Understand the relevance of ERM to all stakeholders
Discuss the relevance of risk measurement and management to all stakeholders
Discuss the risk arising from any misalignment of interests between different groups of stakeholders
Consider the objectives of various stakeholders and their interest in ERM
This module covers different areas relating to the implementation of the ERM process within an org., including an understanding of the wide range of stakeholders to whom ERM is relevant and issues arising from this
Exam note:
For any given scenario, needs to be able to identify the main stakeholders and discuss their roles
Need to be able to analyze a scenario from the RM perspective of a specified stakeholder
Compare and contrast this with the RM perspective of another class of stakeholder
There is typically a wide range of stakeholders for whom risk measurement and management is highly relevant
Stakeholder:
Someone who supports and participates in the survival and success of a company
Stakeholders nowadayws requires more risk transparency
Stakeholders can be categorized based on their relationship to the company
| Category | Relationship | Example |
|---|---|---|
| Principal | Contribute capital and/or expect a return | Shareholders; debt-holders; customers; government; insurance market; financial market |
| Agency | Paid by principals to perform a specific role on their behalf | Company directors; pension scheme trustees and administrators; company managers; employees; auditors; investment managers |
| Controlling | Supervise the principals or their agents | Professional bodies, regulators, industry bodies, government |
| Advisory | Advise the principal or their agents | Actuaries; lawyers; credit rating agencies; investment advisers; shareholder service providers |
| Incidental | Affected by the behavior and actions of the principal or their agents | Creditors; suppliers; other business partners; general public; media |
Characteristics and Roles:
Seek both good value for money and security of the company
Very weak individually
Have different perspectives depending on the type of org.
Bank customers risk appetite \(\approx\) debtholders
Building society account holders risk appetite \(\approx\) shareholders
Insurance company p/h: pure customers or shareholders (mutual company)
Acquiring and retaining customers
Can increase value by improvements in attracting and retaining the right customers
Retention is particularly important as it is cheaper to retain
Company in practice have high customer turnover
Long term customers are particularly valuable:
Tend to purchase larger quantities
Less price sensitive
More likely to recommend the company
Retaining customer loyalty
Dissatisfied customers:
Will leave
Might dissuade potential customers from purchasing
Need to perform sufficiently well to retain the customer’s loyalty
(i.e. continues to purchase from the company)
Knowing your customer
Customer surveys, feedback and data mining
Keep in mind of customer privacy
Effective crisis management
Crisis generally damages reputation unless handled well
(with might actually enhance it)
Company should have contingency plans in place before a crisis occurs
When a crisis strikes:
Should be honest; do not try to cover it up
Act swiftly and resolve it
Keep stakeholders informed
Focus on the long-term future of the business rather than minimizing short term cost
Characteristics and Roles:
Need to balance the needs of other stakeholders and their own personal goals
(Which may be influenced by the form of remuneration)
Have significant duty of care in terms of risk management
Need to fully understand the business
Able and willing to challenge management decisions
Need to ensure that the company remains compliant with all relevant regulation
Risk perspectives \(\approx\) shareholders
(since they are shareholder’s agents)
assets and liabilities of the companyNED:
Responsible purely for safeguarding the interests of shareholders
ED:
Hold roles within the firm and can be considered to an extend as employees
employeesCharacteristics and Roles:
Should be part of the day-to-day ERM process (not just ERM and IA)
Seek Job security and benefits
Part of the company’s op-risk
(e.g. management and retention of staff and their inherent expertise)
Employees with higher levels of agency risk
Low level employees
Members of unions
(They may organize strikes, demand standardized wage arrangements and can influence employee’s morale)
Free agents
3 key aspects of employee management and the potential effects of each
Recruitment
Companies need to identify and recruit the right individuals
Cash compensation, incentives and benefits are important
Retention, promotion and training
Turnover can be costly: Skills and knowledge are lost (or strengthen a competitor)
Career development programmes and continual training: Can improve employee morale, retention and productivity
Important that employees feel valued and that their achievements are recognized
Dismissal and resignations
Large scale redundancies:
Adversely affect morale
Can lead to voluntary resignations by other
(perhaps highly value employees)
Managed programme of dismissals (up or out) can increase employee motivation
Exit interviews are good ways to find out why employees are leaving and can address these issues for the future
Key groups of employees to align their interest with shareholders
Central risk function and CRO
Assess the level of risk across the org. and enforce risk management policies)
Pricing teams
Instrumental in ensuring the profitability of the company
Important to align their interests with those of the shareholders through proportionate rewards for taking appropriate risk
Characteristics and Roles:
Ensure compliance with the relevant regulatory standards
Protect the stability of markets
Balance is key
Needs to be sufficient controls to protect other stakeholders (customers and p/h)
Can not be so restrictive that the market is constrained and can not operate freely and efficiently
Need appropriate intervention process
To ensures that issues are dealt with in good time but also allows opportunity for correction and improvement (avoid closing down operations unnecessarily)
More details in Module 5
Post 2008 Regulatory/Superivsory Change
Much greater interest in companies’ RM practices and capital requirements
Stress tests have become more stringent
Companies are subjected to more regulation from multiple sources**
(e.g. gov and stock exchange)
\(\therefore\) Boards are more actively involved in the oversight of risk (esp. strategic risk)
Updated SEC disclosure requirements
Temporary bans on short-selling
Dodd Frank
New regulators: Consumer Financial Protection Bureau in US
Requirements for banks to have an orderly liquidation plan
Replacement of the FSA with PRA and FCA in UK (See module 5)
Greater likelihood that a company’s regulatory capital requirement will exceed those determined by their own internal model
Characteristics and Roles:
Set regulations and legislation
Intervene when companies get into trouble
Lender of last resort
Nationalization of a company that would otherwise fail
4 key risks faced by governments
Insufficient tax revenues
Inappropriate insolvencies
(failure of strategically important org. lead to contagion risk)
Regulatory arbitrage
Electoral losses
Characteristics and Roles:
External auditors
Perform annual reviews of accounts
Assessments of the inherent risks and the ways in which those risks are being managed
Duty to report openly and honestly on the state of the company on behalf of shareholders and regulators
Other professional advisers
Request from management to investigate and report on specific matters
(e.g. provide assurance or otherwise to the various stakeholders)
Bring independent technical expertise and industry bench-marking information
Management doesn’t have to act on their findings
3 risk faced by professional advisers:
Reputational risk
Risk of litigation
Conflict of interest
(e.g. same accounting firm providing both audit services and consulting services to the same client)
Characteristics and Roles:
Act as gatekeepers to companies wishing to raise capital
Strong influence on share price and can influence the view of external observers
Nowadays place much greater emphasis on risk management
Conflict of interest: Needing to protect reputation and the way their income is generated
2 risk faced by credit rating agencies
Reputational risk
Conflict of interest
Characteristics and Roles:
Require repayment of the money owe to them
Mostly interest in the security of the company over the repayment term
In difficulty, might waive interest payments in order to secure repayment of part of the capital
Key risk for bondholders
Depends on debt seniority, presence of security or covenants
Private debt (e.g. bank facility) is less liquid and more risky
Debt finance choice considerations
Taxation (interest being tax deductible)
Risk of insolvency
Agency cost
Trade creditors risk
Characteristics and Roles:
Affect directly by the failure of a company or its processes
Companies themselves are exposed to the risk of failure of subcontractors and suppliers (esp. when cost of replacement is high)
Characteristics and Roles:
Demand security of the pension scheme (dependent on the overall financial security of the sponsoring company)
Need to balance scheme security with the cost of benefit provision
e.g. Can choose to close a weak scheme rather than increase contributions
(Might not be in the best interest of active members)
Risk perspectives of DC scheme members
= policyholder or investor
\(\approx\) creditors
(e.g. if employer’s contribution are unpaid)
Risk perspectives of DB scheme members
Scheme sponsor’s perspective = equity provider
They benefit from any surplus but may need to provide additional funds
Risk perspectives of scheme trustees
= members (as they are member agents)
May have conflict of interest depending on their other relationships to the scheme
Characteristics and Roles:
Interest through being most of the above
S/h, bond/h, employees, pension scheme members, existing/future customers, taxpayers or the dependents of any of these stakeholders
Assessment of the org. and risk events is heavily influenced by the way they are reported
Speed and geographical spread of the distribution of information has increased from internet and related technologies
In can be debate that media have a duty to ensure that reporting is responsible and in the public interest
Irresponsible reporting can exacerbate the reaction of those with limited access to other information or with limited expertise and can escalate the problems
Benfits of a strategic alliance:
Faster product development
Access to new markets
••Sharing** of financial risks
Benefit from economies of scale
Potential pitfall of a strategic alliance:
Conflicts of interest
Waste of resources
Damage to reputation
Loss of intellectual capital or disputes over intellectual property
Ways to maximize chance of success
Only form an alliance if it really is the best options
Only to meet a specific goal that can best be met through an alliance
Best if significant control is required but a full merger is unnecessary
Find the right alliance partner
Need a decision making team and should reach agreement on the goals of the alliance
Should develop a set of evaluation criteria against which potential partners can be evaluated and a ranked list of potential partners
Entire team should meet and grade each potential partner
Monitoring the progress of the alliance carefully
Standard financial measure may not be appropriate initially
(e.g. Focus on quality of work etc)
Alliance should have sufficient resources and low staff turnover
Work of the alliance may need to be reviewed and refocused regularly
Conflict between stakeholders will arise due to different objectives
Companies should develop a clear understanding of each stakeholder’s interest
Interests should be aligned where possible, with this information recorded and disseminated amongst the stakeholders
Stakeholder interest and requirements should be reflected in the corporate business plan
Board runs the business for the benefit of the owners (e.g. s/h)
Benefits of separation of management and ownership
Have those with expertise in running a business to have decision making responsibilities without investing capital
Investors can invest without getting involved with day-to-day running of the company
Continuity of management despite frequent change in owners
Agency risk:
When interest of the owner and agent are not fully aligned, the agent may not always act in the interest of owners
Similar concept: problem of agency, principal-agent problem, agency dilemma
Difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent
Managers Remuneration
Managers may have different interest to shareholders
Can arise due to the way in which management team is compensated
Reward short term profits rather than long term investment
Executive comp. is an important consideration
An end objective of an ERM framework:
Ensuring that compensation schemes take into **account risk* in an appropriate manner
e.g. Ibanker who are rewarded for good results yet the downside for poor performance is limited
Situations where conflicts or agency risks may arise
Remuneration of key employees
Financing decisions
Situations involving a dominant CEO
Management decisions
Agency Cost:
Cost arising from agency risk
Can include costs associated with mitigating agency risk
e.g. developing astute and robust remuneration and reward schemes;
monitoring the actions of others and seeking to influence their actions
Include actual losses from these actions
Agency risk played a role in 2008 crisis
Underlying misalignment of the interest of employees, management and shareholder in banking
Due to the short term and asymmetric nature of employee and management reward structure
e.g. Employees were given bonuses based on the growth in the total amount loaned
\(\therefore\) Curtailing lending can put loan officer’s career at risk
Competitive forces (such as one bank offering 100% mortgages) exacerbating the lending spiral and drove expansion into higher risk (sub prime) lending
(e.g. US NINJA loan and UK 120% mortgages)
*Conflict between providers of finance
Lenders (banks, bondholders) and the providers of equity capital (s/h)
Difference between the lender’s short-term desire for security and the s/h’s long term interest in the sound development of the company
Risk that the CEO surrounds themselves with “yes” people
Who try to win favor with the CEO irrespective of the risks that their decisions generate for shareholders and other stakeholders
Can exist further down the hierarchy in the form of a very dominant manager or team leader
Example:
Equitable Life and the Mirror Group (Module 32) and Confederation Life
The latter collapsed in 1994 with losses estimated $1.3 bn after a high risk investment strategy set by its domineering Chairman
Mangers try to ensure their personal job security by making low risk investment decisions
Similarly penalize the company’s long term profitability and the s/h return
Manager may resist M&A that might threaten their own prospects
Remuneration and career prospects of regulator and politicians may be misaligned with the interest of the general public
Example:
Regulators rewarded by financial crisis:
Crisis typically lead to greater regulation and higher remuneration of regulators
Absence of direct penalties to regulators from failure to regulate the market and market participants properly can result in dysfunction
Can further misalign their interest with those of the market and the general public
Debate is on-going on the role of (lack of) regulation as a contributor to the global crisis
Line of least resistence
Politician’s inherent interest to get re-elected, they can aim to support policies that upset the least number of people in the short term rather than those that are the best long term solutions
Pursuing the “line of lease resistance” rather than the “line of greatest advantage”