Build a framework for risk management.

The worst thing in today's business climate is not knowing the risks embedded in your business. The next worst thing is not being able to reposition once risk is exposed.

In our current business environment, characterized by globalization, deregulation, and heightened competition, volatility is our constant challenge. With greater volatility, of course, comes greater risk--and greater opportunity. But to realize the opportunities offered by risk, it must be understood and, most importantly, managed at all levels of the organization.

A net risk is embedded at every level of a business--at the strategic level, the operating level, and the financial level. Many companies have instituted risk management programs on the financial level, but few have developed the discipline of examining net risk on the strategic and operating levels of their organizations. Through our own experience in an industry that has gone through dramatic change within the last 20 years, Bankers Trust has developed a framework for risk management that allows us to see that the world is, in fact, organizable. And we are convinced that a framework for risk management is going to be the key perspective for senior leadership in businesses all over the world.

TRAUMA SPURS GROWTH

In the 1970s, as a result of the recession that followed the first oil shock, banks in the U.S. had to face up to the reality of an increasingly deregulated industry and the intense competition that resulted from deregulation. With the emergence of money market funds and other nonbank players and the advent of commercial paper and more efficient capital markets, banks lost many of their best customers.

Bankers Trust was no exception. We realized that we had to make some dramatic changes if we were to continue to prosper. So we undertook a rigorous analysis of the competitive environment, of the risks and volatilities we faced, and we initiated a transformation of our organization that continues to this day. We made the strategic decision to get out of the retail banking business--in the late 1970s, when it was still relatively profitable and saleable--and to direct our efforts toward wholesale banking, focusing our businesses on major corporations, financial institutions, governments, and high net worth individuals worldwide. Today, we have evolved from a money center bank into a global merchant bank.

If you look at Bankers Trust today, you will find that the loan account of the bank is now only 25 percent of total earning assets (vs. over 70 percent in the 1970s), while liquid assets, carried mostly at fair market values, make up over two-thirds. With our current positioning, if adversity or volatility affects our assets, we can reposition them. By being able to liquefy a risk position, we can shift into another position that better suits the circumstances. This flexibility is crucial to our success.

By our own experience, we have learned the value of a systematic evaluation of the risks facing our business, and we are convinced that this is an appropriate perspective for all businesses in today's environment. Our experience has taught us that risk management is possible in a volatile world and that, in any business and at all levels of the business, risks can be disaggregated and the relationships among them understood and managed to enhance the value of the enterprise.

RISK ISN'T ALWAYS WHERE YOU EXPECT

The worst thing, particularly in today's business climate, is not knowing the essential, critical risks embedded in the business. At Bankers Trust, we find that many companies do a thorough examination of their financial risks, but few examine their operating profiles in the marketplace or evaluate the risks they are taking at the strategic level. As a result, the managements of many companies are not aware of the risks to which they're exposed. Not long ago, the senior management of a major energy company asked us to look at their trading operation. They weren't comfortable with the price risk they were running. And with good reason: They were indeed running a price risk in their company's trading operation. But they did not know that they were running a significant price risk at every step of their operations, from the point at which reserves were lifted from the ground to the point at which the refined product was put into the marketplace. Once they understood the risks to which they were exposed throughout their operations, they were able to manage them.

RESPONSIBILITY AT THE TOP

It is the responsibility of senior management to set the risk policy for the organization and to understand what risks are being taken at all levels--strategic, operating, and financial--how these risks are interrelated and on what assumptions they are based.

There are four ways to approach risks: They can be tolerated, eliminated, accumulated or mitigated. Once each risk is identified, it can be analyzed and a decision made as to how it should be managed. Built-in flexibility to respond to changing conditions is essential and, in many cases, the decisions we make to tolerate or increase risk positions are as important as those we make to reduce or eliminate risks.

Strategic Risks--Strategic risks, which affect the company's future performance, are inherent in general business cycles, geopolitical volatility, social and demographic factors, technology advances, regulation and extraordinary events. A company's strategy must take into account the impact of all of these factors.

But what happens if negative volatility strikes at the company's fundamental strategic position? Take the defense industry, for example. The senior management of these companies could not have anticipated the recent dramatic change in the outlook for world peace--and the negative impact it is having on their business. But their dependence on high defense expenditures put them at risk. The senior executives of these companies now are grappling with how to reposition their organizations to deal with the world's changing priorities.

We should all take a lesson from the defense industry. Senior executives of all companies should have in mind the options--acquisitions, mergers, joint ventures, minority stakes--that will enable their companies to reposition assets at a cost the company can afford should strategic bets fail. This is an essential part of the framework at the strategic level.

Operational Risk--Every company faces risk in its decisions on research and development, marketing and distribution strategies, manufacturing, labor, materials sourcing and extraordinary events. Every one of these decisions represents a specific choice among a number of alternatives, and, as changes occur in the marketplace, some of these choices will prove to be suboptimal or even disastrous. The critical question then becomes how the company can take its newly apparent deficiency in, say, distribution and proceed to transform itself into a competitive player.

The framework for dealing with operational risk is the same as that used for strategic risk. Management must understand at the operating level what kinds of risk bets are being undertaken how they are interrelated and what are the underlying assumptions. And it must understand what options it has available.

Obviously, the issues at the operating level are different from those at the strategic level, but the perspective is the same. Life in business is a set of finite choices. Each one has risk that it might not work and opportunity that it will work very well. As the market experience plays out, the company needs the flexibility to exploit opportunities or to mitigate adversity in an affordable way.

Financial Risk--It is in the area of financial risk that companies are the most sophisticated. By financial risks, I refer to risks associated with issues of credit, interest rate levels, currency exchange rates, commodity prices, liquidity, equity prices, pension fund obligations, insurance and tax changes, among others. Derivatives have become the accepted means by which companies protect themselves against financial risk.

Derivatives were developed initially by the financial services industry to manage volatility in its own affairs. Early products were relatively simple tools: swaps, options, caps and floors. The sophistication of derivative techniques has grown exponentially since the mid-1980s, and derivatives now operate over interest rate, currency and commodity risks and, increasingly, over more strategic issues such as equity and acquisition risks, technological risks and product obsolescence risks. We use derivatives to shed, mitigate or, when it's appropriate, even acquire risk. Most importantly, derivatives can be used to manage unexpected adverse volatility.

Derivative technology is expanding in important ways. In addition to the familiar issues of interest rate, currency and commodity risk, derivative technology is now being used in other areas of finance to solve a broader range of financial problems--gains and losses in pension funds that result from market swings, for example.

We are also seeing a marriage of derivative technology with some of the standard financial structures--mergers and acquisitions transactions, recapitalizations and other corporate finance activities--to produce solutions that both mitigate risk and lower the level of capital required to achieve the desired results. I predict that much of the new development in derivative technology will focus on this area.

Take equity risks, for example. Every time a company decides to divest a subsidiary, the transaction is subject to the valuations of the equity market. Every time a company decides to raise equity capital, it is exposed to equity price risk from the moment management decides to raise capital until the registration statement is effective and the equity is priced. Derivative technology will provide solutions for these types of problems and risk exposures in the not-too-distant future.

THE IMPORTANCE OF FLEXIBILITY

If the worst problem in business is not knowing the risks to which your organization is exposed, the next worst problem is not having an affordable exit, or the flexibility to reposition risks in times of volatility. Let me turn again to the example of the U.S. banking industry. Most of the 11,500 banks in this country are in great difficulty now because they have asset quality problems caused by the illiquid loans on their balance sheets. And they are suffering because they have no affordable way to reposition these risks.

What is happening in U.S. banks is happening to companies in all industries. It is critical to build flexibility into a business, providing management with affordable options to deal with adversity. The well-managed companies, which are today at the forefront of risk management in its broadest sense, have built-in flexibilities that traditionally have not been part of corporate structure. The great multinational companies, for example, have the flexibility to switch production around the world, to manage changes in relative exchange rates, to manage flexible sourcing of raw materials, to alter financing to take advantage of changing market environments, to export technology around the world in response to changing conditions in the marketplace. That flexibility will increasingly become a competitive advantage as long as markets continue to be volatile.

A TOTALITY OF RISKS

The ability to manage a business relative to total assumed risks and their potential rewards and volatilities is the essence of good management in today's environment. In well-managed companies, you will find that a comprehensive risk assessment is part of the management processes. Management will have a good understanding of the risk profiles that have been assumed at the strategic, operational, and financial levels. These companies make and review explicit decisions periodically relative to the risk profiles they have assumed. And these decisions always include some option that involves tolerating, eliminating, accumulating or mitigating specific risks at these levels of the business.

If you listen carefully to any senior manager discussing his or her concerns, virtually every subject turns out to be an issue of risk. "I'm worried about the performance of my consumer business. I'm losing market share and it's affecting total profitability." "I'm worried about technological obsolescence in my capital goods business." "I don't know what to do about Eastern Europe." "I'm piling up excess tax credits in Asia and don't have a solution for it." Every one of these concerns involves risk at the strategic, operational or financial level of the business--risks that can be disaggregated, understood and managed. We believe that the companies that excel in the future will be those that master the management of risk.

Mr. Vojta is vice chairman of Bankers Trust New York Corporation.