Enterprise risk management

(ERM).

Enterprise risk management is the process of analysing and managing risk at the level of the business enterprise as a whole.

Examples of ERM

(1) Two divisions of a large multinational firm have traditionally been managed independently. Both have credit policies that are not considered centrally. It turns out that both share a large customer and management decides that the combined credit risk is too large for the firm.

(2) A firm operating in the transport sector is exposed to the commodity risk in fuel prices. While a response to this risk could be to consider it to be purely financial, an ERM view is to consider how selling prices might be adjusted to cope with the volatility in fuel prices, dealing with it as a financial risk over any short-term period. ERM takes into account both the commercial and financial dimensions, including competitive factors."

The Treasurer's Wiki, Guide to risk management.

Four co-ordinated stages

Enterprise risk management establishes co-ordinated risk management objectives with clear links to both the firm’s business strategy and to investor expectations. Using an ERM approach, all managers in the firm become risk managers and indeed risk management could be viewed as simply ‘management’. The treasurer’s speciality is managing financial risk, but crucially as part of the management team...

A very useful way to view enterprise risk management is to recognise four stages in reaching an approach to risk.

• Firstly, risk tolerance represents the amount of risk that the firm can actually bear. This could be represented by its capital, or by an amount of capital above a base amount of capital that cannot be put at risk.
• Secondly, risk appetite is the amount of risk that is actually desired. This might be seen in relation to the return sought by investors. Remember that reward is really only gained by taking risks, so limiting risk will limit reward.
• Thirdly, risk appetite leads naturally to risk budgeting, which is a way of setting out where risks in a firm should be taken. In treasury terms, we might see that if much risk is taken in the business model, then we need a very conservative approach in treasury.
• Finally this is documented in risk policy.

The Treasurer's Wiki, Guide to risk management.

Factors influencing the firm's attitude to risk

A firm’s attitude to risk will be influenced - amongst other things - by:

(1) The philosophy of the firm: Many firms are naturally more cautious, conservative and prudent than others, and will try to manage risks down to a lower level of exposure.

(2) The financial structure of the firm: A firm with high financial gearing (high borrowings) is more at risk to market rates (interest rates in particular, but other rates as well) and is more likely to take steps to reduce this and other risks than a more conservatively financed firm.

(3) The volatility of its cash flows: A firm with high operational gearing or operating in risky markets is more likely to take steps to reduce other risks or, put another way, a firm with stable cash flows can accommodate increased financial risk. This is largely based on the sector in which the firm operates.

(4) The expectations of the financial community, notably:

– shareholders; and

– lenders, including bankers, bondholders and pension trustees.

(5) The advice given by specialists in various areas.

(6) The stage of its corporate strategy: For instance, firms emerging from radical change such as an acquisition or a major capital expenditure programme will be reluctant to accept any additional risks for some time.

(7) The stage of product development, if one product dominates the firm. Thus, for example, an infrastructure or construction project has high risk during the construction phase as compared to the operating phase, similar to the introduction of any new product.

(8) The size of its risks in relation to some benchmark: e.g. the current year’s earnings or the three-year strategic plan.

(9) Natural hedges within its business.

(10) The behaviour of its peer group, as firms will compete not only at the product level but also at the investor level, vying for capital. It is unlikely that one member of a peer group will go too far out of line with all the others."

The Treasurer's Wiki, Guide to risk management.

See also

• Business risk
• Commercial risk
• Commodity risk
• Credit risk
• Enterprise
• Enterprise resource planning (ERP)
• Enterprise-wide resource planning system (ERP)
• Financial risk
• Guide to risk management
• Institute of Risk Management
• Multinational
• Natural hedge
• Operational risk
• Peer
• Risk
• Risk appetite
• Risk budget
• Risk management
• Risk tolerance
• Risk policy
• Volatility