Many commodity companies who are setting up or revamping their risk management function frequently deal with this question in their internal meetings – Should our commodity risk management function structure be centralized, run from head-quarters, or de-centralized, run from individual business units?
We have frequently advised companies on the right structure based on their specific business and needs. Generally speaking, we favor centralized risk management function for most companies – since risk has to be seen not only at the individual business unit / commodity level, but also from an enterprise perspective – taking into account correlations across portfolios of various business units.
However, we also come across companies who find it extremely difficult to move directly to a centralized risk function. Such companies can be broadly identified as those with:
- Huge Geographic Spread – Companies where several business units work out of multiple geographic locations and also lack a centralized ERP generally find it difficult to
- Time Lag in data Collation – Multiple business units spread across the world give their daily transaction and inventory data with a week or more time lag, resulting in incorrect data at all times
- Lack of Centralized ERP / Contract Management System – This usually results in a huge back-office and reporting team which collates all the data manually and is extremely error-prone as well for the same reason.
- Currency hedging at Business Unit level – If business unit heads are solely responsible for the unit’s profitability, then they take care of currency hedging on their transactions locally, instead of aggregating their exposures across the enterprise.
- Taxation Issues – Sometimes companies do not aggregate their data in any single system for optimizing profits due to transfer pricing and reduce tax deductions in their home countries.
These and some other similar issues may lead to severe problems in managing risks centrally – as inaccurate / un-updated transaction data leads to a GIGO (Garbage In Garbage Out) scenario. Besides, currency hedging is far from optimal and there are constant changes to daily risk reports to account for errors in data made the previous day.
Many such companies are now seen to be far more keen to move to a centralized risk management system and some have already initiated efforts towards addressing the above issues. Centralizing your risk management function allows them to see their risks far more accurately – bringing in the confidence in the entire team that worst case scenarios are being taken into consideration and can be avoided.
Besides, we’ve seen centralizing risk function makes utilization of Risk Capital more efficient by anywhere between 20 – 80% (depending upon the correlations within the portfolios of various business units) which can then be re-routed to trading function and additional income generated on that capital as well !
So the next time you come across a discussion on centralizing your risk function, give the RoI of that initiative a re-look !
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