Enterprise Risk Management: Theory and Practice
Enterprise.pdf (Size: 153.83 KB / Downloads: 58)
In this paper, we explain how enterprise risk management creates value for shareholders. In
contrast to the existing finance literature, we emphasize the organizational benefits of risk
management. We show how a firm should choose its risk appetite and measure risk when
implementing enterprise risk management. We also provide an extensive guide to the
implementation issues faced by firms that implement enterprise risk management.
Why does ERM creates shareholder wealth?
ERM creates value both through its impact on the firm at a macro level and at a micro level.
At the macro level, ERM creates value by enabling firms to quantify and rationalize the riskreturn
tradeoff they face and hence make it possible for them to access the resources over time to
implement their strategy and to take risks that create value. At the micro level, ERM becomes a
way of life for the corporation. All material risks are owned and the risk-return tradeoff
associated with individual risks is internalized. Though the academic literature has focused on
the macro level benefit for ERM, the micro level benefits are extremely important in practice.
The macro level benefits of risk management
Students in the first finance course of an MBA program often come away from such a course
with the view that shareholders can diversify their portfolios, so that the value of a firm does not
depend on its total risk.
Such a view of the world makes little sense.1 Adverse cash flow outcomes have costs that go
beyond the cash flow loss itself – in the language of economists, they have deadweight costs. If a
firm expects a cash flow of $200 million for the year and instead achieves a loss of $50 million, a
cash flow shortfall of this magnitude is generally more costly to the firm than the missing $250
million. Obviously, such a cash flow shortfall has implications for the market’s expectation of
future growth, so that it might be associated with a reduction in firm value of much more than
$250 million for that reason alone. However, unless the firm was about to repurchase stock or
debt for $250 million or has excess cash of that amount or more, the cash flow shortfall means that the firm is short of funds and has to either cut back on its planned investments or raise
additional funds. Raising additional funds is costly. Firms with debt capacity can issue debt, but
raising debt to fund the cash flow shortfall reduces debt capacity and is often expensive. If the
firm had what it felt was an optimal amount of leverage before the shortfall.
The micro benefits of ERM
An increase in total risk is costly because it makes it more likely that the corporation will
incur a shortfall that would force it to give up valuable projects. The cost of total risk therefore
creates a risk-return tradeoff at the corporate level. If the corporation takes on a project that
increases the firm’s total risk, that project has to be sufficiently profitable to pay for the cost of
the increase in total risk. This risk-return tradeoff has to be evaluated for all decisions the
corporation makes that have a material impact on the firm’s total risk.
The right amount of risk
How should a corporation determine the optimal amount of total risk it should bear? Or, to
use a language that is popular, what should the corporation’s risk appetite be? To answer that
question, it is important to realize that the adverse costs of cash flow shortfalls we discussed
earlier would not exist if the firm had a larger buffer stock of equity capital invested in liquid
assets. If the firm suffered a cash flow shortfall, it could then simply use its liquid assets instead.
However, having such a buffer stock of equity capital is expensive. By reducing risk, a firm can
lower the buffer stock of equity capital it requires. Consequently, firms face a tradeoff between
equity capital and risk. ERM quantifies this tradeoff and enables firms to optimize it.
When the firm does not have an unlimited buffer stock of equity capital, a drop in the value
of the firm can lead to a situation where the firm cannot pursue all the good projects available to
it because it becomes financially constrained. Let’s define financial distress to be a situation
where a firm has to give up positive net present value (NPV) activities because it is financially
constrained. There are different degrees of financial distress.
Inventory of risks
The first step in operationalizing ERM is to identify the risks the firm is exposed to. A
common approach is to identify the types of risks that will be measured. Early on, financial
institutions focused on market and credit risks. Eventually operational risk was added. As a result,
a common typology for banks is to classify risks into market, credit, and operational risks. For
such an approach to capture all the risks the firm is exposed to, operational risk has to include all
the risks that are not market and credit risks. For banks, the definition of operational risk that
prevails in the Basle 2 accord is much narrower – for instance, it ignores reputational risks.
Consequently, there will be a tension between measurement of operational risk for regulatory
purposes and measurement of operational risk from the perspective of ERM.
Many firms have gone beyond measuring market, credit, and operational risks. In particular,
in recent years, firms have also attempted to measure liquidity, reputation, and strategic risks.
Further, the typology used in banking often does not correspond well to the risks faced in other