Module 2: Why (E)RM?

Question 1

5 Main reasons for managing risk

Answer 1

• benefits society as a whole (reducing contagion risk)
• it’s management’s job to make optimal risk-return decisions on behalf of the shareholders
• to reduce earnings volatility
• to maximise shareholder value
• to enhance job and financial security, especially for senior executives.

Question 2

3 Main practical benefits of ERM over traditional risk management

Answer 2

• improved reporting, transparency and understanding of risk
• improved organisational effectiveness
• resulting in improved business performance

Question 3

ERM programmes have typically been implemented in response to (4)

Answer 3

• previous risk management failures, or near misses in the company itself
• failures in other companies
• a regulatory requirement
• pressure from other stakeholders

Question 4

4 Advantages of reduced earnings volatility

Answer 4

More predictable earnings can:

• increase the market value of a firm (stock markets can react severely if earnings expectations are unmet)
• improve a company’s credit rating
• reduce variability in employee costs
• reduce capital requirements

Question 5

Why might companies that have adopted ERM experienced improvements in business performance?

Answer 5

This is due, in part, to senior management being more informed when taking important decisions.

This enables them to:

• better understand the organisation’s risk exposure
• better comprehend the links between business growth, corporate risk and return
• better understand the impact of changing external factors, such as interest rates
• assess more accurately the risk / return trade-offs of a particular decision
• align strategy more closely with risk appetite

Question 6

How can a centralised ERM function improve an organisation’s operational effectiveness?

Answer 6

By:

• co-ordinating risk management activities across all parts of the organisation
• encouraging and facilitating the sharing of risk information
• identifying and assessing links between risks managed by various teams
• improving efficiency (eg with respect to management time and business resources).

Question 7

How may ERM enhance an organisation’s business performance?

Answer 7

By:

• using and allocating capital more efficiently
• minimising losses and unpleasant surprises
• pricing, managing and/or transferring risks better
• optimising risk mitigation strategies (eg allowing for natural hedges between business units)
• reacting more quickly, e.g. seizing opportunities
• deriving value from the time, effort and money spent on risk management, rather than it being viewed as a box-ticking exercise.

Question 8

Define

risk appetite

Answer 8

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

Question 9

Define

risk profile

Answer 9

The types of risks that a company faces and its current exposure to those risks make up its risk profile.

Question 10

Define

contagion risk

Answer 10

The risk that a problem at an individual institution has an impact on the entire financial system.

Question 11

How might risk management benefit society?

Answer 11

Modern-day society relies on the banking and financial systems to operate smoothly.

Contagion risk is of particular concern.

Arguably, risk management can help to aid society as a whole by reducing this risk.

Question 12

How might risk management maximise shareholder value?

Answer 12

An understanding of risk ensures that management decisions, such as product pricing and allocation of capital, can be made in light of risk information and should better reflect inherent risks.

It ensures that the company undertakes activities that reduce the likelihood of losses and protects against their effects, eg damage to reputation.

This reduces the cost of capital and improves the risk / return trade-off to the benefit of shareholders.

Question 13

How might risk management enhance job security and rewards?

Answer 13

Risk management is a required competence for senior management and effective risk management is likely to lead to better job security (or, conversely, poor risk management is likely to lead to worse job security).

As company stocks and options are a growing part of remuneration packages, leading to many employees becoming shareholders, better company performance leads to higher personal rewards.