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Enterprise Risk Management June 12, 2014 A.V. Vedpuriswar.

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1 Enterprise Risk Management June 12, 2014 A.V. Vedpuriswar

2 1 Objectives  Understanding risk  Getting the big picture  Taking a holistic view  Recognising human infallibilities  Being clear about our priorities

3 2 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

4 3 Ice breaker  What are the fundamental laws of Physics?  What are the fundamental laws of Economics?  What about Financial Economics?

5 4 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.

6 5 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?

7 6 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

8 7  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.

9 8 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.

10 9 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.

11 10 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

12 11 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?

13 12 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.

14 13 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!

15 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 14

16 S&P : ERM Maturity levels Maturity LevelDescription Weaklacks reliable loss control systems for one or more major risks. Adequatehas reliable loss control systems but may still be managing risks in silos instead of coordinating risks across the firm Stronghas 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 Excellenthas the same characteristics as a strong ERM program but is even further into the implementation, effectiveness, and execution of the program. 15

17 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. 16

18 17 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.

19 Three ways to manage risk  Fundamentally, there are three ways to manage risk.  Which are these ways?

20 19 Different approaches to managing risk Targeted financial instruments (Transfer) Modifying operations, (Hold) Adjusting capital structure (Buffer) Integrated Risk Management for the Firm: A Senior Manager’s Guide, Working paper by Lisa K. Meulbroek

21 Visualising ERM 20

22 Risks in P&C Insurance 21 Ref : ERM- An Insurance perspective and overview, Calandro, Fusler, Sansone

23 Risk Mapping 22

24 23 Preventable, Strategy and External Risks

25 24 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 seemingly- unrelated 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?

26 25 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

27 26 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.

28 27 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.

29 28 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.

30 29 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.

31 Effectiveness at managing different risks: Deloitte 2013 Risk Survey 30

32 Effectiveness of Risk management systems : Deloitte 2013 survey 31

33 Effectiveness of risk data strategy and infrastructure : Deloitte 2013 Risk Survey 32

34 Issues in Risk MIS : Deloitte 2013 Risk Survey 33

35 The most important risks faced by Corporates 34 Ref : Servaes,Tamayo, Tuffano, “ The theory and practice of corporate risk management”, Journal of Applied Corporate Finance, Fall 2009

36 Benefits of risk management for Corporates 35 Ref : Servaes,Tamayo, Tuffano, “ The theory and practice of corporate risk management”, Journal of Applied Corporate Finance, Fall 2009

37 Costs of risk management for corporates 36 Ref : Servaes,Tamayo, Tuffano, “ The theory and practice of corporate risk management”, Journal of Applied Corporate Finance, Fall 2009

38 The most important risk management products used by corporates 37 Ref : Servaes,Tamayo, Tuffano, “ The theory and practice of corporate risk management”, Journal of Applied Corporate Finance, Fall 2009

39 Measuring risk management 38 Ref : Servaes,Tamayo, Tuffano, “ The theory and practice of corporate risk management”, Journal of Applied Corporate Finance, Fall 2009

40 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.

41  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. 40 Credit and Market risks

42  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. 41 Market and operational Risks

43 42 Behavioral issues in Risk Management

44 43 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.

45 44 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.

46 45 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

47 46 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.

48 47 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.

49 48 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.

50 49 Risk Management vs. Risk Hedging: A summary Risk HedgingRisk Management View of riskRisk is a dangerRisk is a danger & an opportunity ObjectiveProtect against the downsideExploit the upside ApproachFinancial, Product orientedStrategy/cross functional process oriented Measure of successReduce volatility in earnings, cash flows, value Higher value Type of real optionPutCall Primary impact on valueLower discount rateHigher & sustainable excess returns Ideal situationClosely 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

51 ERM : Managing the upside and the downside 50 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

52 51 Competitive advantage through superior risk management  Information  Speed  Experience/Knowledge  Resource  Flexibility  Corporate governance  People  Reward/punishment mechanisms Ref : Strategic Risk Taking, Aswath Damodaran

53 52 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.

54 53 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.

55 54 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.

56 55 The Resource advantage  Having the resources to deal with a crisis can give a company a significant advantage over competitors.

57 56 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.

58 57 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.

59 58 People  When facing a crisis, some people panic, others freeze but a few thrive and become better decision makers.

60 59 Reward/Punishment mechanisms  A good compensation system must consider both process and results.

61 60 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 off- limits?  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

62 61 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

63 62 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.

64 63 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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