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Enterprise Risk Management
A.V. Vedpuriswar
June 12, 2014
Objectives
Understanding risk
Getting the big picture
Taking a holistic view
Recognising human infallibilities
Being clear about our priorities
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Acknowledgements
 Enterprise Risk Management: Theory and Practice, Brian W. Nocco, and
René M. Stulz, Journal of Applied Corporate Finance, Fall 2006
 Strategic Risk Taking, Aswath Damodaran
 The Black Swan, Nassim Nicholas Taleb
 Integrated Risk Management for the Firm: A Senior Manager’s Guide,
Working paper by Lisa K. Meulbroek
 Kenneth Froot, David Scharfstein & Jeremy Stein, “ A famework for risk
management”, Harvard Business Review, Nov-Dec1994
 Options, futures and Derivative Securities, John C Hull
 Risk Management and Financial Institutions, John C Hull
 FRM Body of Knowledge
2
Ice breaker
What are the fundamental laws of Physics?
What are the fundamental laws of Economics?
What about Financial Economics?
3
A problem which took 160 years to solve
Luca Pacioli, an Italian monk framed a famous problem.
Two gamblers are playing a best-of-five dice game.
They are interrupted after three games with one gambler
leading 2 to 1.
What is the fairest way to divide the pot between the two
gamblers, taking into account the current status of the
game?
Blaise Pascal and Pierre de Format solved the problem after
about 160 years.
How? Assume all the 5 games are played.
4
Another teaser
I give you two options
– Take Rs. 50
– I toss a coin. Heads you get Rs. 100 and tails you get 0
Which will you choose?
I give you two options
– Pay Rs. 50
– I toss a coin. Heads you pay Rs. 100 and tails you pay 0
Which will you choose?
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A third teaser
The bird flue epidemic is expected to hit your town and it is
estimated that 600 people die. Which of the following two
drugs, A or B, will people recommend to combat the
epidemic, given the following information?
– If Drug A is used: 200 will be saved.
– If Drug B is used: 1/3 chance that all 600 will be saved and
2/3 chance that nobody will be saved.
It seems a greater percentage of the respondents vote
for Drug A
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The bird flue epidemic is expected to hit your town and it is
estimated that 600 people will die. Which of the following two
drugs, C or D, will people recommend to combat the
epidemic, given the following information?
– If Drug C is used : 400 will die.
– If Drug D is used: 1/3 chance that nobody will die, and 2/3
chance that 600 will die.
It seems a greater percentage of the respondents vote
for Drug D.
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Key messages
Our attitudes towards risk are highly perplexing.
The essence of good risk management is making the right
choices when it comes to dealing with different risks .
Risk management should not be equated with risk hedging.
The most successful companies rise to the top by embracing
risks they can exploit better than their competitors.
Some risks are “black swans”.
They come when we least expect them but their effects can be
catastrophic.
An integrated approach to risk management can be highly
rewarding.
8
How Enterprise Risk Management adds value
Enterprise Risk management creates value at both a “macro”
or company-wide level and a “micro” or business-unit level.
At the macro level, ERM enables senior managers to quantify
and manage the risk-return tradeoff that faces the entire firm .
At the micro level, ERM becomes a way of life for managers
and employees at all levels of the company.
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What determines the value of a firm?
The value of a firm can generally be considered a function of
four key inputs
– Cash flow from assets in place or investments already
made
– Expected growth rate in cash flows during a period of high
growth excess returns
– Time before stable growth sets in and excess returns are
eliminated
– Discount rate which reflects both the risk of the investment
and the financing mix used by the firm
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What can a firm do to increase its value?
Generate more cash flows from existing assets
Grow faster or more efficiently during the high growth phase
Prolong the high growth phase
Lower the cost of capital
What is the role of risk management in adding value to firm?
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How hedging can help?
Managers often under invest because of risk aversion.
By providing hedging tools, we can remove the disincentive
that prevents them from investing.
By hedging and smoothening earnings, firms can extend
their high growth/excess returns period .
Hedging firm specific risks can align the interest of
stockholders and managers, leading to higher firm value.
The pay off from risk hedging is greater for firms with weak
corporate governance structures.
The payoff is also greater in case of managers with long
tenure.
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How taking risk helps
The way the firm strategically manages its risk exposure,
such as by making the right R&D investments, will clearly
help in extending the growth phase.
Taking risk has higher pay offs in businesses that are
volatile but yield high returns on investment.
We must look for the positive black swans!
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Benefits of Risk management : A Summary
Researchers have identified various value-increasing benefits of
risk management that can generally be classified as reduction in
expected costs related to the following:
 Tax payments,
 Financial distress,
 Underinvestment,
 Asymmetric information,
 Undiversifiable stakeholders
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S&P : ERM Maturity levels
Maturity Level
Description
Weak
• lacks reliable loss control systems for one or more major risks.
Adequate
• has reliable loss control systems
• but may still be managing risks in silos instead of coordinating
risks across the firm
Strong
• has progressed beyond silo risk management to deal with
risks in a coordinated approach,
• has the capability to envision and handle emerging risks, and
well-developed risk-control processes ,
• has a focus on optimizing risk-adjusted returns necessary for
effective strategic risk management
Excellent
• has the same characteristics as a strong ERM program
• but is even further into the implementation, effectiveness, and
execution of the program.
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Risk Management Failures
 Failure to use appropriate risk metrics.
 Wrong measurement of known risks.
 Failure to take known risks into account.
 Failure in communicating risks to top management.
 Failure in monitoring and managing risks.
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Strategy, Finance, Operations : Need for integration
Risk management as a discipline has evolved unevenly
across different functional areas.
In strategy, the focus has been on competitive advantage
and barriers to entry.
In finance, the preoccupation has been with hedging and
discount rates. Little attention has been paid to the upside.
People in charge of operations may not have the big picture.
Risk management at most organizations is splintered.
There is little communication between those who assess
risk and those who make decisions based on those risk
assessments.
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Three ways to manage risk
Fundamentally, there are three ways to manage risk.
Which are these ways?
Different approaches to managing risk
Adjusting
capital
structure
(Buffer)
Targeted
financial
instruments
–(Transfer)
Modifying
operations,
(Hold)
Integrated Risk Management for the Firm: A Senior Manager’s Guide, Working paper
by Lisa K. Meulbroek
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Visualising ERM
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Risks in P&C Insurance
Ref : ERM- An Insurance perspective and overview, Calandro, Fusler, Sansone
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Risk Mapping
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Preventable, Strategy and External Risks
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Integrated risk management
“Integration” refers to the combination of these three risk
management techniques, and to the aggregation of all the
risks faced by the firm.
Integrated risk management is by its nature “strategic”, rather
than “tactical”.
Because the three ways to manage risk are functionally
equivalent in their effect on risk, their use connects seeminglyunrelated managerial decisions.
For instance, capital structure decisions cannot be decided in
isolation from the firm’s other risk management decisions.
Can we think of some examples?
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Modifying operations to gain competitive advantage
Companies are in business to take strategic and business
risks.
By reducing non-core exposures, ERM effectively enables
companies to take more strategic business risks.
Consider the following :
– Pharma R&D
– Human capital management in software company
– Cricket pitch during rainy season
– Environmental management
– Oil company
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When to hold the risk?
Companies should be guided by the principle of comparative
advantage in risk-bearing.
A company that has no special ability to forecast market
variables has no comparative advantage in bearing the risk
associated with those variables.
But the same company may have a comparative advantage in
bearing information-intensive, firm-specific business risks.
That is because it knows more about these risks than
anybody else.
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Risk transfer using targeted financial instruments
When should firms use targeted financial instruments?
Some risks cannot be managed effectively through the
operations of the firm.
 Either because no feasible operational approach exists.
Or an operational solution is simply too expensive to
implement or it is too disruptive of the firm’s strategic goals.
Targeted financial instruments are especially suited for firms
with large exposures to commodity prices, currencies, interest
rates, or the overall stock market.
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Risk adjustment via the capital structure
By decreasing the amount of debt in the capital structure,
managers can reduce the shareholder’s total risk exposure.
Lower debt means that the firm has fewer fixed expenses.
This translates into greater flexibility in responding to any
type of volatility that affects firm value .
Lower debt also reduces the chance that the firm becomes
financially distressed.
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Equity: An all purpose cushion
Equity provides an all-purpose risk cushion against loss.
There are some risks that a firm can both anticipate and
measure relatively precisely.
Such risks can be shed through targeted risk management.
Equity provides ideal protection against
– risks that cannot be readily anticipated or measured,
– or for which no specific targeted financial instrument exists .
The larger the amount of risk that cannot be accurately
measured or shed, the larger the firm’s equity cushion
should be.
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Effectiveness at managing different risks: Deloitte
2013 Risk Survey
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Effectiveness of Risk management systems : Deloitte
2013 survey
31
Effectiveness of risk data strategy and infrastructure :
Deloitte 2013 Risk Survey
32
Issues in Risk MIS : Deloitte 2013 Risk Survey
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The most important risks faced by Corporates
Ref : Servaes,Tamayo,
Tuffano, “ The theory
and practice of
corporate risk
management”, Journal
of Applied Corporate
Finance, Fall 200934
Benefits of risk management for Corporates
Ref : Servaes,Tamayo,
Tuffano, “ The theory
and practice of
corporate risk
management”, Journal
of Applied Corporate
Finance, Fall 200935
Costs of risk management for corporates
Ref : Servaes,Tamayo,
Tuffano, “ The theory
and practice of
corporate risk
management”, Journal
of Applied Corporate
Finance, Fall 200936
The most important risk management products used
by corporates
Ref : Servaes,Tamayo,
Tuffano, “ The theory
and practice of
corporate risk
management”, Journal
of Applied Corporate
Finance, Fall 200937
Measuring risk management
Ref : Servaes,Tamayo,
Tuffano, “ The theory
and practice of
corporate risk
management”, Journal
of Applied Corporate
Finance, Fall 200938
Liquidity, model and market risks
 Liquidity, market and model risks are interrelated.
 Breakdown of markets leads to liquidity problems.
 When markets are not in place, models become necessary.
 Models pose various risks.
Credit and Market risks
 Credit and market risks are inter related.
 Consider bonds.
 Change in credit rating can lead to change in bond price
 Consider swaps.
 Change in value can lead to credit risk.
 Financial disintermediation has led to more integration.
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Market and operational Risks
 Market and operational risks are interrelated
 When positions move, losses may have to be booked.
 Trader’s psychology may lead to systems and processes
being breached.
 More risks may be taken than warranted.
 Sound systems and processes can help.
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Behavioral issues in Risk Management
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The duality of risk
It is part of human nature to be attracted to risk.
At the same time, there is evidence that human beings try to
avoid risk in both physical and financial pursuits.
Some individuals take more risk than others.
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Behavioural finance and prospect theory
Decisions are affected by the way choices are framed.
Individuals may be risk seeking in some situations and risk
averse in others.
Individuals feel more pain from losses than from equivalent
gains.
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Propositions about risk aversion (1/2)
Individuals are generally risk averse and more so when the
stakes are large than when they are small.
There are big differences in risk aversion across the population
and noticeable differences across sub groups.
Individuals are far more affected by losses than by equivalent
gains.
The choices that people make when presented with risky choices
or gambles depend on how the choice is presented.
Individuals tend to be much more willing to take risk with what
they consider found money than with money they have earned.
Ref : Strategic Risk Taking, Aswath Damodaran
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Propositions about risk aversion (2/2)
There are two scenarios where risk aversion seems to
decrease and is even replaced by risk seeking.
One is when individuals are offered the chance of making an
extremely large sum with a small probability of success.
The other is when individuals who have lost money are
presented with choices that give them a chance to get their
money back.
When faced with risky choices, individuals often make
mistakes in assessing the probabilities of outcomes, over
estimating the likelihood of success.
The problem gets worse as the choices become more
complex.
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Risk Management vs. Risk hedging
Risk management is aimed at generating higher and more
sustainable excess returns.
The benefits of risk management will be greatest in
businesses with high volatility and strong barriers to entry.
The greater the range of firm specific risks, the greater the
potential for risk management.
Risk management will create more value if new entrants can
be kept out of business.
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Managing the upside
A simple vision of successful risk taking is to expand our
exposure to upside risk while reducing the potential for
downside risk.
The excess returns on new investments and the length of
the high growth period will be directly affected by decisions
on how much risk to take in new investments .
There is a positive pay off to risk taking but not if it is
reckless.
Firms that are selective about the risks they take can exploit
these risks to their advantage.
Firms that take risks without sufficiently preparing for their
consequences can be hurt badly.
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Risk Management vs. Risk Hedging: A summary
Risk Hedging
Risk Management
View of risk
Risk is a danger
Risk is a danger & an opportunity
Objective
Protect against the downside
Exploit the upside
Approach
Financial, Product oriented
Strategy/cross functional process
oriented
Measure of success
Reduce volatility in earnings,
cash flows, value
Higher value
Type of real option
Put
Call
Primary impact on value
Lower discount rate
Higher & sustainable excess returns
Ideal situation
Closely held, private firms, publicly
traded firms with high financial
leverage or distress costs
Volatile businesses with significant
potential for excess returns
Ref : Strategic Risk Taking, Aswath Damodaran
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ERM : Managing the upside and the downside
Ref : Ten Common misconceptions about ERM, , by John R. S. Fraser, Hydro One, and Betty J.
Simkins, Oklahoma State University, Journal of Applied Corporate Finance, Fall 2007
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Competitive advantage through superior risk management
Information
Speed
Experience/Knowledge
Resource
Flexibility
Corporate governance
People
Reward/punishment mechanisms
Ref : Strategic Risk Taking, Aswath Damodaran
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The Information advantage
Firms that take risk must invest in superior information
networks.
Companies must be clear about the kind of information
needed for decision making in a crisis and put in place
necessary information systems.
Early warning information systems must trigger alerts and
preset responses.
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The Speed advantage
The speed of response can be critical in a crisis .
Speed depends on the quality of information, and
understanding the potential consequences and the interests
of the stakeholders.
Organizational structure and culture also determine the
speed of response.
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The Experience/knowledge advantage
Having experienced similar crises in the past can give us an
advantage.
Firms must invest in learning.
They can enter new and unfamiliar markets, expose
themselves to risk and learn from mistakes.
They can acquire firms in unfamiliar markets.
They can form strategic alliances or recruit people with the
necessary expertise.
54
The Resource advantage
Having the resources to deal with a crisis can give a company
a significant advantage over competitors.
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Flexibility
A flexible response to changing circumstances can be a
generic advantage.
For some firms, flexibility may come from production
facilities that can be modified at short notice to produce
modified products that better fit customer demand.
For other firms, flexibility may come from lower overheads
and fixed costs.
Flexibility also means the ability to get rid of past baggage,
cannibalising existing product lines and having a “paranoid”
culture.
56
Corporate governance
Interests of decision makers must be aligned with those of
the owners.
Both managers with too little wealth and too much wealth
tied up in their business will not take risk.
The appropriate corporate governance structure for the risk
taking firms would call for decision makers to be invested in
the equity of the firm but also to be diversified.
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People
When facing a crisis, some people panic, others freeze but a
few thrive and become better decision makers.
58
Reward/Punishment mechanisms
A good compensation system must consider both process
and results.
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Five questions about risk
Question #1: Have senior managers communicated the core
values of the business in a way that people understand and
embrace?
Question #2: Have managers in the organization clearly
identified the specific actions and behaviors that are offlimits?
Question #3: Are diagnostic control systems adequate at
monitoring critical performance variables?
Question #4: Are the control systems interactive and
designed to stimulate learning?
Question #5: Is the company paying enough for traditional
internal controls?
Ref : Strategic Risk Taking, Aswath Damodaran
60
Risk management: First principles (1/2)
 Risk is everywhere: Our biggest risks will come from places that we
least expect them to come from and in forms that we did not anticipate
that they would take.
 Risk is threat and opportunity: Good risk management is about
striking the right balance between seeking out and avoiding risk.
 We are ambivalent about risks and not always rational: A risk
management system is only as good as the people manning it.
 Not all risk is created equal: Different risks have different implications
for different stakeholders.
 Risk can be measured: The debate should be about what tools to use
to assess risk than whether they can be assessed.
 Good risk measurement should lead to better decisions : The risk
assessment tools should be tailored to the decision making process.
Ref : Strategic Risk Taking, Aswath Damodaran
61
Risk management: First principles (2/2)
 The key to good risk management is deciding which risks to avoid, which
ones to pass through and which to exploit : Hedging risk is only a small
part of risk management.
 The pay off to better risk management is higher value: To manage risk
right, we must understand the levers that determine the value of a business.
 Risk management is part of everyone’s job : Ultimately, managing risks well
is the essence of good business practice and is everyone’s responsibility.
 Successful risk taking organizations do not get there by accident :The
risk management philosophy must be embedded in the company’s structure
and culture.
 Aligning the interests of managers and owners, good and timely
information, solid analysis, flexibility and good people is key : Indeed,
these are the key building blocks of a successful risk taking organization.
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Concluding remarks
 Extreme negative outcomes are always a possibility, and the effectiveness
of risk management cannot be judged on whether such outcomes
materialize.
 The role of risk management is to limit the probability of such outcomes to
an agreed-upon, value maximizing level.
 A company where risk is well understood and well managed will command
the resources required to invest in the valuable projects available to it
because it is trusted by investors.
 In such cases, investors will be able to distinguish bad outcomes that are
the result of bad luck rather than bad management, and that should give
them confidence to keep investing in the firm.
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