LESSON 6 - Risk in Resource Optimization

“Risk comes from not knowing what you are doing” (Warren Buffett). Buffett’s
statement emphasizes the action-related aspect of risk: take your present
decisions and strive to be capable for making new decisions to continue your
business. This requires management differentiation between those factors
that have to be sensitive to external settings, and other factors that are
created and help create the settings of our organization.

6.1 The Current angle of risk in business

In modern business, risk also covers the probability that an actual return on
an investment will be lower than the expected return. Therefore, risk is the
observation and classification of uncertainties to define areas of decision and
of functional structures. Risk covers the fact that the consumption of
resources is higher than the production of new resources or services taking
into account the effects of losses. Following the Basel Committee, we will
therefore divide risk in business into the following five general categories:
1. Country risk covers the uncertainties of political systems and the internal
dynamics of societies.
2. Settlement risk covers the external uncertainties of running financial
processes as well as of operating sequences.
3. Market risk covers the uncertainties of factors inside markets in relation to
price mechanisms and valuation.
4. Credit risk covers the uncertainties of external economic influences on
resources needed from the economic environment. This relates to external
circumstances other than those of the respective actor, e.g., the repayment
of a credit.
5. Operational risk extends to parameters and structures of internal
organizational processes in relation to individual misbehavior and individual
failure, covering therefore the efficiency of adequate integration of an
organization’s members.

The first two risk categories are observations of things with direct influence
on our own activities, but which actually detract from our actions. These are
alterations that happen and that we have to cope with. The third and fourth
categories of risk are observations of circumstances we accept in order to
gain various advantages in terms of additional resources: credit risk covers
the uncertainty of expected results due to previous inputs, whereas market
risk covers the change of social evaluation. Both risks are accepted if the
profits (not only the monetary ones) are appropriate. The fifth risk category,
operational risk, belongs to appropriate action of all involved individuals and
to the question of an adequate fit of human behavior and organizational
structures. The following sections outline the details of these risk categories.

6.2 Country risk and settlement risk

Country risk refers to a country’s political system and its economic reliability.
It acknowledges that economic and political changes in a foreign country will
affect loan repayments. As a result, a buyer or seller of a financial
instrument, of other economic obligations, or of foreign currency will not be
able to meet associated delivery obligations at maturity. In a way, this risk is
related to exchange rate risk, the appreciation or depreciation of a currency
resulting in a loss or a “naked position” with regard to the exchange rate. In
the end, the state as an actor is referred to in political risk, covering
concerns that political changes in a debtor's country will jeopardize debt-
service payments. The state is also concerned with sovereign risk: the risk
that a local or foreign debtor-government will refuse to honor its debt
obligations.

Settlement risk is a term for all issues that could prevent the fulfillment of a
business contract. This could be, for example, the failure of a major bank,
resulting in a chain-reaction that reduces other banks’ ability to honor
commitments. It also includes underwriting risk, i.e. the risk that a new issue
of securities will not be sold or that its market price will drop. Settlement risk
also covers payment system risk, where payment systems of a major bank
will malfunction and will hinder its payments.

6.3 Credit risk and market risk

Market factors challenge the expected availability of resources outside the
organization or the financial system and also the liquidity of resources inside
respective markets (e.g., financial markets). Generally, they are separated
into default risks and capital risk. Default risk denotes a situation where a
business partner or borrower might not be able to repay principal and
interest from delivered resources. Capital risk refers to losses that accrue
from unrecovered loans or from contracts with business partners. They can
affect the organization's capital base and may necessitate new capital.
Economic risk, in addition, designates changes in the state of the economy
that will impair the debtors’ ability to pay or the potential borrower's ability
to borrow.
Interest rate risk indicates possible declines in net interest income that will
result from changes in the relationship between interest income and interest
expense. Liquidity risk denotes a deficiency of resources, cash, or cash-
equivalents to meet the needs of principals, depositors, and borrowers. This
risk is related to reinvestment risk, the lack of opportunities for reinvesting
interest-earning assets (loans) at current market rates. Finally there is a
refinancing risk, the lack of opportunities to refinance maturing liabilities
(deposits) at economic cost and terms.

6.4 Operational risk

Operational and reputational risk indicate possible and real failure that will
prevent an organization from maintaining its critical operations, or meeting
the expectations of customers and business partners, especially in core
values of business behavior. Compliance risk specifically identifies the failure
of fulfilling the intrinsic meaning of a rule or of all organizational guidelines
due to misunderstandings and misbehavior of individuals. Focusing more on
the individual aspects than on processes of human resource management,
we face motivation risk and loyalty risk as a lack of employee integration into
the organization or into the personal requirements of the processes.
Professional alignment of organizational gains and ideas among the
employees solves these problems. This leads to qualification risk as the lack
of employee skills with which to fulfill their job description and to meet all
required spontaneous actions, and finally to the risk of poor skill adjustment.
The latter constitutes the lack of integration of people into complex project
requirements, which impairs expected or required human cooperation.