Why a proactive and active risk management strategy critical in Indian corporate boards

KV Prasad Jun 13, 2022, 06:35 AM IST (Published)

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Risk is the paramount truth governing the world of business. It transcends industry and other boundaries, remaining an omnipresent force that shapes decisions, influences strategy, and underpins the very foundation of corporate governance. Risk, in a sense is the raw material of the business of finance.

While the capital content is contributed by both the depositors and the investors — a sort of given —, the exercise of tying up raw materials as factors of production, learning to manage the underlying and the potential risks associated, and to produce the final product ie., net value for the depositors and the shareholders, — is complex and least-understood. 

For Indian corporate boards, understanding and effectively managing risk is a fundamental expectation of their leadership. It is essential that they develop a robust risk management strategy that aligns with the dynamic nature of risk itself. Risk is not a static concept; it’s dynamic, multi-faceted, and integral to the very essence of corporate operations. 

In a text book sense, risk management is understood to be involving identification, assessment, measurement and management of risks associated directly and indirectly with the business. It has also been taught to the students of finance that what cannot be measured, cannot be managed. Sans suitable techniques and tools to measure risks, the theoretical claim of management of risks stands hollow. 

From macro-financial volatility, operational challenges, and regulatory compliance, to cybersecurity threats, reputation management, and financial stability, risks take on various forms. Geopolitical uncertainties, environmental sustainability, and technological innovations further compound the landscape.Recognising and preparing for these diverse risks is paramount for Boards in safeguarding the organisation’s future.

In the data-driven modern commerce, risk assessment becomes the compass by which organisations navigate the unpredictable terrain of today’s global markets. Risk is not a one-size-fits-all concept. It could be institution-specific, macro-economic conditions-specific and of course strategy-specific. It’s a multifaceted entity and has witnessed complete transformation in its  colour, contour and characteristics. 

The “colour” of risk signifies its severity — is it a minor bump in the road or a potential catastrophe? The “contour” indicates the landscape it can traverse, and “characteristics” of risk is about understanding the type of risk, where it originates, and how it can impact the organisation. One can also envisage understanding, the “contagion” aspect of risk which is explained by its potential to spread from one kind of risk to another thus causing a domino effect that renders risks to be conclusively measured and hence managed. Movement in interest rates and hence the associated market risks influence the repayment ability of the borrowers of the banks and generate counterparty credit risks.

Further, the concept of keeping sufficient capital to meet the contingencies created out of risks remaining adequately hedged or covered thus keeping the firm off from snowballing into a state of insolvency has become tricky to identify or assess given the fact that risks are not easy to understand or measure. 

Boards often fall short in dedicating adequate time and attention to understanding risks due to a variety of factors. Apart from the cited premises, the other primary reason is the prevailing pressure to focus on short-term financial performance and immediate business goals, which has overshadowed the importance of trying to understand and measure long-term intrinsic as also possible risk.

Additionally, the complexity and dynamic nature of risks can be overwhelming, leading to a reluctance to deep dive into a comprehensive risk analysis. Boards may also lack the necessary expertise and competencies to effectively evaluate and manage risks, often relying on their senior management to handle these matters. Finally, the absence of tangible and immediate consequences from overlooking risks can create a false sense of comfort on solvency position, making it tempting to trespass into risky strategies and prioritise objectives, which though look shining, could be false dawns.

Indian Corporate Boards must acknowledge that risk is as critical a discussion as growth. There is no business scenario without risk, and the ability to comprehend risk and craft effective prevention strategies is an invaluable corporate asset. 

The disruptive and unpredictable nature of the risk landscape necessitates an equally dynamic risk appetite framework for organisations. Risk appetite should evolve in sync with the changing business environment and strategic objectives. A dynamic risk appetite framework allows an organisation to adapt to new challenges and opportunities as they arise, striking a balance between risk-taking and risk aversion. 

Consequently, capital allocation, a critical element of an organisation’s strategic decision-making, must also be dynamic. Allocating capital in a flexible and adaptable manner enables organisations to align their investments with their evolving risk appetite, ensuring that resources are directed towards the most promising ventures while adequately considering potential risks.

Boards play a pivotal role in overseeing an organisation’s approach to risk management. They are entrusted with the responsibility of providing strategic guidance and governance, which includes understanding, assessing, and mitigating risks. The board’s role in risk management is not just about compliance but about fostering a culture of risk awareness and ensuring that the organisation’s risk appetite aligns with its overall strategy.

Boards are also instrumental in setting the tone for risk governance and accountability throughout the organisation, reinforcing the idea that risk is an integral aspect of decision-making and not a separate, isolated concern. Effective board engagement with risks can be a powerful driver of an organisation’s long-term resilience and success. While ‘Tone from the Top’ is necessary, the sufficient conditions of ‘chaos in the middle’ and ‘crisis in the bottom’ need equally to be understood and their underneath root causes resolved.

What Should Boards Do?

1. Dynamic Risk Assessment: Implement a continuous and dynamic risk assessment process. This means regularly evaluating and updating the risk landscape to stay ahead of potential issues.
2. Tailored Risk Appetite: Develop a risk appetite framework that aligns with the organisation’s strategic objectives and culture. This framework should consider the severity, type, and contagion potential of risks.
3. Competency Development: Build a Board with a diverse skill set, including members with expertise in risk management, financial acumen, legal knowledge, and industry-specific insights. Training and education in risk management are crucial.
4. Known Known vs. Known Unknown vs Unknown Unknown Risks: Distinguish between ‘known known’ risks (those that can be anticipated based on historical data and experience) and ‘known unknown’ risks (emerging threats that require a forward-looking approach). Boards must be prepared for both. Post-covid, a new animal has emerged. The ‘unknown unknown’ risks. Those need to be also made a part of the whole exercise of dynamic risk appetite and capital allocation framework. 
5. Comprehensive Risk Reporting: Require management to provide comprehensive risk reports, focusing not only on the risk itself but also its potential impact and mitigation strategies as also the amount of capital cushion required to keep as reserve to meet unforeseen eventualities to help sustain solvency position and its running into the unseen horizon of perpetuity
6. Scenario Planning: Engage in scenario planning to prepare for a range of possible outcomes. This helps in understanding the character and contagion potential of risks.
7. Cross-Functional Collaboration: Encourage collaboration between various departments and units to enhance the understanding of where risks originate, how they can spread and the extent of interconnectedness among various possible identified risks.

Action Points Checklist for Boards:

• •  Regularly review and update the risk appetite framework.
  •  Prioritise investments in risk management and mitigation strategies.
  •  Foster a culture of risk awareness and proactive risk management.
  •  Institute a process for monitoring and reporting on emerging risks.
  •  Conduct stress tests and simulations to assess resilience.
  •  Evaluate the effectiveness of risk prevention plans.
  •  Establish clear roles and responsibilities for risk management.
  •  Develop a crisis response plan for major risks.
  •  Build a proactive and active risk management team in the organisation.

—The authors; Dr Rabi N. Mishra and Dr Srinath Sridharan, are Senior BFSI Sector Governance & Surveillance Specialist, and Policy Researcher & Corporate Advisor, respectively. The views expressed are their personal.

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