Describe the concept of ERM:
RM can benefit society
RM is part of the job of management
Reduce earnings volatility
Maximize shareholder value
Enhance job security and rewards
Modern Society relies on the banking and financial systems to operate smoothly
Avoid contagion risk
The Board is supposed to optimise risk/return decisions for shareholders
Investors/fund managers is several degrees away for effective risk management as it requires:
Historical data on risk/return results, volatilities and correlations
Risk exposure and concentration in the business
Future business and investment plan that may alter the firm’s risk profile
… Because predictable earnings:
\(\uparrow\) MV of firm (reduce risk of bankruptcy and tax liability)
\(\uparrow\) Company’s credit rating
\(\downarrow\) Variability in employee costs (reduce swings in # of employees required)
\(\downarrow\) Capital requirements (less risk capital is needed)
RM is a required competence for senior management
Benefits employee with stock options
Need a clear statement of risk appetite and profile to make decisions on which risk to accept or avoid
Risk appetite:
Risk a company is willing to accept on an ongoing basis
Risk profile:
Types of risks that a company faces and its current exposure to those risks
ERM takes responsibility for risk reporting across the whole organization to ensure that all risks are reported in a consistent and appropriate format to stakeholders
Provide timely and concise information on the company’s key risks
E.g. aggregate losses, policy exceptions, risk incidents, key exposures, early warning indicators etc
\(\hookrightarrow\) Improve risk transparency
\(\hookrightarrow\) Management more informed when making decisions due to:
Better understanding of risk exposure
Better comprehension of the links between growth, corporate risk/return
Better understanding of the impact of \(\Delta\)-ing external factors (e.g. interest rate)
More accureate accessment of a decisions’s risk/return trade-offs
Align strategy more closely with risk appetite
\(\hookrightarrow\) Improve business performance
Co-ordinating risk management activities across all parts of the organization
E.g. corrdinate existing risk and oversight functions such as finance, audit/compliance and other specialist risk units
CRO can provide top down coordination
Centralization enable firms to react quickly to emerging risk
Prioritize various risks arising from various areas of an organization
Encourage and facilitating the sharing of risk information
Identifying and assessing links between risks managed by various teams
Improving efficiency (w/ management time and business resources)
Cost savings from dealing with it firm wide
Or just natural hedge
ERM’s support on key management decisions leads to:
More efficient use and allocation of capital
Minimize losses
Early warning of risk
Improve pricing, managing, transferring risks better
Optimizing risk mitigation strategies (e.g. natural hedges between BUs)
Reacting more quickly to opportunities (or risks)
Gain value from RM by understanding the true risk/return economics of a business
\(\hookrightarrow\) Take more of the profitable risks that make sense
ERM requires integration:
Integrated risk organization (e.g. IRM that reports to the CEO and board)
Integration of risk transfer strategies to account for diversification and concentration
Integration of risk management into the business processes of the company
ERM optimizes business performance by:
Supporting/inflencing pricing, resource allocation, etc
This is the stage where ERM is an offensive weapon
Problem with traditional risk managment w.r.t intergration
Risks faced by companies are highly interdependent
\(\hookrightarrow\) Silo based RM is not efficient or effective
Missing the interdependencies, associated risks maybe not be captured and the big picture maybe be overlooked
Challenge of aggregating risk exposures across the organization
Benefits of ERM w.r.t intergration
Has integrated analyses, strategies, and reporting
\(\hookrightarrow\) Addresses interdependencies and aggregate expsoures
Supports the alignment of oversight functions (risk, audit, compliance)
Rationalize risk assessment, risk mitigation, and reporting activities
Consider how macro factors impact the organization’s risk/return profile
System integration allows for :
Enterprise level data management
Robust business and data analytics
Straight through transaction processing
More effective reporting and information sharing
Integration of strategy and risk allows:
Managment to better understand and challenge the underlying assumptions and risks associated with the business strategy
Driver of market value declines are driven by strategic risks 60% of the time, op risk 30% of the time and then financial risks
Company usually pressured to implement ERM due to:
Previous management failures
Near miss
High profile disaster in another organization
Regulator/auditor criticism or demands
Other influential stakeholders concerns (s/h, employees, rating agnecies, etc)
Stakeholder’s expectation of effective risk management practice due to increased in available tools to assess and manage risk
e.g. VaR and RAROC to measure risk
e.g. Credit derivatives and CAT bonds for risk risk transfer
Based on Lam Ch.21 case studies
Investors will pay a premium for well governed companies
On the flip side, they would avoid companies with poor governance standards
Companies with strong governance structures:
Sought after by investors at a premium (12-30%) and weak ones are avoided
Tend to outperform (ROE) companies with weaker governance
Lower volatility of returns, improved s/h value, financial stability, commands ~16% equity premium (For insurance companies)
Perform better during stock market crashes (e.g. 2008, companies with excellent S&P EMR rating did better)
Effect is amplified for larger companies