Risk Management in Turbulent Times

By Gilles Bénéplanc; Jean-Charles Rochet | Go to book overview

PART FIVE
What To Do in Practice
Risk management is a well-established activity. It uses a wide range of sophisticated methods that have been elaborated slowly through a patient trial-and-error process. However, it is fair to say that these methods, and more generally the panorama of risk management, have changed dramatically over the last 20 years. A completely new methodology has emerged. Instead of managing each risk on an individual basis, risk managers now tend to adopt an integrated approach, called enterprise risk management (ERM).Chapter 3 has presented two important building blocks of ERM: risk mapping, which identifies, quantifies, and models the entire set of risks that threaten the entreprise, and risk allocation, which determines which risks are retained inside the entreprise (self-insurance) and which instruments (insurance, re-insurance, derivatives, securitization) are used to transfer to outsiders the risks that are not retained.Many books have recently been published that explain this notion of ERM and show how it can be implemented within large corporations. However, something important is missing from the picture: What are we trying to do exactly? What is the precise aim and purpose of risk management? How should we organize the governance around risk management, first with the Board of Directors but also between the head office and operating entities?The chief risk officer (CRO) of a large corporation is typically in a position to provide top management with a complete assessment of the risks that can impact the key accounting and financial variables of the corporation (such as earnings, economic value added, liquidity ratio, leverage and cost of capital,...). However, the precise implications for risk allocation decisions are not clear. Which of these variables are the best indicators of the firm performance? Which should be targeted by ERM? In other words, where should ERM go?The objective of the last part of this book is to try and answer these questions and explain where ERM should go. We provide the missing link between the powerful methodology of risk mapping and the sophisticated instruments of risk allocation. This missing link is our notion of shareholder value function (SVF), which was already presented in Chapters 11 and 12.Roughly speaking, a shareholder value function consists of two things:
A list of fundamental variables that summarize the firm’s accounting and financial situation: earnings, cash reserves, assets in place and investment opportunities, leverage, and cost of capital (or credit ratings).
A function that maps these variables into shareholder value. In other words, the SVF is a way to systematize the assessment that financial analysts perform when they try to predict the way stock markets will react to any

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