LO 38.3: Describe the development and implementation of an ERM system, as

LO 38.3: Describe the development and implementation of an ERM system, as well as challenges to the implementation of an ERM system.
In developing an ERM, management should follow this framework: Determine the firm s acceptable level o f risk. The critical component of this determination
is selecting the probability of financial distress that maximizes the value of the firm. Financial distress in this context means any time the firm must forego projects with positive net present values, due to inadequate resources. The likelihood of financial distress could be minimized by investing all funds into U.S. Treasury securities, but this should not be the firms objective. The objective should be maximizing firm value by selecting an appropriate probability of distress. For many firms, the proxy used for measuring the probability of distress is the firms credit rating assigned by external agencies. Thus, the firm may determine that the objective under ERM is to avoid a minimum credit rating below BBB. If the firm is currently rated AA, for example, the likelihood of falling below BBB can be estimated by average data supplied by the rating agency.
Based on the firm s target debt rating, estimate the capital (i.e., buffer) required to support
the current level o f risk in the firm s operations. In other words, how much capital does the firm need to have (on hand or available externally) to ensure that it can avoid financial distress. A company with liquid assets sufficient to fund all of its positive NPV projects would not be exposed to the underinvestment problem when it encountered cash flow deficits. Thus, risk management can be viewed as a substitute for investing equity capital in liquid assets. Keeping a large amount of equity in the form of liquid assets is costly. Instead of maintaining a large liquid asset buffer, a company can institute a risk management program to ensure (at some level of statistical significance) that its operating cash flow will not fall below the level needed to fund valuable projects. That is, the firm can take actions to limit the probability of financial distress to a level that maximizes firm value. The goal of ERM is to optimize (not eliminate) total risk by trading off the expected returns from taking risks with the expected costs of financial distress.
Determine the ideal mix o f capital and risk that will achieve the appropriate debt rating. At this level of capital, the firm will be indifferent between increasing capital and decreasing risk.
Decentralize the risk/capital tradeoff by giving individual managers the information and the
incentive they need to make decisions appropriate to maintain the risk/capital tradeoff.
The implementation steps of ERM are as follows: Step 1: Identify the risks o f the firm. For many banks, risks are classified as falling into one of three categories: market, credit, or operational. Other financial institutions broaden the list to include asset, liability, liquidity, and strategic risks. Identification of risks should be performed both top-down (by senior management) and bottom-up (by individual managers of business units or other functional areas).
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Topic 38 Cross Reference to GARP Assigned Reading – Nocco & Stulz
Step 2: Develop a consistent method to evaluate the firm s exposure to the risks identified above. If the methodology is not consistent, the ERM system will fail because capital will be mis-allocated across business units.
Implementation of an ERM system is challenging, and it is important that the entire organization supports the system. Thus, it is critical for all levels of the organization to understand how the system is designed and how it can create value. Monitoring the ERM system may be neglected due to its time-consuming nature. However, the inability to identify relevant risks on a regular basis could lead to corporate failures.
E c o n o m i c V a l u e v s . A c c o u n t i n g V a l u e
Credit ratings are typically based on accounting data, combined with some level of subjective assessment by analysts. Economic value, as determined by management, may very well be a more accurate reflection of the true value of the firm.
In determining whether accounting value or economic value is more relevant, the firm must consider its objective. If the objective is to manage the probability of default, the question of how default is determined becomes important. If default is determined by failure to meet certain accounting measures (e.g., debt ratio, interest coverage), then accounting measures will be a critical component of meeting the objectives.
If the objective is to manage the present value of future cash flows, then economic measures may be more appropriate than accounting measurements that do not accurately capture economic reality. Management must consider that managing economic value may lead to more volatile accounting earnings, which may ultimately affect economic value as well.
R i s k A g g r e g a t i o n