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Enterprise Risk Management

ERM: The business case

Improved business results now are pushing companies in the direction of ERM

By Michael J. Moody, ARM, MBA

Enterprise risk management (ERM) continues to grab attention in the traditional business press and is gaining favor with corporate America as well. In addition, over the past six months, almost all of the major management consulting firms and some smaller specialty consulting firms have indicated a sharp increase in their ERM project work. Many also note a sizable backlog in ERM projects, while suggesting that ERM is attracting the attention of corporate executives and directors. However, there has now been a significant change in ERM’s strategic value.

For the past three or four years, Rough Notes has chronicled the overall ERM movement within corporate America. During that period, two facts have remained pretty much constant. The first fact was that the financial services sector, in particular banks, had been leading the charge with regard to designing and implementing ERM programs. And that fact remains true today. Banks are more committed than ever to the ERM process.

Changing focus

The second fact had been that regulatory compliance was the principal driver of the ERM movement. Once the Sarbanes-Oxley Act of 2002 (SOX) was passed in response to lax financial reporting and general corporate wrongdoing, increased pressure fell on risk management. SOX mandated that corporations know the risks that they faced and take appropriate action to deal with them. To be sure, there were a number of other factors driving the ERM movement, but it has, for the most part, started and ended with regulatory compliance. However, according to a recent study, that may be changing as the primary driver.

A recent benchmarking survey of banking risk management professionals completed by SAS, a leader in business intelligence software and services, provides some interesting results. The survey notes that, “the risk management market is currently very active both on the supply side (solution providers) and the demand side (financial institutions themselves).” The survey also points out that the awareness of ERM “has been growing in recent years and risk is now on every business’s agenda.”

The survey that included 339 financial service executives notes one remarkable finding: “Reaping business benefits now matches regulatory compliance as a key driver of ERM.” Obviously, this signals a major change in ERM’s overall strategic value and provides even more reason for firms to adopt the ERM model. Among the key business benefits that the survey participants noted most often are:

• Improved performance management
• Better risk based pricing and
• Reduced capital allocation and credit losses

The survey indicates that 83% of the participating financial institutions “view ERM as a strategic priority.” This overwhelming majority of respondents said that ERM has become “fundamental and on the critical path of their company’s business plan.” The survey also notes that the financial services industry sees ERM as a far bigger issue than a simple matter of regulatory compliance. In fact, the survey documents that today there is some “creative tension” between those individuals that follow a regulatory compliance-driven approach to ERM and those that follow more of a business case approach.

Additionally, the survey participants state that credit risk management remains the top risk management expenditure for their firms. The majority (78%) also view credit risk management as critical. And for the first time, participants expect significant and quantifiable economic rewards within 24 months if ERM programs are implemented. Included within the significant and quantifiable economic rewards they expect to obtain are a 10% reduction in the capital allocation for credit risks and a 14% reduction in cost-of-credit losses as a result of ERM implementation.

Based on this information, the survey authors went one step further and developed a model which illustrates the impact of ERM implementation based on the responses. The model was designed to project the cost savings from ERM implementation at a large, unidentified financial institution with $10 billion in regulatory capital allocation, of which $6 billion was allocated for credit risk.

Impressive results

In developing the model, the survey authors assumed that the financial institution would apply an advanced, systemic ERM program that would be supported by the management of the bank at all levels. Based on the survey results, the first improvement would be an immediate reduction in the capital allocation of $600 million. Then, by applying the standard 10% cost of capital rate, the ERM implementation would provide the bank with a net benefit of $60 million over 12 months. In addition, there is a credit risk cost savings as well. Assuming that the bank has a $1 billion annual credit risk loss as reported in its recent annual report, the bank would save about $140 million annually through the improved credit risk management portion of the ERM program. The combined savings from just these two areas would be in the $200 million per year range.

The survey clearly shows that financial institutions will be continuing to make meaningful investments in ERM. However, the survey also points out that there are still some roadblocks to an integrated approach to ERM. One of the conclusions that surprised some experts was that it appears that some respondents “may be overselling the short-term benefits (i.e., regulatory compliance) that can be expected from ERM in order to secure funding for ERM projects.”

However, they also note that, “fixation on a regulatory timetable may be obstructing progress toward more forward looking ERM.” The long-term economic rewards must also remain clear. As the survey points out, over the next few years, “financial institutions will be looking to get value from their investment” in ERM process and systems. The survey goes on to say that “the move from compliance to performance is fundamental to the future success of all ERM initiatives.”

Continue to struggle

Despite the progress in developing a long-term view of ERM, many firms continue to struggle with implementation issues. Another survey, the 2006 Oversight Systems Report on Risk Management found that companies are embracing the concept of ERM in greater numbers; however, implementation is not keeping pace. While the survey has documented the increasing interest by corporate America in a holistic approach to risk management, “it appears many critical elements of ERM are still not in place.”

Without question, executives are seeing the need for better risk management, the survey notes. But the real issue is the “gap between top management believing that their company employs ERM and the reality that they are not pushing ERM down through the organization with awareness and training.” The survey observes that while management is beginning to embrace the ERM concept, “the implementation and effectiveness are still in their infancy.”

Based on a wide variety of studies that have been completed over the past 12 months, there is little doubt that ERM has broad appeal within corporate management. The fact that executives are now beginning to associate performance-related benefits with successful ERM implementation is a critical element in further growth of the ERM concept. Despite this, regulatory compliance will also be closely associated with ERM and those goals must continue to be considered when designing an ERM program. *

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