Enterprise Risk Management: Aligning Design Principles to Corporate Goals
As most financial institutions have taken steps to increase their firm's value creation and capital productivity, further business optimization will likely require substantial transformation of their organizational structure and operating environment. Implementing an Enterprise Risk Management (ERM) function properly integrated with key management processes is one critical task facing many firms.
The language of bank executives and asset managers has
converged significantly in recent years. And, while bankers are not yet
talking about Alpha and Risk Budgeting, aren't they referring to the
same concepts when they discuss Economic Value Added (EVA) and Required
Capital? Investors and competitors are pressuring both sides toward
performance optimization, forcing them to apply well-accepted laws of
finance, derived from the Capital Asset Pricing Model, with more rigor.
Risk-adjusted return has become the norm, and the market is increasingly less inclined to reward performance that doesn't exceed expected averages for given risk levels.
Risk-Adjusted Performance Management (RAPM) is not limited to Enterprise Risk Management (ERM), but it is generally recognized that ERM is the cornerstone of RAPM. To that extent, ERM could be defined as the capability to assess risks and control exposure at the business unit and enterprise levels, in a manner that supports the optimization of a firm's financial performance.
Effective management of economic quantities such as Risk-Adjusted Return on Capital (RAROC) and EVA requires a framework that includes, for example, an appropriate set of metrics and processes as well as a proper governance model. While the financial services industry has made substantial progress toward this goal, there is still a ways to go before economic management functions become fully effective in terms of enterprise optimization. Multiple challenges, conceptual, organizational and technical in nature, remain to be overcome.
Some challenges, such as reconciling measures across different time horizons, modeling risk preferences, or relating performance to business policy, may keep academics employed for many years. Practical implementations, however, will require the resolution of several pressing issues, generally through significant simplification. These include:
• Measurement and aggregation of
• Estimation and attribution of diversification benefits, and
• Reconciliation of economic and book values
In any approach to enterprise optimization, it is important to recognize that views and best practices will continue to evolve. Designing an operating environment flexible enough to accommodate these changes will alleviate future implementation costs.
In the recent years, most financial services organizations have appointed a chief risk officer, generally segregated organizationally from the chief financial officer. The distribution of roles and responsibilities between the risk and finance functions, as well as between those functions and business line management, remains to be optimally delineated. For many firms undertaking enterprise optimization, a new governance model will need to be implemented, grounded on new policies and a new culture.
Board directors and senior executives appreciate both the priority and degree of transformation required. As a result, several enablers and accelerators are attracting increased attention:
• Development of enterprise standards and terminologies
• Training and knowledge management
• Teaming and collaboration initiatives
• Internal communication
• Evaluation and incentive programs
• Change monitoring and benchmarking
• Specific change leadership functions
The success of ERM and RAPM will depend on the ability of financial institutions to manage these projects effectively.
For most financial services firms, a significant obstacle in their approach toward enterprise optimization is technical implementation. Financial institutions have not been designed to operate as a single integrated portfolio, and the huge legacy environment generally does not support cross-enterprise processes well. A large proportion of nearly all financial firms' IT budgets is devoted to the integration of siloed and heterogeneous components. Specific tasks, such as unifying the loan exposure or enabling consistent aggregation of client information, generally require extensive financial and staff resources. Because achieving enterprise optimization is a multi-year journey, today's choices of technology, methods and architectures will be highly critical to the firm's ability to ensure future competitiveness.
As implementation of the Basle II requirements recently highlighted, enterprise-wide projects require considerable resources, skills and management attention. Clear definitions and specifications are essential, as is the continuous monitoring of gaps between target and current states. For this, a robust program management framework is essential.
Implementing ERM is frequently seen as an extension of the Basle II effort, since Basle II:
• Enforces cross-enterprise
• Demands a substantial amount of information aggregation
• Requires the implementation of a number of governance processes
All of these attributes contribute to the development of a sound foundation for an ERM program.
Value in aligning risk and finance projects can be maximized through post-Basle project planning and incorporation of future requirements into the Basle II strategy. For example, Pillar II of the Bank for International Settlements (BIS) regulation can be considered a starting point for designing an enterprise-wide ERM program.
A vision unifying the four functional areas can help organizations reduce the overall cost of their enterprise functions and facilitate development.