Over the last two decades we have witnessed the adoption, by an ever-rising number of companies, of management techniques which are meant to contain the risks they carry. These risks can be either associated with the business activities of these companies or their financial structure. Although managing the business risk is of obvious interest to the stakeholders of every company, it is the management of the financial risk that has been attracting most of the attention of investors, media and various supervisory authorities.

Financial risk management has risen to such a prominent position, among the various management challenges a modern company is facing, due to several reasons. First, modern companies are more reliant on debt finance, which makes them more vulnerable to either interest rate spikes or liquidity crashes that prevent them from accessing the capital markets or banks. Second, advances in the theory of Finance and in computing power have enabled the pricing of derivative products, which can be used in hedging financial risks, the use of massive amounts of data and the minimization of calculation costs. Third, the expansion of the financial sector of the economy, which is measured not just from its contribution to a country’s GDP, but most importantly from its contribution to the development of complex networks of payments and credit supply, has raised worries concerning the stability not just of national economies but of the global financial system as well.

Although the management of the aggregate financial risk poses an obvious challenge for the State authorities in order to prevent the development of systemic risks with detrimental repercussions to the real economy, the corresponding endeavor from a firm’s perspective is more difficult, intuitively, to be understood. If the value of a firm is linearly related to its earnings then the volatility of the latter doesn’t affect the firm’s expected value; therefore, managing this volatility is not going to generate any additional value to the shareholders. It is the presence of a non-linear relationship between the value and earnings under which reducing the volatility of earnings produces a higher expected value for the firm.  This non-linearity is usually rationalized by invoking the eventuality that the firm might go bankrupt when exposed to severely adverse realizations of earnings. Therefore, financial risk management is value enhancing because it reduces the probability that a firm faces bankruptcy.

Someone might therefore be tempted to think that since the large availability of hedging instruments makes the goal of eliminating the financial risks more easily attainable, that the exposure to financial risks is a problem of the past. This is an entirely fallacious conclusion for at least two reasons. The first is that the presence of risks is inextricably intermingled with the idea of entrepreneurship in the sense that the latter cannot exist without the former. Therefore, the management of risks cannot reach such levels of applicability where it will destroy value for the companies. The second and most important argument is related to the fallacy that hedging a certain financial risk erases it, not only from the company exposed to that risk but from the entire financial system as well. However, hedging a risk simply transfers it to another party which obviously believes that it is more capable of handling it; either because it is included in a larger portfolio with better diversification properties or because the risk has been mispriced and an opportunity for profit has opened.  The recent Global Financial Crisis of 2007-2009 had its roots exactly on this fallacy that, somehow, companies that had hedged their risks could be immune even to the consequences of the outbreak of a systemic crisis.

On a practical level, the management of financial risks assumes that a company can both identify the risks it is exposed to and measure correctly the size of each exposure. By itself the activity of searching for sources of risk is value adding in the sense that it increases the awareness of the company to the presence of risks in its business environment. However, the measurement of risks is not a straightforward and risk-free procedure. The adoption of the wrong models, the choice of estimation periods relying on outdated data and the continuous shift of the type of risks a company faces, are some of the reasons why the risk measurement procedure can be an additional source of risk that leads sometimes to catastrophic decisions.

For instance, the expansion of fintech in the years to come will change drastically the type, the delivery and the use of financial services. Although in the financial industry it is widely accepted that fintech will provide new business opportunities while rendering obsolete those institutions which fail to follow the technological changes, it is surprising that only few companies in the financial sector incorporate in their risk analyses this source of risk. Another example of the problems inherent in the risk measurement procedures refers to the adoption of common techniques and methodologies from the great majority of companies in the financial sector. This feature of the market is usually a byproduct of the compliance of the financial sector companies to the requirements set by their regulatory authorities. Those requirements impose the same rules and identical procedures, in the measurement of risks, which must be followed by everyone under the regulator’s jurisdiction. The drawback, however, of this practice is that financial institutions are “taught” to perceive the financial risk in similar ways and to react to shocks in identical ways as well. This obviously adds an element of homogeneity in the policies that financial companies adopt when an external shock hits them; in other words, the systemic risk is strengthened through this endogenous procedure.

The enhanced presence of the financial markets in modern economies has contributed the most to the efficient allocation of capital but it also has increased the exposure to financial risks. Managing those risks can be a value adding activity since it can protect a company from facing adverse shocks, but it can, on the other hand, generate new type of risks or propagate those shocks to the entire financial system. However, the purpose of the management of risks under no circumstances can be interpreted as being tantamount to the elimination of risks. A deep knowledge of the risks someone is exposed to, lays at the heart of every profitable business decision and this can’t be swept away by automatic mechanisms that are incapable of addressing this problem in an integrated way.

Dimitris A. Georgoutsos is Professor of Finance at AUEB’s Department of Accounting and Finance.