LO 38.1: Define enterprise risk management (ERM) and explain how implementing ERM practices and policies can create shareholder value, both at the macro and the micro level.
A business can manage its risks separately, one at a time, or all together in a cohesive framework. Enterprise risk management (ERM) is the process of managing all of a corporations risks within an integrated framework.
The benefit of ERM is that a comprehensive program for managing risk allows the business to achieve its ideal balance of risk and return.
Macro Level
At the macro level, ERM allows management to optimize the firms risk/return tradeoff. This optimization assures access to the capital needed to execute the firms strategic plan.
The perfect markets view of finance implies that a companys cost of capital is unrelated to its diversifiable risk. Rather, the cost of capital is determined by the firms systematic risk (also referred to as nondiversifiable, market, or beta risk). According to this view, efforts to hedge diversifiable risk provide no benefit to shareholders, who can eliminate this risk by diversifying their portfolios.
However, reducing diversifiable risk can be beneficial when markets are imperfect. Suppose a firm experiences a large and unexpected drop in its operating cash flow and does not have
2018 Kaplan, Inc.
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Topic 38 Cross Reference to GARP Assigned Reading – Nocco & Stulz
funds sufficient to fund valuable investment opportunities. In perfect markets, the firm would be able to raise funds on fair terms to fund all of its value-creating projects. When markets are not perfect (i.e., investors information about project values is incomplete), the firm may not be able to raise the needed funds on fair terms. This can lead to the underinvestment problem, where the company passes up valuable strategic investments rather than raise equity on onerous terms. The inability to fund strategic investments on a timely basis can result in a permanent reduction in shareholder value, even if the cash shortfall is temporary. By hedging diversifiable risks, the company reduces the likelihood of facing the underinvestment problem. Thus, the primary function of corporate risk management is to protect the companys strategic plan by ensuring timely investment. The ability to carry out the strategic plan in a timely manner confers an advantage over competitors who are unable to do so.
Micro Level
In order for ERM to achieve the objective of optimizing the risk/return tradeoff, each project must be evaluated not only for the inherent risk of the project but also for the effect on the overall risk of the firm. Thus, ERM requires that managers throughout the firm be aware of the ERM program. This decentralization of evaluating the risk/return tradeoff has two components: Any managers evaluating new projects must consider the risks of the project in the
context of how the project will affect the firms total risk.
Business units must be evaluated on how each unit contributes to the total risk of the
firm. This gives the individual managers an incentive to monitor the effect of individual projects on overall firm risk.
There are three reasons why decentralizing the risk-return tradeoff in a company is important: 1. Transformation o f the risk management culture: A consistent, systematic assessment of risks by all business units ensures that managers consider the impact of all important risks.
2. Every risk is owned: Because performance evaluations are based on risk, managers have
an incentive to consider important risks in their decision making.
3. Risk assessment by those closest to the risk: Managers in the individual business units have the knowledge and expertise needed to assess and manage the risks of the business unit.
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Topic 38 Cross Reference to GARP Assigned Reading – Nocco & Stulz
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