Risk Management and Corporate Governance

Introduction

It is being recognised everywhere that good governance is important for corporate performance. Indeed firms are being expected to make statements about their governance as part of their annual reporting and every corporate website makes a statement about the company's governance procedures. It is easy to claim that this is because of a reaction to all the corporate scandals which we have witnessed in the last decade, starting with the collapse of Enron.

The relationship is direct and the evidence is overwhelming. The evidence is so great that it is clear that investors are increasingly willing to pay a premium to invest in a company with good procedures for its governance. This is because they recognise that this will lead to expected improvements in sustainable performance which will, over time, be reflected in future dividend streams. In other words it is more profitable for an investor to invest in a well governed company and the benefits accrue both in the short term and in the long term.

There has been much written about globalisation - either positive or negative - and the effects which it is having. One consequence of globalisation though is manifesting itself in the structure and organization of corporations. This is concerned with the harmonization procedures and structures which will manifest themselves through the emergence of global norms for corporate governance. One factor which is significantly affected by such governance is that of risk assessment and management. Good governance reduces and facilitates the management of risk.

Attitudes to risk

Risk management has become an important aspect of business management and governance has a role to play in this because a full understanding of corporate governance and its implications can reduce risk. In terms of their attitude to risk, people can be classified into three types:

Risk seeking

A risk seeker is a person who will value the opportunity of a positive outcome more highly than the risk of a negative outcome. When faced with two equal possibilities of a profit or a loss arising from a particular decision, a risk seeking person will choose to proceed because of the possibility of profit.

Risk averse

A risk averter would value the possibility of a negative outcome more highly than the opportunity of a positive and in the same situation would choose not to proceed because of the possibility of a loss.

Risk neutral

A risk neutral person would value both outcomes equally and would be indifferent about whether to proceed or not in this situation.

Different people have different attitudes to risk and this influences their decision making and how they value possible outcomes. Research has shown however that for important business decisions, such as capital expenditure appraisal, managers tend to be risk averse in their decision making. They therefore tend to choose decisions which might have lower expected values than other decisions but which have less risk associated with them.

Managers of a business have responsibilities to the owners of that business (ie the shareholders) and one of these responsibilities is to act as stewards of that business and to maintain the value of the business and its future viability. It might be thought that this duty will tend to lead managers towards less risky decisions, because they are making them on behalf of the owners of the business, than they would perhaps make on their own behalf. In actual fact the evidence tends to show the opposite - that they are more inclined to take risks because it is not their own money which is being risked.