three risks singled out by Allen (2003, pp. 33 – 34) are the market, the credit, and the operational risk. The operational risk, to which Allen (2002) attributes the highest degree of importance, is all about “direct or indirect loss resulting from inadequate or failed internal processes, people, or systems, or from external events” (Allen, 2002, p. 33). Further on, Allen (2002), as if developing the ideas by Crouchy (2001), subdivides the operational risks into:
- Operations risk – possible risk of fraud, disinformation, disasters, or personnel failures;
- Legal risk – risk of non-conformity of a company’s policies or contract terms to local or international laws and regulations;
- Reputational risk – the company’s reputation might be at risk of being damaged by improper policies;
- Accounting risk – risk of accounting errors potentially resulting in operations and reputational risks;
- Funding liquidity risk – risk that a company will spend more than it earns;
- Enterprise risk – risk of being unable to adjust to environmental changes like competition change, market conditions’ modifications, etc (Allen, 2002, pp. 34 – 35).
The classification of risks presented by Allen (2002) is developed and generalized further by Weetman (2006, pp. 344 – 345), who defines only to risk types, operating and financial risks, but the essence of these types remains strictly in the area of forecasts and expected plan outcomes.
What Decisions Expose Companies to Risks
Based on the above presented theoretical frame, it is now possible to look at what scholars consider as the main factors, i. e. decision making processes, which expose business companies to the various types of financial risks. First of all, it is necessary to state clearly in this respect that the decisions that make companies face financial risks might be conditioned by both external and internal factors (Bonaccio and Dalal, 2006, p. 128). The risky decisions conditioned by the external factors, as Christoffersen (2000, p. 12) argues, concern the above listed risk-causing environmental factors, while the internal risky decisions, according to Turan and Theodossiou (2008, p. 414), are mainly the result of the companies’ needs, developmental initiatives, or failing projections.
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Theoretically, the externally conditioned decisions that expose business companies to financial risks might include the situations in which companies lend money or property under the conditions of the global economic recession. According to Thomas (2000), lending to consumers or even partners has always been a risky decision as it is practically impossible to forecast the behavior and activities of a business entity that has to repay its loan but faces a shortage of funds at the loan deadline (pp. 154 – 155). Needless to say, in the time of an economic recession when numerous US and UK banks go bankrupt, lending decisions are far riskier as neither interest rate can guarantee that the loan will be returned.
As well, any developmental decisions and trading operations are risky under the current conditions of the market. For example, a company’s decision to introduce a more varied product line based on the increasing demand for certain product items is rather risky as the unstable financial environment might change the supply and demand relation rather quickly and a company will face not the risk already, but a harsh reality of losing a considerable part of its operating capital (Lore, 2000, pp. 18 – 19). Finally, a decision to accept the increased governmental regulation in a company is also a risky one, as the reputation and trust of the loyal customers might decrease towards the company in which the bulk of funds and resources are governmentally controlled (Engelmann, Capra, Noussair, and Berns, 2009, p. 54). The practice shows that the above listed decisions have exposed a number of companies to risks in the context of the economic downturn.
The examples from the industry prove that the above presented theoretical framework might in fact expose companies to risks. For example, according to Moore (2009), in the United Kingdoms financial companies and insurers are currently protesting against the governmental financial initiatives allegedly aimed at solving the financial risk problems that have increased in the recessive environment (p. 7). In more detail, understanding the risky character of the newly proposed initiatives, the UK banks like Barclays, HSBC, and others would not like to take up radical restructuring in the unstable period of changes. Neither would they like the Government to regulate them more than it does now (Moore, 2009, p. 7).
At the same time, Fletcher (2009) and Moore (2009) argue that the UK banks that earlier did not face any credit risks are nowadays under the threat of collapse as a result of their decisions not to stop lending programs for individual and corporate customers. The falling of such banking giants of UK as Lloyds Banking Group (from 51.10 to 4.48 in FTSE 100 rating), Barclays (273.85 to 18.15), Royal Bank of Scotland (30.74 to 1.11), and HSBC (684.1 to 24.9) proves that decisions lacking adequate forecasting and protective means are sure to expose companies to considerable risks.
The decision to introduce the higher degree of governmental regulation has also recently proved rather risky. The brightest example from the industry is the General Motors Corporation, the former world’s leader of the automotive market based in the United States. According to Winston (2008), General Motors made a decision to become more governmentally regulated, and this exposed the company to the risk of the decreasing customer support, loyalty, and trust (pp. 119 – 120). Combined with the economically conditioned fall of sales and production rates decline in all markets, General Motors experienced the harsh crisis, had to sell a bulk of its international plants, and introduce direct governmental financing to at least save the company from a collapse and disappearance.
Risk Management Techniques
The above discussion allows seeing how dangerous the decisions exposing the companies to risks might be. The theoretical framework by scholars like Winston (2008), Thomas (2000), etc., proves that one improperly developed decision that lacks risk protective means and is not projected beforehand might affect the company’s income as well as create the conditions for the overall company’s decline. The examples of the mentioned UK banks and the automotive giant from the United States prove this point and stress the need of adequate and, most importantly, efficient, techniques to handle various degrees of financial uncertainty and risk in decision making.
Moreover, Weetman (2006) points out that all stakeholders of the company whose decision might expose it to a kind of risk, will be affected by that risk if it actually happens (pp. 14 – 16). This might mean that, for instance, if the company’s management makes a decision to invest in a potentially risky project and fails, it is not only the management, but the company’s owners, customers, partners, and suppliers who will experience the effects of this decision’s being a mistake and this risk happening. Drawing from this, it is impossible not to agree with the views by Weetman (2006), Fehr-Duda, de Gennaro, Schubert (2006), and McMillan and Speight (2007), who stress the need for any reputable and ambitious company to have adequate risk management techniques.
Major Risk and Uncertainty Handling Techniques
Naturally, given the importance of risk management, scholars like Weetman (2006), Allen (2002), Vance (2002), Mandira, Thomas, and Shah (2003), Nadler and Slywotzky (2006), Riabacke (2006), and Sarno and Valente (2005) developed a set of risk and uncertainty handling techniques that might be used in different contexts but often have limited applicability. The general characteristics of all the risk management tools discussed further is that the companies need to first forecast the risk and develop preemptive methods of handling those risks, but if they fail to do so they should take steps to minimize the effects of those risks becoming reality.
Thus, Weetman (2006), Mandira, Thomas, and Shah (2003), and Riabacke (2006) argue about the importance of the detailed questioning as a technique of minimizing the effects of the actualized risk and avoiding similar risks in future. The essence of the technique lies, according to Weetman (2006, p. 254), in carrying out numerous and regular questionings among the company management and employees with the aim of finding out why an allegedly properly planned and forecasted decision turned into a risk for the company. In this way, evidently, the internally conditioned risky decisions can be handled as the task of questioning the competitors’ employees or officials in governmental institutions would be far more difficult if not impossible.
Further on, Allen (2002) and Nadler and Slywotzky (2006) develop the model risk management theory that, as can be observed from the title, argues about the role of previously designed situational models for purposes of both forecasting the possible risks and fighting their consequences in a comprehensive manner (Allen, 2002, p. 97). Nadler and Slywotzky (2006, p. 47) single out four major risk management models including business, financial, operational, and organizational models that together embrace the whole scope of organizational activity. Having these models, a company is able to follow all its developments and make necessary improvements as soon as a risk occurs. Finally, Vance (2002) promotes the two fold theory of risk management that presupposes either the use of a priori probabilities or historic data to forecast and manage risks (pp. 68 – 69). However, the practice proves that the applicability of the discussed techniques is rather limited.
For example, the risk management technique that Coca-Cola used to fight the risk of losing its market share as a result of introducing the new recipe for its beverages can hardly be explained with any of the mentioned theories (Sharma, 2009, p. 31). To some extent, the technique of detailed questioning can be applied to the case as Coca-Cola analyzed the risk, saw the risky factor in the unpopularity of the new recipe, and simply returned to old one not to try its fortune any more. The questioning might have been used by the company to analyze the situation and find out the reasons why the allegedly successful innovation became an actual risk for Coca-Cola, but it can only be assumed as scholars like Sharma (2009) do not present any specific information on risk management in the case.
On the other hand, the example of failing risk management can be General Motors again. The lack of any risk modeling procedures or use of historic data analysis can be considered as one of the reasons that the company was not ready to face the global economic downturn that started last year and decrease of its sales all over the world. The GM officials seemed completely unaware of what was going on and what can be done to stop the decline (Engelmann, Capra, Noussair, and Berns, 2009, pp. 53 – 54). The fast development of the crisis at GM manifested, as the author of this research supposes, that General Motors did not developed its risk management policies and did not have any suitable model of the situation to trace the crisis progress and make necessary improvements. Therefore, it can assumed that risk management techniques argued about by scholars can be irrelevant and inapplicable as well as useful and necessary but never used.
Accordingly, the above discussion allows concluding that although risk is an integral part of any business activity, it is crucial for any company to have in place all the effective and adequate risk management techniques. This will allow business companies to forecast and prepare for facing potential risks or minimize the effects of the latter when even a properly developed risk model or analysis of historic data failed to foresee the risk that nevertheless occurred. The examples from the companies like Coca-Cola, General Motors, Barclays, HSBC, Lloyds, and other companies show, however, that theoretical grounds for risk management technique may not always be relevant for every particular situation. At the same time, there are cases when a proper risk management technique might have protected a company from long-lasting issues. Thus, what business companies have to do for their own protection is implement the existing risk handling methods and research new, more effective, ones.
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