Enterprise Risk Budgeting: Bringing Risk Management into the Financial Planning Process

Article excerpt

Enterprise Risk Management (ERM) is a holistic, integrated approach to managing a company's risks, in contrast to the so-called "silo-approach" prevalent in many firms in which risks are managed independently of each other. Yet for all the risk exposures that are brought under the corporate umbrella in an ERM initiative, it may be inadequate for addressing the firm's aggregate risk in terms of the probability of failing to meet important corporate objectives, such as implementing the business plan or protecting debt covenants. In this paper we present a quantitative approach to risk management in the non-financial firm that retains the integrative, enterprise-wide mindset, yet also equips corporate management with the ability to evaluate financial distress-probabilities by incorporating ideas related to the concept of a firm's Economic Capital. We term such an effort Enterprise Risk Budgeting (ERB). ERB makes possible an ongoing reassessment of the firm's expected financial position and overall risk profile, and in particular how these change as a result of corporate policy decisions, for example relating to capital expenditure, acquisitions, dividends, and hedging. The transparency created by such a tool increases the likelihood that management makes sound proactive decisions with respect to its risk profile, rather than reacting to challenging circumstances once they occur. We illustrate using the experiences of Norwegian aluminium producer Norsk Hydro.

* One of the most significant trends in corporate risk management over the last decade is the rise of Enterprise Risk Management (ERM). ERM is about taking a holistic, company-wide approach to managing a company's risks, and aggregating information centrally in the organization regarding various different risk exposures.1 All relevant risks which have an impact on the future cash flow, profitability and continued existence of a company may be described as its Risk Universe. The main objective of the ERM risk mapping process is to describe and structure the Risk Universe and to assess the importance of the risk factors in terms of likelihood and impact, as well as to define risk mitigating actions and risk owners.

Embracing ERM means leaving behind the so-called "silo" thinking (hereafter called Silo Approach) related to risk management, where each category of risks is managed separately, normally by the respective departments responsible for that part of the business activity. In this regard one may argue that ERM traces some of its intellectual roots to portfolio theory, which expresses the idea that risks should be measured and managed on a portfolio basis, and that the risk of the portfolio should be balanced against potential rewards (Markowitz, 1952). The risk aggregation that takes place in ERM allows management to assess interdependencies between its various risk exposures and to take this information into account when developing risk mitigation strategies. Furthermore, the proponents of ERM argue that it can enhance shareholder value by improving the way a company trades off risk and opportunity. By systematically mapping out its risks and opportunities a company is in a better position to decide which risks to retain and which to do something about.

There is another key insight of financial theorists that has implications for the design of a corporate risk management program, namely the insight that financial distress entails various costly consequences and that any value from a risk management effort largely comes from avoiding such costs ("Corporate Risk Theory").2 Corporate management therefore has an incentive to assess the likelihood and severity of such outcomes. Following this line of thinking, we will use the term Total Risk to signify the risk that the firm fails to meet important corporate level objectives, such as implementing the investment plan, protecting debt covenants and maintaining a certain credit rating, or that it experiences financial distress, for example, in terms of having to make asset sales in a depressed market (asset fire sales) or difficulties in raising external funding. …