When Dealing with Risk, You Need a Seasoned Professional
According to the traditional theory of finance, risk management in manufacturing corporations means resorting to financial derivatives, instruments like options, futures and forward contracts to hedge against various types of macroeconomic risk, such as exchange rate risk and interest rate risk. But how widespread is the use of derivatives in industrial companies? Very little, judging from the responses of administrators taken from a large sample of international companies. It is therefore often concluded that very few industrial corporations, only the largest and most transnational ones, can implement risk management policies.
The early findings from a research project on corporate finance which is part of the Generali Chair in Insurance and Risk Management point to a totally new perspective on risk management in industrial companies. Such an approach is based on the observation that most significant risk for companies is volatility of operating results, and not simply financial volatility. Companies use a battery of instruments much more extensive than derivatives to manage operational risk, starting from their policies and strategies on dividend, treasury, and investment.
In fact, when access to financial markets is expensive, it is possible to prove that a company becomes risk-averse about the instability of its operating flows, because this translates into an increase in the cost of capital to the detriment of the company's growth prospects. This is true from the point of view of the administrators, who mainly have to rely on internal resources to finance growth, and from the point of view of shareholders, for whom this kind of risk is structural and cannot be diversified.
From this new perspective, therefore, managing risk means stabilizing operating results (the net result produced by assets on the balance sheet), and not just adding derivatives to the column of liabilities. To reduce the variance of operating results, the first levers at the administrators' disposal are dividend, treasury and investment policies, taking an integrated view that focuses on minimizing the variability of operating flows.
A first consequence is that the stability of operating flows emerges as an attractive element for institutional investors. How can a company with stable operating flows signal its attractiveness to the market? The results of the research study show that a natural lever is dividend policy. If administrators know that the company's future operational risk profile is favorable, the way to communicate it credibly to markets is to increase the dividend paid. The reason is precisely that the increase in dividends is expensive for companies, because it decreases internal resources available for growth and increases the cost of capital, so that only companies with a more favorable risk profile can afford it.
These results represent a contribution to the theory of dividends. Since the work of Modigliani and Miller, the dominating theory has been that dividends signal a company's future operating results. However, a systematic analysis of the data shows that, contrary to what is contemplated by the signaling theory of dividends, an increase in the dividend paid to shareholders is not followed by an increase in operating results.
The results of my research show that the dividend acts as a signal not of future operating results, but of their variability. Only companies with more stable operating flows, for example because they have reached optimal size and operate in mature industries, can afford to increase the dividend without affecting future growth opportunities. Therefore, when the market observes a company increasing its dividend, it revises downwards its valuation about the riskiness of the company's operating flows.
The message for the business world is simple: we can no longer afford to see risk management as a disconnected patchwork of various areas of intervention. It requires the presence of a reference figure, the Chief Risk Officer, an experienced professional capable of managing the operational risk of an enterprise from an integrated perspective. A good CRO acts like a methodical architect, rather than an improvised plumber harried by plugging leaks.