Risk management is a very diverse field. This is because all human activities are inherently risky. This explains the large number of professional who handle various risk assessment tasks for their clients. Risks exist in business, as well as in sports, in music as well as in the military. In each case, the same underlying concept influence the risk management measures used to mitigate or eliminate risk. Financing projects is a very risky aspect based on the number of things that can go wrong. Money is very fluid, making its management extremely risky. On one hand, it is important to ensure that money committed to a project ends in the right place. On the other hand, whether the project delivers the foreseen result depends on factors beyond the managers. In this regard, the financing of projects presents two main types of risk. The first type is the risk of loss of funds because of fraud, pilferage, or misuse. The second type of risk arises from losses associated to problems with the design of the project. A project may bring about financial risks because of losses arising from operational issues, and not poor financial management. This paper looks at the risks associated with financing projects. Its goal is to examine the efficacy of risk management tools in financing projects.Click the button, and we will write you a custom essay from scratch for only $13.00 $11.05/page 322 academic experts available
The structure of the paper is as follows. The first section is a literature review of risk management in financing projects. This section deals with the definitions of risk, and various aspects of project management that carry risks. It also examines types of financial risks and risk management tools available to project managers. The second section looks at case studies in risk management in financing projects. The discussions give way to the analysis of the facts presented, which culminates in general recommendations for project managers in regards to financing projects.
The definition of risk follows the same trends of non-conformance, which is common to many academic fields of endeavour. However, it is still necessary to examine a few definitions that underlie this concept. The basic view of risk is the likelihood of an event happening coupled with the event actually occurring (Conrow 2003). According to Pidgeon, Kasperson & Slovic (2003) scholars choose to engage in the debate on what risk means, or they avoid trying to define risk altogether. In their view, the definition of risk must start with a discussion on reality and possibility (Pidgeon, Kasperson & Slovic 2003).This is an attempt to distinguish between events arising from predetermined activities, and the events whose occurrence are beyond prediction. For instance, the risk that an employee will commit fraud is in the realm of possibility, because employees have access to the instruments needed to commit fraud, and only needs a motive, and the opportunity. On the other hand, a risk such as the collapse of the stock market is unpredictable because of the dynamics entailed. This leads to the philosophical question on whether risk is a real phenomenon or a perceived one (Karim et al. 2007).
The second aspect of the definition offered by Pidgeon, Kasperson & Slovic (2003) is that risk must affect people in some way. In this regard, an event does not qualify to be called a risk if its occurrence does not affect anyone. The definition they propose is “a risk is a situation or an event where something of human value (including humans themselves) is at stake, and where the outcome is uncertain” (Pidgeon, Kasperson & Slovic 2003, p. 56). A second definition of interest to this paper is the one offered by Garrick (2008) looks at risk as a triad. Garrick (2008) states that when someone asks questions in regard to risk, the three fundamental concerns are, “what can go wrong, how likely is that to happen?, and what are the consequences if it does happen”. An interesting aspect of Garrick’s(2008) work is that he focusses on the qualitative aspects of risk management. These view of risk all focus on the occurrence of negative disruptive events. There is need to adjust the definition to take into account positive events that can lead to new opportunities for project managers (Conrow 2003).
In light of the above definitions, risk management the context of this paper refers to all the efforts a project manager, or the body executing the management function, puts in place to deal with unplanned occurences that may have an impact on the project. While the use of the term management connotes active administration, the reality of risk management is that it is an indirect approach to management. Risks are by their nature uncontrollable, hence philosophically unmanageable. It is was possible to “manage risks” then risk management would not be necessary. Risk events would be fully mitigated.
Projects face various types of financial risks that can be classified in several ways. In one classification, the risks include credit risks, market risks, operational risks, and liquidity risks (Chumo 2011). The veracity of each of these risks varies from project to project. Credit risks usually affect large projects funded using external resources. It is common for large projects to have multiple funders. If one or more of the funders fail to provide credit as agreed, it may put the other funders at risk. Credit risk many also occur if a project that should pay back credit extended to it fails to deliver on this promise. In such a situation, the credit risk affects the funding agency. The impacts of credit risks on a project include loss of opportunities, loss of time, and difficulties in project scope management. Market risks come from the operating conditions of a given project (Chumo 2011). To a financing agency, market risks include aspects such as fluctuations in exchange rates, and inflation. According to the definition of risk provided by Pidgeon, Kasperson and Slovic (2003), market risk is an example of the risk that fall within the purview of possible risks, rather than expected risks. It is very difficult to predict the direction of market forces. Operational risks are also called process risks. These risks arise from the operational activities related to a given project. They include aspects of the project handled internally by employees, institutional processes, and internal procedures. Any weakness in the operational framework of a company amplifies the impact of operational risks affecting a project. Liquidity risks occur when a projects experiences cash flow constraints affecting its ability to meet its short-term obligations (Chumo 2011). This risk can be a subset of credit risks but can occur regardless of the credit situation of a company or project.Only 3 hours, and you will receive a custom essay written from scratch tailored to your instructions
In project financing, funders face risks from various sources. The first source is in the organisations investment portfolio. The nature of projects a funding organisation chooses to participate in can expose it to a high degree of risks. Investment portfolio risks usually affect funders who lend to projects in specific sectors. For instance, organisations that specialised in lending to the real estate sector in the US suffered serious financial risks when the credit crunch hit this market in 2008 (Meon & Sekkat 2012). The second source of financial risks is in the overdrafts issued by funders (Chumo 2011). By nature, overdrafts are short-term credit tools meant to increase a client’s liquidity to eliminate disruption of operations. The risks in overdrafts occur when the project cannot pay back in time. Overdrafts have a high interest rate hence a project can suffer financial ruin if it is unable to meet its short term lending obligations (Garrick 2008). If the funder has a big commitment to overdraft facilities in a given industry, it may mean that that industry is facing financial difficulties. The risk of default can be very high in such situations. In addition, overdraft facilities can affect the credit rating of a funding organization. In this case, the organizations reputation in the money markets suffers because of the debt financing
A funder can also experience risks in its operations from its letter of credit (Karim et al. 2007). Letters of Credit, if wrongly used, can give the project implementers undue confidence over their capacity to handle credit. A letter of credit from a funding agency tells potential funders that the project is viable and has attracted financing (UNEP 2004). Since the funder may not have full access to credit acquisition discussion between the project managers and other potential funders, the funding agency may find itself exposed to credit risks by the project managers.
Another source of risk for funders is foreign exchange fluctuation (Conrow 2003). Funding agencies have no control over foreign exchange rates. In many cases, the agencies factor foreign exchange fluctuation in their overall financial agreements. However, it is usual for exchange rates to fall out of the projected ranges (KPMG 2003). This can result from other sources such as trade sanctions, the collapse of a local economy, or political factors (Karim et al. 2007). In this regard, foreign exchange fluctuation remains one of the most significant sources of risk for funding agencies.
Financing organisations have several risk management tools at their disposal. First, they can use contract to mitigate project risks. In very large projects, contracts can stipulate the terms of finding and can create the review mechanisms needed to ensure that the project managers keep within the projects scope. Contracts can also help to distribute liabilities depending on who caused it. An example of the use of contracts in project funding is Chinese aid. Chinese development organisations usually prefer to deliver projects rather than funding to beneficiaries (Chow 2007). This helps the agencies to escape fraud and to limit the control beneficiaries exert over the funds. Contracts also serve as a guarantee that suppliers will meet their obligations. Usually the security in this case is the money due the supplier after rendering services. Failure to render services leads to loss of money for the contractor. Contracts are also the basis for seeking legal recourse in the event of a dispute. This makes contracts an essential part of risk minimization strategies.
The second tool used by fund managers to mitigate risk is insurance and reinsurance (UNEP 2004). Insurance companies have products that shield funders from a variety of project risks. Essentially, the funding agency buys insurance to insure their money against project risks. These policies are common for large funders because of the risk exposure of large funding projects (Garrick 2008). Insurance companies take reinsurance on large risks to reduce the impact of a payout in case the risk occurs.
The third risk management tool available to project financiers is alternative risk transfer (KPMG 2003). Alternative risk transfer is very important for situations where a primary risk leads to a secondary risk. For instance, delay in funding or delivery of material will lead to an escalation of the cost of salaries of project staff (Othman 2008). Such a cost can be very significant in large projects. Alternative risk transfer helps the insurers to meet the costs of risks beyond its traditional bounds (KPMG 2003).Get a 15% discount for your first original paper from our academic experts
The fourth risk management strategy used by funding agencies is credit enhancement products (Chumo 2011). In some cases, issuing more credit can make a project more viable (Lingard & Rowlinson 2005). The need for credit may arise from changes in the operating environment. Such changes can occur because of many reasons. Provided the reasons leading to the need for more credit are justifiable, more credit can actually reduce the risk of project failure.
This section contains three case studies relating to the causes and impacts of financial risks. The purpose of the case studies is to identify ways of mitigating financial risks. The two case studies relate to Washington Mutual and Long Term Capital Management (LTCM).
Washington Mutual was one of the organisations that did not survive the financial crisis that hit the US in 2008. The company engaged in risky behaviour that affected its financial soundness. The result was that the fund was unable to sustain its operations leading to its collapse. The events that led to the takeover of the fund were as follows.
In 2004, the Washington Mutual decided to pursue higher profits in its capacity as a mutual fund. This decision led to the development of a risky lending strategy to attain higher profits (SCI 2011). The strategy implementation process went on for two years without any significant consequence. However, in 2006, the default rates of the risky loans started to grow uncontrollably. This created concern internally and attracted the attention of regulators. However, no one took steps to reverse the trend. At the time, it was not clear to the players how serious the consequences of these actions were going to be. In 2007, the mortgage market begun to show serious signs of stress. This led to a downgrade of the ratings of securities backed by the mortgages (Chumo 2011). In the same year, Washington Mutual ran into losses driven by financially unsound loans and weak security (SCI 2011). Essentially, the mutual fund had given out large loans without adequate and credible security. The stock of price of Washington Mutual collapsed after these events because of loss of public confidence in the company. At the same time, investors in the fund started to withdraw their money, leading to liquidity problems (SCI 2011). Finally, the Office of Thrift Supervision took over the operations of the company and put it under receivership administered by the Federal Deposit Insurance Corporation (SCI 2011). JPMorgan bought Washington Mutual in 2008 at $1.9 billion (Chumo 2011).
The events above show how Washington Mutual exposed itself to crippling credit risks. An analysis of the operations of the company revealed several practices that led to its eventual buy out. First, the fund failed to observe due diligence when it was screening large borrowers. Usually, financial institutions must ensure that borrowers have the capacity to finance loan repayments (Meon & Sekkat 2012). In the case of Washington Mutual, the fund failed to screen applicants, and when it did, it did not take the analysis seriously. Its high appetite for profit also caused it to fail to secure appropriate collateral for the loans. The regulators also found that the fund preferred to direct borrowers away from conventional mortgage products to other loan products that had higher risks (SCI 2011). This not only exposed their clients to unnecessary risk, but also increased the firm’s exposure to financial risks. The drive for higher profits led to a collapse of the traditional values of mutual funds, which usually include low-risk investment approaches.
The regulators also found that the fund approved loans without verifying whether the borrowers had an income that could support the loan (SCI 2011). The result was that a number of the firm’s clients were unable to repay their loans. This finding illustrates how business objectives led to a complete disregard for the fundamental rules of loaning. The regulators also found that the fund authorised the issuance of loans that had multiple layers of risks (Chumo 2011). Obviously, such a finding shows that the company had lost its capacity to manage risks. Risk management is the most important aspect of lending (Koenig & Meissner 2011).For $13.00 $11.05/page, our academic experts will deliver a completely original paper according to your requirements
The findings above show that Washington Mutual weakened its risk management structures leading to its eventual takeover. It is interesting that the fund adopted a strategy aiming to increase its profits but at the same time lowered its risk assessment criteria. Usually, a high-risk approach to business calls for the adoption of stringent risk management strategies (Kutsch & Hall 2010).
While this case relates to a mutual fund, the lessons apply to any type of project-financing organization. The mistakes that affected this mutual fund can affect any project-financing organisation.
The second case study on the failure of a financial institution is LTCM. LTCM was an investment company founded by several people who had a solid reputation in the money markets as competent investments managers. The most visible founder of this company was John Meriwether. Meriwether had worked in the financial markets for many years before the founding of LTCM in 1993 (David 2013). He rounded up some of the best-known investment managers in Wall Street and opened up the company. The profiles of the senior partners in the company made it one of the most respected firms in Wall Street. The company commanded the respect of clients and regulators alike.
The confidence of the market in the company was one of the most prominent factors in the attitude the company adopted before it started making high-risk investment decisions (SCI 2011). The reputation of the partners warded off scrutiny from clients and regulators alike. This gave the firm’s management the confidence to carry out risky investment activities. In theory, the investments made by LTCM were sound. However, the company made extreme investments and ended up in a very risky position once market conditions started to change. For instance, the company undertook stress tests to confirm the stability of its business. The stress tests did use the extreme financial conditions found in the market during the financial crisis.
The company developed a portfolio of investments based on leveraging. Therefore, it matched its risky investments with relatively low risk investments. Over time, the company became more confident of its ability to balance out its accounts indefinitely. The fundamental flaw in this type of business was that it was not possible to predict how the value of investments would change over time. If investments in either extreme went out balance, the company risked insolvency. However, there were also scenarios where the company made supernormal profits. This depended on market fluctuation.
When regulators finally went to investigate the financial position of the company, things were already out of hand. The most shocking aspect of this was that the company had a capital base of only $4 billion but its balance sheet showed that it had assets of over $125 billion dollars (David 2013). This means that the company had leveraged its capital over thirty times (David 2013). In 1998, the company lost $2.5 billion (52% of its value) because of market dynamics. At some point, the company was confident that if it received a capital injection, it could balance its position. The problem was that it was impossible to find a suitable suitor. This is because the company had driven itself into a position where it was competing against the market. It was profitable to trade against the company’s position. It is also possible that the potential suitors knew that the company would be willing to take give up more stake than it was offering at the time.
The difficulties associated with getting a suitor also arose from the difficulties of predicting when the markets would converge. LTCM had no way of assuring investors that the market would swing in a favourable direction since market convergence or otherwise was not under LTCMs control (Chumo 2011).
Apart from the issue of convergence, LTCM was unable to untangle itself from its financial position because it could not get help from its counterparties (SCI 2011). Many of the counterparties held the same investments as LTCM. This means that they had the same financial problems as LTCM. They also needed capital injection to survive. Additionally, the counterparties had lost confidence in LTCM (SCI 2011). The counterparties were aware of the situation LTCM was dealing with because they traded together. When they saw their positions weakening, they knew that LTCM was also in a compromised situation. However, they did not know the seriousness of LTCMs position.
The most interesting situation was that some of the counterparties found it more profitable to bet against LTCMs positions. LTCMs woes were a blessing in disguise for them. The assets of some counterparties appreciated as the value of assets held by LTCM plummeted.
In summary, LTCM found itself rigged against the market in many ways. The company had risked too much and had no means of dealing with the resulting risk exposure. It had to rely on the goodwill of investors, who at this point did not find it profitable to invest in the company. The company had also lost trust, which was its most significant asset in the marketplace. The company overestimated its capacity to handle market risks. This led to its downfall.
Analysis and Recommendations
The occurrence of risk when financing projects is a normal part of business for project financing organizations. It is not possible to get rid of all risks in a project. This section re-examines the main issues uncovered so far, with the view of developing recommendations for project managers dealing with project financing.
Part of the discussions presented in the sections above dealt to the definition of risk. In the discussions that followed, it was clear that there is no consensus on a specific definition of risk in the context of project financing. The main facet uncovered in this regard is that the definition of risk depends on the discipline of application. In this regard, it is important to develop a definition of risk that fits in the context of project financing. An analysis of the literature reviewed shows that the definition of risk befitting a financing project must have three elements. First, it is important to verify the nature of risk in question. The distinction between real risks and perceived risks is very important for project planning. Secondly, this definition must clarify the importance of human players. There are many cases where human players are not affected by the occurrence of risks. In this case, the fitting definition needs to clarify this distinction. Finally, the definition of risk in project financing should be limited to the financial aspects of risk. This is important as a means of limiting the focus of risk management. An expanded definition can lead to loss of focus regarding project-financing risks.
The case studies revealed the weaknesses that affected financial institutions. While the cases looked at the collapse of whole institutions, the same risks can affect project-financing organizations. In a sense, a project is an organisation albeit with limited life. The following lessons and their application to project-financing organizations emanate from the case studies.
First, every project-financing organisation needs to determine its liquidity risk tolerance (Garrick 2008). It is very tempting to accept credit positions that overstretch the capacity of the project-financing organisation. A project-financing organisation can end up with more debt than it can support. Both Washington Mutual and LTCM did not take into account their capacity to sustain risk when they took the debt portfolios that led in their collapse. While there is need to determine the liquidity risk tolerance of the entire organisation, it is also crucial to determine this ratio for the each project.
Secondly, every project-financing organisation needs to determine the liquidity levels needed for sustainable operations (Kerzner 2009). It was clear from the literature that cash flow is a very essential component of business operations. Usually project-financing organisations handle many projects at a go. While each of the projects may have acceptable risk elements, the capacity of the funding organisation to handle all these risks is the crucial issue. This means that the organisation must have adequate revenues to match its financial needs. It also means that it must monitor risks in each project that may lead to situations where it needs to intervene.
Thirdly, the project-financing organisation must measure all liquidity risks associated with its portfolio (Tejavibulya & Eiamkanchanalai 2011). Risk measurement is important because it gives risk managers a means of assessing risks and their impacts. This enables them to prioritise mitigation measures. One of the main issues that led to the collapse of LTCM was its failure to keep track of the overall risks affecting its entire portfolio. A project-financing organisation may ignore small risks in different companies in its portfolio, which may be a significant risk when taken in totality. The organisations should take adequate steps to analyse each category of risks and then look at the overall impact of that risk on its portfolio
The fourth issue of relevance to project-financing organisations is the balance between risks and rewards (Wheeler 2011). In the case of Washington Mutual, the managers made a deliberate decision to maximise profits (Chumo 2011). This decision is what led to the collapse of the principle of due diligence in the operations of the organisation. The result was that the company found itself with unassailable losses. In the case of LTCM, the company took its trade in derivatives beyond the understood limits, and in the process, it ended up with unbalanced books. The lesson here is that a project-financing organisation needs to keep in mind that the balance between risk and reward should not exceed risk tolerance limits (Ardichvili, Cardozo & Ray 2003).
Finally, a project-financing organisation must not abandon the basic principles of finance in the pursuit of business objectives (Yazdanifard, Edres & Seyedi 2011). Washington Mutual did not screen loan applicants because it concentrated on increasing its loan portfolio to improve its margins. In the process, it ended up with loans that had no collateral, and the debtors lacked the capacity to repay the loans. In this regard, project-financing organisations should ensure that all loans given to projects have adequate collateral. The nature of collateral can vary depending on the project. This concept is illustrative of the care any funding agency needs to take when it issues loans.
The second set of recommendations cover the use of early warning indicators by project financing organisations. This philosophy is similar to the one used by quality control specialists. In quality control, it is better to prevent defects rather than to repair defective items at the end of the production process (Lingard & Rowlinson 2005). In this regard, a project-financing organisation is better off avoiding risk rather than hoping to mitigate the risk after it occurs. Some of the early warning signals it can be aware of are as follows.
The most obvious cause for concern is a credit rating downgrade of a project-financing organisation (Othman 2005). Project-financing organisations must take utmost care to retain their credit rating. This can influence liquidity if the credit rating affects relations with funders. Credit rating agencies use various ratios to determine an organisation’s credit rating. Whenever the credit rating goes down, the project-financing organisation suffers a reputational loss. This, in turn, affects its ability to obtain credit in the open market.
The second early warning sign for a project-financing organisation is its balance sheet (Duffey & Dorp 2000). Rapid increases in the assets and the liabilities of the organisation should lead to concern in regards to the financial position of the organisation. If LTCM took the rapid growth in their assets seriously, it would have taken measures to forestall the catastrophic financial position of the organisation in the days leading to its collapse. As soon as a project-financing organisation realises that it has very rapid changes in its balance sheet, it should analyse its position to find out whether it is operating sustainably.
The third early warning sign for a project-financing organisation is negative publicity (Project Management Institute 2003). This may not seem like a technical criterion, but it is extremely important for the credit reputation of a project-financing organisation. This reputation affects the chances of getting credit from higher level funding agencies, and investors (Garrick 2008). Negative publicity does not just come from people with ill will. It may also come from people who have a solid understanding of how money markets work. In such cases, it is prudent to carry out assessments to verify the facts presented.
From a project management standpoint, it is extremely important to deal with all the risks associated to a projec (Arson & Gray 2011)t. In fact, project-financing organisations should insist on complete project risk evaluation covering all activities that may affect the success of the project (PM4DEV 2008). This is because the success of a project depends on the successful funding of the project (Arson & Gray 2011).
The final point in this discussion is the need for accountability in business operations. This does not only mean that a company should submit reports to a regulator. Rather the reports should have sufficient detail to enable regulators to understand the risk exposure of the organisation. Organisations that maintain a form of accountability tend to perform better in the marketplace. One of the issues that lacked in both Washington Mutual and LTCM was regulatory oversight. The regulators and investors did not know the full extent of risk exposure of the two organisations.
The main lessons from this review are that any organisation can suffer from the impacts of risks. Financial risks are only one category of risks but they can affect the business prospects of a funding organisation. It is vital to keep all operations above board. Secondly, it is clear that there is need to clarify risks for better management. Failure to identify risks makes it impossible to manage risks. It is also clear that risk can affect any type of organisation and any type of project. It is important to limit operations within understood practices in a given industry. Experimental approaches to any type of project-financing can lead to the destruction of the funding organisation. This is not to mean that innovation is unwelcome, it means that innovative approaches must be within the well-understood business and financial principles. Finally, regulators have a very important role to play in the financial life of every organisation. The financial crisis of 2008 led to the collapse of many financial institutions. This means that a volatile market is poisonous to all the players. Regulators must ensure that all organisations that play a role in availing credit account for their activities. This includes conducting stress tests to determine how well the organisations can handle risks.
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