Enterprise Risk

Management-
An Introduction
Institute of Public Enterprise
2011
 What is Risk?
 Risk is that part of uncertainty which
can be measured, quantified and
hence can be managed.
Introduction to Risk Management
“A business has to try to minimize
risks. But if its behaviour is governed
by the attempt to escape risk, it will
end up by taking the greatest and
least rational risk of all: the risk of
doing nothing”
Peter Drucker
“In a business environment, risks can
not be totally avoided, they need to
be managed”
 Risk Management-Basics
 Risk reduction is one of the prime objectives of corporate
management
 Returns and risks go hand in hand – Usually higher returns
accompany higher level of risks
 Corporate objectives for maximization of return is therefore
getting replaced by maximization of returns per unit risk – as
this can appropriately ensure maximization of shareholders
wealth
 In a business environment, it is not possible to completely
avoid risks – Thus, it is extremely important to manage risks.
 In this context, it has been rightly concluded that
organizations which manage their risks effectively have been
proved to be the most successful organizations in the world.
 Risk Concepts
 Accounting Risk :Accounting Risk arises when use of
inappropriate accounting methods, systems and policies result
in losses. This risk is part of Operational Risk.
 Business Risk: The risk of business failure which stems
from factors such as the cost structure of a venture (i.e.,
Fixed Cost vs. Variable Cost), intra-industry competition,
and government policies. It is reflected in the variability of
profits before interest and taxes.
Commodity Risk : Commodity Risk arises from potential
movements in the value of commodity contracts, which
include agricultural products, metals and energy products.
Country Risk: It Is the risk that a foreign entity, private or
sovereign, may be unwilling or unable to fulfill its foreign
obligations for reasons beyond the usual risks, which arise
in relation to any contractual obligation, legal, political,
settlement, and other risks associated with a cross-border
transaction into a specific country.
 Risk Concepts
 Credit Risk : The risk that a counterparty may fail to perform on
its obligations. Originates from the fact that counter party may be
unwilling or unable to fulfill its contractual obligations. At the most
basic level, it involves the risk of default on the asset, which can
be a loan, or some other type of contract.
 Currency Risk: Currency Risk arises from potential movements
in the value of foreign currencies. This includes currency-specific
volatility, correlations across currencies and devaluation risk.
 Disclosure Risk: The risk that mandatory or voluntary disclosure
of company information will put an enterprise at a disadvantage
when it needs to make future transactions to roll its positions
over, control its risks, or otherwise modify its financial position.
 Equity Risk: Arises from potential movements in the value of the
stock prices. The risk of owning stock or having some other form
of ownership interest.
 Risk Concepts
 Event Risk :Can be characterized as the risk of loss due to an
observable political or economic event. These include –Changes in
governments leading to changes in economic policies, , such as
default, capital controls, inconvertibility, changes in tax laws,
expropriations and so on. Coups, civil wars, invasions, or other
signs of political instability , currency devaluations, which are
usually accompanied by other drastic changes in market variables.
 Financial Risk :Risks associated with assets and liabilities of an
organization which includes Credit, Market and Operational Risks.
 Implementation Risk :The risk suffered by the promoter /
investor during the implementation stage of the project. This
includes construction risk, time and cost over runs, difficulty in
obtaining various forms of approvals etc.
 Inflation Risk :The threat of erosion in the purchasing power of
income, as a result of rising prices. Investors having Bonds, Fixed
Deposits or other securities which yield only a fixed income are
vulnerable to this inflation induced risk.
 Risk Concepts
 Integrity Risk: It is a form of people risk. The loss that is
expected to be suffered on account of lack of integrity of the
managers and the executives.
 Intellectual Risk: The risk that the employees capable of
controlling a firm's business will leave the firm.
 Interest Rate Risk : Interest Rate Risk can be viewed as
sensitivity of earnings and price (market value) of instruments to
changes in interest rates. It also occurs on account of having
exposure on one side of the balance sheet (asset/liability) in fixed
interest rate, while taking exposure on other side (liability/asset)
in variable interest rate.
 Legal Risk : A legal risk arises when a transaction becomes
unenforceable in law.
 Market risk : The risk that an asset (or an instrument such as a
derivatives contract) will decrease in value with changes in market
conditions, such as changes in interest and currency rates or
fluctuations in equity and commodity prices.
 Risk Concepts
 Marketability Risk : The risk of inability to sell a security /
commodity / movable / immovable asset quickly and at a
reasonable price. Often lenders find the collaterals to suffer from
marketability risk.
 Off Balance Sheet Risk : Pertains to the commitments made by
the bank / institution and which appear as contingent claims. Off-
balance sheet exposures could also be due to certain fee-based
activities like letters of credit, bank guarantees, underwriting of
securities, etc. undertaken by the institution.
 Operational Risk : The risk of direct and indirect loss resulting
from inadequate or failed internal processes, people and systems,
or from external events.
 Political Risk: Sovereign Credit evaluation involves not only the
ability to repay debts when due, but also political risk (the
willingness to pay).
 Risk Concepts
 Price Risk : Exposure to loss as a result of a change in the
market price of a physical commodity or a financial instrument.
 Prepayment Risk : It is the risk that the borrower will prepay
and the pre-paid amount cannot be reinvested at the earlier
contracted rate. Same as Reinvestment Risk.
 Reputation Risk: It is the risk of indirect losses to earnings
arising from negative public opinion.
 Strategic Risks : Risk exposures that occur because of adoption
or otherwise of certain business strategies.
 Systematic Risk : Risk associated with the movement of a
market or market segment as opposed to distinct elements of risk
associated with a specific security. Systematic risk cannot be
diversified away; it can only be hedged.
 Risk Concepts
 Tax Risk : Risk from uncertainty in tax rates, tax regime, tax
laws and tax provisions etc.
 Technology Risk : The probability of loss that may occur by
using or not using a particular type of technology.
 Unsystematic Risk : Risk due to events which affect individual
companies, not the market as a whole. It can be removed by
holding a well-diversified portfolio. Risk which can be mitigated
through diversification.
 Risk Analysis
 Performing Risk Analysis

Determine the
Objectives

Identify the
Risks

Grade the risks in

terms of importance

Identify the
Control Measures
 Risk Management
 Implementing Risk Management

Perform Risk
Analysis

Update Risk
Analysis

Evaluate Choose Control

Control Measures
Measures

Implement
Control
Measures
 Risk Management
Control Loop
 Control Loop
Risk
Analysis

Risk Planning Risk

Identification Factors Management

Risk
Monitoring
 Risk Management Process
 Risk Management

Avoid

Transfer
All
Potential
Risks Reduce

Carry
 Prioritizing Risks
 High

Create Take
Contingency Immediate
plan Action

Impact of Risk

Conduct Conduct
Periodic Ongoing
Review Review

 Low Likely hood of Risk High

 Risk Management Approaches
 Top-Down & Bottom-up Approaches
Bottom-Up Top Down
Approach Approach

Risk System
Risk Inventory
Risk Policies
Risk Reporting
Risk
Risk Management Management
Principles

Risk Manual
 Types of Risks
 Systematic & Non-Systematic Risks

Systematic Risks

Inflation Risk + Market Risk +Sector Risk

+ Capital Structure Risk + Political Risks

Non-Systematic Risks

Project Risks
 10 Golden Rules of Project Risk
Management
 Make Risk management part of your project
report
 Identify Risks early in your project
 Communicate about risks
 Consider both threats and opportunities
 Clarify Risk Ownership Issues ( Risk Sharing)
 Prioritize Risks
 Analyze Risks
 Plan and Implement Risk Responses
 Register project Risks (Maintaining a Risk log)
 Track Risks and Associated Tasks
 Corporate Risk Situations
 Raw material price is increasing
 Machinery and equipment are aging
 Frequent breakdown of production process
 Proportion of defects in production is increasing
 Market competition is increasing
 Market share is declining
 Most of the products have crossed the maturity stage
 Product-mix is inappropriate for increasing profit
 Labour productivity is declining
 Rupee is appreciating – Export earning is declining
 Key financial ratios are becoming more and more adverse
 Cost of funds/ borrowing is increasing
 Asset – Liability mismatch is becoming a cause of concern
 Senior Management professionals are leaving
 Examples of Corporate Risks –
Leading to Corporate Failure
 Enron
 Arthur Anderson
 Satyam Computers
 World Com
 General Motors
 Lehman Brothers
 Global Trust Bank
 Key Identified Risks in Indian Infrastructure
Projects
 Public risks, involving political, administrative,
legal, regulatory and dispute resolution and
enforcement mechanisms;
 Economic and Financial Risks, those dealing with
interest rates, currency risks and other
macroeconomic factors;
 Market risks which concern with traffic, revenue /
tariff and business forecasts;
 Construction risks, or the problems associated
with timely completion and force majeure:
 Key Identified Risks in Indian Infrastructure
Projects
 Operating and maintenance risks;
 Environmental risks;
 The risk of public unacceptability of project
features, such as level of tariffs, the inability of
government entities to levy appropriate charges,
and the arbitrary actions of the state
governments as consumers.
 Some Examples of Risks
Encountered
 Noida Toll Bridge : Initial traffic was over
estimated by 50%
 Mumbai-Pune Highway : An untolled road was
running parallel to the tolled road
 Coimbatore bypass project in Tamilnadu :
Because of political clout consumers refused to
pay the appropriate charges
 Dabhol : MSEB terminated its Power Purchase
Agreement arbitrarily.
 Most state government guarantees are not
financially credible / enforceable
 Force Majeure Risks
 “Force majeure” means “Superior Force”
 Force majeure risks are those types of risks which results
from certain events beyond the control of the parties to the
project financing and thereby exempt parties from the legal
consequences of non-performance.
 These include: War, Strikes, Lockouts, Riots, Expropriation,
Changes in Laws, Rules and Regulations, Closing of Harbors
or docks, severe storms and natural disasters, epidemics
etc.
 Lenders normally shift all these types of risks to sponsors,
suppliers and purchasers through contractual obligations or
insurance protection.
Manifestations of Political Risks

Breach of Contract by the Government
 Discriminatory Taxation Policy
 Risk of Expropriation ( deprived of Possession) or
Nationalization of Property
 Failure to obtain statutory permissions or to receive them late
 Problem of adapting regional plans, zoning plans etc.
 Inconvertibility of Currency
 Restriction on Remittances
 Civil Strife
 Terrorism
 War
 Action Against People, like kidnapping
 Manifestation of Technology Risks
 Incorrect assessment of technologies and construction
methods
 Problems in transfer of technology know how
 Modification in assumptions in design and construction
estimates
 Applying new methods of execution,/ new materials
 Design modification during execution
 Inability to reach contracted technical parameters in a
changed environment
 Incorrect estimate of quantity of necessary materials
 Disappointing performance by contractor/designer
 Manifestation of Legal Risks
 Lack of or insufficient insight into all of the legal
requirements and possible modifications in the
areas of : (a) Safety (b) Environment
(c ) Noise (d) purchase of real estates (e)
invitation to tender
(f) exemptions and permits (g) procedure
regarding regional planning , zoning etc.
 Possibility of Claims: (a) Claims from contractors
(b) claims from state regarding certain violation
(c ) claims from neighbors as a result of damage to
their home / business / properties, (d) claim from
other interested parties
Risk Reduction

Commodity Swap
 Risk Reduction (Commodity
Swap)
 If market price of commodity exceeds Rs.120.00 per unit , then the
producer pays the excess amount to swap writer and if it is less than
Rs. 120.00 per unit, then swap writer pays the difference amount to
the producer. As a result the producer in all situations earn Rs.120.00
per unit. Swap writer feels that price of the commodity will remain
above Rs.120.00 and he will continue to gain in the process and writes
the swap

Producer of commodity
Swap Writer
(Unit cost Rs. 100.00
Counter Party
Profit margin desired 20%
( feels unit price
Wants to realize sale price
would remain high,-
Rs.120.00)
greater than Rs.120.00)

Market for Commodity

Risk Transfer

Securitization
 Securitization Process –
Securitization
Three Stage Structuring
• Credit Enhancement
• (Through Cherry Picking)

• Portfolio rating –BBB

• Select pool rating- A Credit Rating Structural Credit Enhancement

Originator SPV
Originator

• Credit Enhancement (senior, Mezzanine, Junior)

• (Guarantee, Insurance etc)
 Risk Sharing

Independent Power Projects

 Risk Sharing by Stakeholders (IPPs)
Consultants/ SHAREHOLDERS
Advisers
Other
Promoter 1 Promoter 2 equity
FUEL investors POWER
SUPPLIER PURCHASER

Fuel supply Shareholder’s Power purchase

Agreement agreement agreement

“Delivery or pay “Take or pay

agreement” agreement”
HOST
FINANCIAL Funding PROJECT COMPANY Permits & licenses GOVERNMENT
INSTITUTIONS agreement

Sub- EPC/spare parts Insurance Operation &

contractor contract agreement Maintenance contract

MAIN
CONTRACTOR INSURANCE COMPANY PLANT OPERATOR
Thanks