The Value of ERM

In prior posts, I have extolled the virtues of a professionalized, independent and comprehensive risk management function that ultimately rests with board of directors. The goal of this vision of Enterprise-Wide Risk Management (ERM) is the accurate disclosure of risk to investors which in turn implies that the enterprise is operated and governed in accordance with the risk profile supplied to investors. I have termed this the "Holy Grail" of corporate governance because this should avert the massive risk-mismanagement that drove all elements of the Great Financial Crisis of 2008 ranging from AIG's reckless gambling on subprime mortgages to the knowing predatory lending carried out by Angelo Mozilo at Countrywide. If the market had adequate disclosure of the true risks (including leverage) undertaken by firms like AIG, Countrywide, Lehman, Fannie Mae and others (see video above), then such activities would have led to the swift de-capitalization these firms and much of the crisis would have been short-circuited.

Yet, this fails to account for all the benefits of sound ERM programs. Articulating and managing the risks facing the firm, on a comprehensive basis, is apt to minimize net agency costs and enhance financial performance. Recent studies conclude that high-quality ERM programs enhance financial performance and firm value.

Thus, for example, a new study in the Journal of Risk and Insurance finds:

that the use of economic capital models [to measure insolvency risk] and dedicated risk managers improve operating performance. Requiring the dedicated risk manager report to the board of directors or to the chief executive officer (CEO) also increases value. The following combination of enterprise risk management initiatives yields the greatest increase in firm value: a simple economic capital model, a dedicated risk manager that is a cross-functional committee, and requiring the risk manager report to the board or CEO.

This paper is significant because it highlights the best ERM practices for unlocking enhanced value. For purposes of structuring corporate governance, the key finding is that a dedicated risk officer operating through a risk management committee that includes cross-functional expertise which has direct board or CEO access is associated with the most effective ERM programs in terms of financial performance. 

Another very recent study in Contemporary Accounting Research made a similar finding:

Using ERM quality ratings of financial companies by Standard & Poor's, we find that higher ERM quality is associated with greater complexity, less resource constraint, and better corporate governance. Controlling for such characteristics, we find that higher ERM quality is associated with improved accounting performance. Results show a market reaction to signals of enhanced management control from initial ERM quality ratings and rating revisions, and a stronger response to earnings surprises for firms with higher ERM quality. Focusing on the recent global financial crisis, our analysis suggests that there is no relation between ERM quality and market performance prior to and during the market collapse. However, returns of higher ERM quality companies are higher during the market rebound. Overall, results reveal that firm performance and value are enhanced by high-quality controls that integrate risk management efforts across the firm, enabling better oversight of managers' risk-taking behavior and aligning that behavior with the strategic direction of the company.

The empirical record has now clarified that ERM adds value, and firms that implement high-quality ERM programs outperform firms that do not. There is also growing evidence that firms with superior ERM capability weather crises better than firms with less ERM capability. The gains from sound ERM programs can boost firm value (measured through Tobin's Q) as much as 20 percent.

Of course, each firm has unique risks and therefore risk management needs. But the ideal ERM mechanisms are becoming clearer for larger firms or firms with higher complexity. Further, for sophisticated financial firms it appears that the steps the Fed and the OCC have taken to insist on greater ERM capabilities in the financial sector are backed by solid empirical data. Certainly improvements are possible, but the banking agencies are definitely moving in the right direction. All of these recent developments (new regulatory insights and new empirical data) should cause all public firms to rethink their corporate governance structures.

CEOs do not favor ERM initiatives because ERM necessarily limits CEO autonomy over risk management (and manipulation). Beyond that small group of individuals robust ERM initiatives mean more stable financial markets and superior corporate performance. Policymakers, judges, legislators and board directors should fully embrace ERM programs and encourage greater ERM capabilities.