Economic Risk

Managing Recession and Risks in the Economy

A recession in the economy tends to have ripple effects that spread out in increasing waves to affect more and more businesses.

A Recession is an economic situation, of which for at least two consecutive three-month periods (quarters), the value of all the goods produced and sold in the economy falls.

Business organizations Opens in new window are decision-making units that need to manage risk if they are to survive and prosper.

The 2008–2009 recession highlighted issues associated with poor risk management, particularly in the financial sector of the economy.

In response to the crisis, and what was seen as a systemic failure in banking and financial institutions, the government set up the Walker Review (2009) Opens in new window to come up with recommendations about improving the effectiveness of this sector, including better controls on risk management.

The resulting Walker Report recommended that in banks and other financial intermediaries (BOFIs) there should be a separate ‘risk committee’ made up of independent directors responsible for monitoring and reviewing risk.

The Report also recommended that there should be an officer specifically responsible for risk management and control in BOFIs.

Risk is the chance of damage or loss resulting from an event or activity. Risks are taken in order to secure benefits (such as shareholder returns or profits).

The two key variables determining the magnitude of risk are:

  1. the likelihood of the risk, and
  2. the impact that results.

Different organizations will have different risk appetites — in other words, they will be prepared to take on larger or smaller risks.

Some industries are characterized by a higher risk appetite (e.g. speculative finance), while others have low risk appetites (e.g. insurance).

Business by its very nature involves risk:

There is a chance that a business may make a profit but there is also a chance that a business may make a loss.

The owners of the business (i.e., the entrepreneurs Opens in new window) must decide on how much risk they are prepared to take.

As stated above, the insurance industry is typically conservative in the amount of risk that shareholders in insurance companies expect to take.

In contrast, there are industries where far more speculation takes place.

For example, in the search for precious minerals and oil and gas reserves entrepreneurs Opens in new window may take more of a gamble on profits materializing.

Should abundant deposits of precious resources be found then the entrepreneur Opens in new window may make a substantial gain.

People who seek higher returns from riskier ventures are said to have a strong risk appetite — more cautious investors are described as being risk averse.

It should be clear from the above that organizations cannot eliminate business risks. However, they can choose a number of alternatives:

Many of the risks that businesses face stem from the economic environment. UK Company Law requires companies to produce a Business Review as part of the Directors’ Report to shareholders. This process is still in development, but good practice typically involves three steps:

  1. The identification and description of key risks.
  2. Outlining the potential impact of these risks.
  3. Detailing the steps that an organization has taken to mitigate these risks.

For example, a food company might list some of its principal risks as including:

  • Increasing competition, product innovation, technical advances and changes in the market.
  • Global economic downturn.
  • Volatile global market trends.
  • Change in the cost of supplies.
  • Foreign currency and interest rate exposure.

Each of the uncertainties listed above is an economic risk.

Business graduates and business managers need to understand the causes and effects of these economic risks because they can have such a dramatic effect on business performance.

A business needs to be able to respond to these risks in an appropriate way. It is important therefore to develop a clear understanding of economic factors that constitute business risk.

Knowing the potential impact of a risk enables a business to identify the seriousness of the consequences.

For example, it is possible to argue that failures to fully identify economic risk factors have led to serious problems for many economies such as Greece, Ireland and Portugal in the wake of the 2008-2009 crisis.

Today these governments and many others are taking action to mitigate future risks — for example, by demanding that banks hold more liquid assets (cash and near cash equivalents), and that they ring-fence the impact of speculative bank activity so that it does not impact so severely on other banking operations.

  • Risk mitigation — involves controlling risk to a level that is compatible with the risk appetite of the economy. Measures should be taken to limit risk.
  • Liquid assets — the financial reserves that a bank (or other business) holds in a form that can quickly be converted to cash.

Requiring banks to hold more liquid assets means that should depositors withdraw deposits from the banks then the banks will have more reserves to meet customers’ demands for liquidity.