The managerial landscape is often defined by situations of risk and uncertainty. The decision-making process is an attempt to reduce, mitigate, or even removed risks and uncertainties. As such, the decisions of managers impact the extent to which risks and uncertainties remain.
Uncertainty has a fairly linear effect on decision making in that it delays it. When confronted with uncertainty, managers will attempt to put off decisions until uncertain circumstances become more certain.
It is important to note that uncertainty and risk are not the same thing, but both play an important role in the decision-making process. Uncertainty is a probabilistic state where multiple outcomes are possible yet unknown. Risk is a state of uncertainty whereby possible outcomes involve losses of varying degrees depending on the actual outcome.
Decision making within a risk management context should therefore seek, wherever possible, to identify, quantify, and absorb risk. Identifying risk entails an awareness of current business risks that might be facing the organization. Business risks are typically classified as follows:
- Strategic risks: These are industrial risks that arise from competing in a specific industry and can include macroeconomic risks (the alignment of buyers and sellers consistent with the principles of supply and demand), transaction risks (the operational risks from M&A activity, divestures, or partnerships), and investor relations risk (the risks associated with communicating effectively with the investment community).
- Financial risks: These are derived from potential losses in the financial accounts of a business. They can include risks from investing capital, risks to principal or interest value, or risks to other business related transactions.
- Operational risks: Risks that arise during the day-to-day operations of the business. This varies considerably amongst different industries.
- Legal risks: The extent of a business' compliance with all applicable laws would dictate the overal impact of legal risks on decision making.
- Other risks: Usually risks associated with force majeure. This is difficult to account for and include within decision-making criteria.
Once management has identified the appropriate risk category that may impact upon a certain decision, it may go about quantifying these risks. In other words, management will ascertain the costs incurred if a risky outcome were to happen. This can be mathematically daunting for many types of risk, especially financial risk, but generally speaking risk is equal to the sum of the probabilities of a risky outcome (or various outcomes) multiplied by the anticipated loss as a result of the outcome. This is similar to performing a sensitivity analysis if the universe of outcomes is known.
The ability of a firm to absorb, transfer, and manage risk is critical in management's decision-making process when risky outcomes are involved. This will often define management's risk apetite and helps determine, once risks are identified and quantified, whether risky outcomes may be tolerated. For example, many financial risks can be absorbed or transfered through the use of a hedge, while legal risks might be mitigated through unique contract language. If managers believe that the firm is suited to absorb potential losses in the event the risky outcome is triggered, then they will naturally have a larger apetite for risk given their capabilities to manage it. Figure 1