ERM Chapter 2

Question 1

What are the key reasons for RM?

Answer 1

1. Benefit society by reducing contagion risk (the risk that a problem at an individual institution has an impact on the entire financial system).
2. RM is part of the job of management. Shareholders appoint board members to optimise risk/return decisions for them.
3. RM can reduce earnings volatility which can have several flow on benefits:
   - increase market value of the firm
   - improve the company’s credit rating
   - reduce the variability in employee costs
   reduce capital requirements
4. Maximise shareholder value. Having a knowledge of risk ensures that decision are made in light of risk information and better reflect the inherent risks. By undertaking activities that reduce the likelihood of losses and protects against their effects, the cost of capital is reduced and the risk/return trade-off improves to the benefit of shareholders.
5. Job security and rewards can be enhanced. As RM is a required competence it leads to greater job security. Further, the fact that company stocks and options are a growing part of remuneration packages means that increasing share values will increase their own value.

Question 2

What is risk appetite?

Answer 2

The amount of risk that a company is willing to accept on an ongoing basis.

Question 3

What is a company’s risk profile?

Answer 3

The types of risks that a company faces and its current exposure to those risks.

Question 4

What are the distinct benefits of ERM?

Answer 4

By embedding ERM into their processes, business performance is improved. Senior manage become more informed when making important decisions, leading to:
- a better understanding of risk exposure
- better comprehending the links between growth, risk and return
- better understanding of external factors that may impact the company e.g. interest rates
- assess more accurately the risk/return trade-off of a particular decision
- align strategy more closely with risk appetite.
A central ERM function can take responsibility for risk reporting across the whole company, ensuring they are reported in a consistent and appropriate manner to stakeholders, increasing risk transparency. This improves operational effectiveness by:
- coordinating RM activities across all parts of the organisation
- encouraging and facilitating the sharing of risk information
- identifying and assessing links between risks managed by different teams
- improving efficiency w.r.t. management time and business resources.
As a result, ERM can enhance business performance by:
- using and allocating capital more efficiently
- minimising losses and unpleasant surprises
- pricing, managing and/or transferring risks better
- optimising risk mitigation strategies e.g. natural hedges
- reacting more quickly e.g. seizing opportunities, detecting risks earlier
- deriving value from the time, effort and money spent on RM, rather than it being a box-ticking exercise

Question 5

What pressures might cause a company to start using ERM?

Answer 5

1. Previous management failures
2. A ‘near miss’ within their own organisation
3. High profile disaster in another similar organisation
4. Criticism or demands from a regulatory body or auditor
5. Concerns from (other) stakeholders