Foreign Exchange Risk Management

By M. Isi Eromosele

Never before have global companies been so exposed to currency market volatility and the risks associated with it. As supply chains stretch around the globe, more companies are venturing farther into foreign markets, buying and selling goods in places long considered out of reach for all but the largest multinationals.

These international ventures often generate spectacular opportunities for business growth and financial prosperity, but they can also expose companies to significant and potentially damaging foreign exchange risk.

Currency Risk Management as Competitive Advantage

In an environment where currency fluctuations bear little discernible relationship to business fundamentals, profits can be wiped out in an instant and business models can be destroyed. The global landscape is littered with the remains of companies that failed to manage foreign exchange risk appropriately.

While most companies acknowledge the risks involved in doing business internationally, the positive impact that currency risk management can have on competitiveness is less often recognized.

The ability to effectively work across borders while avoiding currency-related losses can expand a company’s reach and increase profits substantially. A robust trading framework can provide a solid foundation for business success while positively differentiating a company from its competitors.

Primary Objectives

In order to achieve true effectiveness, a currency trading framework should be

designed with three goals in mind:

• Cash Flow Efficiency: Unpredictable and highly volatile cash flows can wreak havoc on resource allocation, dramatically lowering organizational efficiency. Increasing the predictive accuracy and accounting simplicity associated with the cycle of cash though a business can lower costs and substantially improve strategic planning efforts.
• Risk Mitigation: Vulnerability to swings in exchange rates can compromise profits and undermine a company’s ability to survive and succeed in new markets. Protecting the bottom line is absolutely crucial in ensuring that companies remain stable and sustainable in the long term.
• Opportunistic Market Entry: Exchange rate volatility represents both risk and opportunity. Few businesses are prepared to completely ignore the opportunities that can be captured when currencies move in a favorable direction and often leave themselves exposed to risk as a result. In order to survive changes in objectives and leadership, create a framework for executing trades at favorable levels, while keeping the organization protected against material risks.

Four Crucial Components of a Risk Management Strategy

With the global economy in upheaval, the only constant is change. Against this backdrop, building an effective risk management framework begins with envisioning a complete, integrated process.

A feedback loop must be created between business objectives and the tools and strategies used to achieve them, so that the organization continually adapts in response to evolving markets and circumstances. This cycle can be broken down into four essential components: 

Understand

Managing risk is impossible without having a clear picture of where exposures exist and the processes currently being used to manage them, if any.

Exposures: Broadly, there are three types of external currency risk that can materially

influence business performance:

• Transaction exposure is the simplest and most transparent – it is the gain or loss that can be generated when the exchange rate applied to cash flows changes. When costs or revenues are affected by currency fluctuations, the resulting unpredictability can damage many areas of the business.
• Translation exposures are more complex and occur when the value of a foreign asset or liability fluctuates due to exchange rate changes, resulting in a requirement to adjust balance sheet values. Translation vulnerabilities can create volatility on both the income and balance sheets.
• Structural exposures are those that may influence the very viability of a business model. If input costs rise in China over the years due to an appreciating exchange rate, does the operational structure collapse? If European sales become untenable, will the business survive?

Each of the above forms of risk can have substantial effects on earnings and sustainability. Traditionally, transaction exposures were the most commonly hedged, but the materiality of translation and economic vulnerabilities has increased in recent years as businesses have expanded internationally. The need for sophisticated monitoring and management techniques has grown exponentially.

Controls: After developing a picture of where exposures lie, it is important to look at the processes and strategies that are currently in place. Clarifying existing procedures for measuring and managing risk can help to identify areas of potential improvement. Mapping out the financial controls that are already in place is essential in determining where weaknesses may be present.

Objectives: If you don’t know where you’re going, you’re likely to wind up somewhere else. Interviewing internal and external stakeholders is often a good method for building an understanding of the risk tolerances and goals that should drive ongoing exposure management.

Lenders, investors and senior leadership often have differing perspectives, and these must be considered in order to avoid missteps. Of course, defining these objectives can be a highly subjective endeavor – performing a sensitivity analysis on earnings and quantifying these tolerances in terms of probabilities and percentages can be vital when building a robust policy framework.

Strategize

By ensuring that personnel are clearly accountable, processes are unambiguously defined, and strategic goals are well understood, a written policy helps to ensure that theory is translated into practice.

Formal policies vary widely in length and complexity, and the best are designed to scale up as the business itself evolves. While this process may sound time-consuming, a strong written document can be created relatively quickly and easily – particularly with the assistance of a foreign exchange specialist.

Ultimately, a risk policy simply needs to address four questions:

Why?

Defining the objectives of a currency risk management program can be tremendously beneficial for internal personnel as well as external stakeholders. The articulation of these goals in a written policy can be paired with ongoing education to ensure that all foreign exchange activities are aligned with primary business

objectives and risk tolerances.

When?

The more time that elapses between when an exposure is identified and when an offsetting hedge is placed, the greater the financial risk. Allowing subjectivity

into this process is one of the greatest sources of risk for the typical company.

Accordingly, specify the event that triggers analysis and establish the measurement process used to define and prioritize the exposure. Clear deadlines should be communicated, defining when exposures must be reported internally and when offsetting positions must be placed. Set out an exception process to be used when an issue occurs.

Who?

Without accountability, risk management theory never becomes practice. Clearly define functions and levels of responsibility within the organization while segregating duties so that appropriate financial controls can be maintained.

These roles and responsibilities should be assigned on a functional rather than individual basis so that procedures survive the inevitable personnel changes which so frequently derail otherwise sound policies.

Include personnel not normally considered financial decision-makers. Buyers, sales teams and executives often make decisions that carry foreign exchange implications. These decisions are a primary source of uncertainty, frustrating cash flow planning efforts and

often leading to substantial losses.

What?

Effectively managing currency risk requires using hedging tools in a disciplined and pragmatic manner. The strongest policies clearly name the set of financial tools that may be used by risk managers and describe the criteria to be used to judge their applicability in specific situations.

Applicable Tools

In general, currency risk can be managed in two ways: internally or via external financial hedges.

Offsetting exposures internally is unquestionably the most cost-efficient and effective method for lowering risk and should always be considered before resorting to external tools.

Netting an incoming cash flow against an outgoing one can sharply reduce the amount of currency exposed to exchange rate fluctuations without requiring entering into a financial instrument. Changing functional accounting currencies to better reflect cash flows is an excellent way to reduce the impact of foreign exchange on earnings.

Moving operations into a country where revenues are earned is often called natural hedging. Natural hedging can be an effective method for managing structural exposures, particularly when these operations support long-term strategic goals.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2012 Oseme Group

A Multifaceted Approach To Risk Appetite Management

By M. Isi Eromosele

The financial crisis that started in the summer of 2008 with a sharp devaluation of U.S. sub-prime mortgage assets has raised concerns about the effectiveness of financial firms’ risk management.

Several issues certainly deserve specific attention, including the effectiveness of exposure control processes, the objectivity of credit derivatives valuation and the ability of institutions to respond to rapid changes in market liquidity.

Risk management is difficult to define precisely, but may be adequately summarized as the analysis, control and mitigation of risk exposure in relation to specific business objectives.

Any business activity should deliver a return on investment (both financial and non-financial) that at least balances the entire portfolio of risks it is associated with. This concept of balance is essential.

Businesses need to focus on managing financial risk intelligently so that they can realize a profit commensurate with the level of risk. The goal, then, is to identify improvements that can be made to current management practices that can strengthen the risk-return relationship.

Risk Appetite

Typically, risk appetite is thought of as equivalent to risk tolerance. A more useful view of risk appetite, however, balances risk hunger against risk aversion and is multifaceted, taking into account several fundamental considerations.

Risk appetite reflects:

• The business strategy
• The expectations of stakeholders at different time horizons
• The characteristics of the risk-bearing entities
• The nature and characteristics of the risks undertaken
• The possible contagion of risk situations across organizational units, assets-at-risk and future time horizons

Risk appetite can and should be a key part of business architecture. Of particular note is that:

• Risk exposure results from the business activity. It has to be controlled from a solvency standpoint and it impacts the pricing of financial products.
• Risk appetite drives business activity. It combines anticipations in risk and profitability with management preferences to control capital and resource allocation as well as the distribution of exposure across activities and portfolios.

Business performance can be increased if capital and resources are allocated more effectively, reflecting the balance of risks and rewards in a more integrated and dynamic fashion.

In that respect, risk appetite can be considered the cornerstone of modern approaches to bank management, such as value-based management (VBM) and its various implementations.

Risk Appetite And Business Strategy

Any viable business strategy involves a series of tradeoffs that combine the assessment of uncertain business outcomes with the organization’s objectives and preferences. The parties involved in the formation of the strategy usually have different goals.

Any risk measure is not fully relevant if dissociated from its strategic context. Risk appetite is a critical consideration when evaluating strategic decisions, especially those concerning mergers and acquisitions, product portfolio and geographical expansion.

By contrast, using risk appetite as an input to drive transformational projects should be given a relatively lower priority. While organizational and operational design are part of the strategy, their relationship with risk and profitability profiles is less direct than for the other components.

Risk Appetite Should Reflect The Expectations Of Stakeholders

The recent credit crisis highlights a particular issue that has long been the subject of debate in business: How can both short and long-term performance be coherently managed?

Often, decisions made to address one are not compatible with the optimization of the other. Decisions are typically made in isolation, either for short-term or long-term horizons. Seldom are these time horizons being considered as a whole, which can lead

to sudden and unexpected risk exposure.

Risk measures, however, are by definition related to a single horizon, such as the expected holding period, the financial year, etc. Extrapolating them is generally difficult, making the implementation of multi-horizon management a particularly ambitious goal. Not surprisingly, few of the survey respondents are applying such practices consistently.

Risk Appetite Should Reflect The Nature Of The Risks Undertaken

Information about the magnitude of a risk alone is not sufficient to make decisions about risk exposure. Put it differently, two exposures with identical risk levels should be treated differently depending on the nature and characteristics of the risk involved.

The statement may at first sound irrational, but it simply recognizes the fact that practical

mathematical models do not capture all the complexity of event dynamics, nor do they leave room for human judgment and preferences.

A key consideration is the organization’s ability to offset, transfer or engineer the risk exposure, frequently referred to as risk liquidity.

The Role Of Risk Appetite In Risk Management

Risk appetite management can have an important role in correctly linking risk to business decisions.

Required economic capital, defined as the higher potential loss or depreciation that a business might face over a given horizon under a given confidence level, has emerged as the preferred normalized measure of risk. Matching financial resources to economic capital has become the centerpiece of the art of financial management.

Indeed, most organizations already have economic capital allocation processes in place, with most of them presently allocating capital across units, with sophisticated methods based on profit-and-loss correlation as well as marginal cost of risk.

However, the linkage between capital allocation and business decisions is not as effective as it could be. Efforts should be devoted to expanding the granularity of economic capital allocation post-event and leveraging Basel II infrastructures.

In the short term, institutions should implement appropriate policies and change programs to address:

• The responsibility of business units to estimate and disclose the comprehensive list of risks they are exposed to, as well as the connections between those risks and expected returns
• The inclusion of comprehensive risk indicators (short- and long-term) into financial plans and reports
• The deployment of a cross-enterprise enterprise risk management (ERM) framework that drives and facilitates adoption of risk-based management practices.

Risk Appetite Management

The management of risk appetite is practiced inconsistently in most companies, but it is being more widely adopted across organizations and its nature is evolving over time.

An important point concerns the granularity of risk management on an enterprise wide level. As far as allocation of economic capital management is concerned, there must be a moderate granularity of risk management for the three major dimensions of the business structure: organizational, portfolio and geographical.

Risk appetite is sometimes established top-down, but in most cases a mixture of top-down and bottom-up should be used. The unit of analysis can be a business or product line, a department or a portfolio.

Risk appetite has yet to be established at a lower granularity level. No common practice emerges when it comes to the frequency of analysis. Some organizations review capital on an ad-hoc basis, while others do it annually or even quarterly.

Recommendations For Managing Risk Appetite

For those organizations seeking to better integrate risk and finance management, risk appetite should be given a heightened emphasis. Risk appetite involves all of the “Three P’s” of total risk management: price, preferences and probabilities.

It cannot rely purely on conventional risk exposure metrics. Rather, it incorporates those into the broader context of bank management.

For capital and resource allocation to be effective, risk appetite should progressively be integrated alongside income, investment and expenditure in day-to-day management systems.

In such a model, the degree of cooperation between risk, finance and the business would be increased. It would in particular be:

• Continuous, rather than cyclical
• More adaptive, less normative
• Relying on an increased number of shared processes and databases

Multiple benefits could be derived from this approach. Capital and resource allocation would be better optimized (enhancing profitability as a result), alignment between risk and finance would be improved and difficult-to-quantify elements, as well as longer-term business assumptions, would be better captured through an enhanced dialogue between the parties involved.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2012 Oseme Group

Operational Risk: A Business Manager’s Mission

By M. Isi Eromosele

In today’s market, most financial services firms have a Chief Risk Officer or even more specifically a Head of Operational Risk. Few would argue that these roles exist as a means to solely satisfy regulators.

These roles are critical to protecting a firm’s earnings and reputation. In addition, many have found that having a solid operational risk strategy can deliver significant additional benefits.

Despite the importance of these roles, the day to day responsibility for operational risk does not lie with the CRO or Head of Operational Risk. These individuals are primarily responsible for promoting proper management of and measurement of the amount of operational risk across the organization. It is a firm’s Business Managers who control the resources that control operational risk.

Unfortunately, not enough Business Managers engage in formal operational risk strategies. As a result many firms face unnecessary threats to the successful achievement of their financial objectives.

This needs to be addressed. Today, global financial institutions face pressure to continuously tackle mounting regulatory change and growing market scrutiny while striving to increase customer confidence, drive competitive advantage, and optimize stakeholder value.

Paramount to their success is their Business Manager’s ability to accurately monitor internal processes and procedures to manage risks and business opportunities.

The Role of a Business Manager for Operational Risk

Business Managers play the most critical role in promoting a controlled risk culture. As a manager, they have an obligation to ensure that you and your staff are conducting business efficiently, honestly and fairly.

If your Business Manager does not keep this obligation, regulators can impose sanctions on the firm and individual staff members who have violated these requirements. Hefty damages, lost jobs and irreparable damage to the firm’s reputation may follow if you do not constantly pursue effective leadership and supervision.

Operational risk needs to be a priority in the management agenda. Business Managers have specific responsibilities that they must carry out in order to meet regulatory and fiduciary requirements.

A good operational risk methodology and management structure will promote appropriate behavior.

It is also important to understand that a management structure will need to complement the firm’s overall operational risk methodology. A good operational risk methodology should be collaboration between Operational Risk Managers and Business Managers to achieve well-considered risk assessments.

These assessments should be based on thorough research into all the risks which exist in each business unit, looking at the potential for a loss on a near term basis as well as a worst case basis.

This will also vary by organization as some may feel a more control based approach works for them, whilst others may believe examining risks and controls along processes is more in keeping with the way they consider things. This methodology will also likely include the usual questionnaires, scorecards, causal factors, etc.

How to Identify And Avoid Management Failure

Identifying and avoiding the potentially negative consequences of management failure or more importantly being a successful Business Manager takes a great deal of effort. One can considerably improve the chance of success by regularly reviewing the current management data and its structure and being knowledgeable about some of the common mistakes business managers make.

On a regular basis, Business Managers should examine and review their current management systems and execution, identify areas for improvement and make the necessary changes.

Critical to this review is the availability of timely, complete and reliable related data. Where in most cases the Risk Management team takes on responsibility for organizing, collecting and maintaining this data, it is the Business Managers who can extract real value from it.

Business Managers should be taking the lead in using this data to reduce losses by strengthening controls where necessary, perhaps stream-lining some processes after examination and consultation with internal audit.

More controls are not always the solution; simplifying processes can improve controls too in certain situations. In this activity, the Operational Risk Manager will prove an invaluable partner by doing nearly all the work leaving the Business Manager to do what they do best and that is make decisions based on recommendations.

There is usually a lot of data to be collected and kept up to date. In addition, this data needs to be analyzed and regularly reviewed. To maximize the benefits of this analysis, most mature financial firms should endeavor to rely on a unified computer system that gives flexibility to a manager to manipulate and analyze varied selections of related information.

This is very difficult to do when risk managers keep different Governance, Risk and Compliance information in spreadsheets or in different systems that were designed at different times with different architectures. This fragmented approach often produces data barriers across business units and leads to inefficient and costly maintenance and operations.

Firms that are able to readily access and use critical data across traditionally disparate business unit silos, will be able to increase their data integrity while more effectively quantifying, analyzing and measuring the effectiveness of their Governance, Risk and Compliance initiatives.

Having all this information in one, unified system that allows busy Business Managers to quickly see all the different types of risks and the state of controls in that part of the organization for which they are responsible enables them to make good decisions about whether changes are required.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2012 Oseme Group

Developing Risk Management Strategies For The Stock Market

By M. Isi Eromosele

A stock market is an investment platform where risk cannot be ignored.

In order to develop effective stock market portfolio management strategies, it is important to first gain a good understanding of what factors influence share price movements and to what extent.

Speculators monitor movements in economic indicators to decide whether to buy or sell stocks, bonds, shares, commodities, foreign currency and other instruments or goods traded in speculative markets.

In order for movements in economic indicators to be monitored, one needs to have some historical data on the indicators to use as a comparative base for new data. Different macroeconomic forces impact on each other and ultimately influence share prices.

Having gained an understanding of the fundamental analysis and technical analysis tools available for the investment portfolio manager, these tools should be incorporated into the risk management strategies.

These strategies include consideration of the macroeconomic factors likely to influence share prices, an analysis of which market sectors are likely to benefit from the macroeconomic environment and selection criteria for companies within those sectors.

These would be pro-active strategies to position the stock market investment portfolio manager in a reduced risk starting block with profit potential.

Buying and selling signals are addressed as part of the risk management  strategy, as it is important to remove emotion from the decisions made. Due to the cyclical nature of the stock market, timing of transactions cannot be ignored when developing these strategies.

Fundamental Analysis

The macroeconomic environment must be scanned to ascertain whether conditions are favorable for an increase in the value of shares as a whole. Thereafter, consideration should be given to how the forces in the macroeconomic environment are likely to influence the different market sectors.

Once the sectors most likely to benefit have been identified, companies within those sectors need to be evaluated on the basis of their financial soundness with the use of financial ratios.

Macroeconomic Environment

It is important to ascertain in which phase of the business cycle the economy is functioning, to gain insight into what is likely to happen with factors such as production and sales, exports, imports, interest rates, and inflation. These factors will all influence share prices because they impact on company profits.

Factors influencing balance of payments should be researched to enable the investment portfolio manager to anticipate changes in the balance of payments, so as to evaluate currency stability or predict changes in currency strength.

As a result of the varied impact on different market sectors, the risk management strategies developed need to address the risk associated with investing in a single market sector. Deciding that the companies selected for the investment portfolio should be representative of two or more market sectors can effect this.

It is important to ascertain which companies in the selected sectors are fundamentally poised to benefit from activity in the economic environment, and are most likely to show a positive movement in their share prices.

Different levels of reaction can occur from different companies in the same sector to influences on that sector. This may have been as a result of the traders’ perceptions of how much each company would benefit based on their fundamental position.

There is no relationship between market capitalization of shares and risk, as well as no relationship between market capitalization and trading frequency. Market capitalization will, therefore, not be considered as an influence on liquidity or risk and, as a result will be excluded from the selection criteria.

Price: Earnings (PE) Ratio

Price: Earnings (PE) ratio acts as a good indicator of the value of a company’s shares. If the projected growth in earnings does not justify the inflated PE ratio, then the shares are overpriced. If on the other hand a PE ratio is deflated, it could mean that the shares are under-priced, or that the company is perceived by investors to be in trouble.

Generally, a high PE ratio means high projected earnings for the company in the future. A company with a high PE ratio will have to deliver on the expectation, or its share price will drop.

A PE ratio of 40, for example, means that an investor would have to wait 40 years to see a return on investment. Historically, a desirable PE ratio is one that falls between 15 and 30. A company with a PE ratio of 30 has greater scope for a fall in the price of shares than a company with a PE ratio of 9.

In developing risk management strategies for stock markets, PE ratios should be used as a guide to the value of the companies’ shares. No numerical boundaries need be selected for the PE ratio.

Risk Exposure

Beta is a measure of the volatility of a share in relation to the volatility of the market as a whole. Beta gives the stock market investment portfolio manager an indication of how much risk as a result of volatility of the company’s shares they are exposing themselves to.

If a company has a beta of 5, for example, it has historically moved in the same direction as the market, but with five times the intensity. If the market surrenders 2 per cent of its value in one day, a company with a beta of 5 will historically have surrendered 10 per cent of its value on the same day.

These values are calculated using weekly data over a three-year period.

Return On Shareholders’ Funds

Return on shareholders’ funds is a ratio, which demonstrates the percentage return that the company has generated on the shareholders’ funds at its disposal. It serves as an indicator of profitability, which would result in a profit opportunity for the stock market investment portfolio manager.

Developing A Watch List

Once the list of companies has been developed based on the above-mentioned criteria, these shares can be monitored for buying signals. The watch-list should be updated whenever new selection criteria information or new economic data is available.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2012 Oseme Group

Financial Insights On Global Risk Management

By M. Isi Eromosele

In an uncertain world, the financial industry has stepped up its compliance regulations dramatically. So have individual governments.  The cost of failure is very high. The spotlight has fallen on the adoption of effective risk management practices.

Where credit and operational risks have always been traditional areas of focus, regulatory and reputation risks have come to the fore as potentially more damaging to financial institutions.

Financial institutions looking to implement an effective enterprise risk management system should first ensure that basic elements, which includes internal control policies, methodologies and infrastructure are in place. This will determine their ability to integrate all risk components down to the transactional level.

In addition, vulnerability to specific risks should be weighed alongside the probability of their occurrence. Responses would vary from merely tracking a risk and keeping it on the radar screen, to identifying mission-critical risks that would have the greatest adverse impact on the organization.

There are challenges involved in fostering a culture of risk awareness and getting management buy-in to increase risk budgets at financial institutions. After effectively centralizing their risk management functions, a critical success factor for financial institutions is to successfully position risk as a business driver. For a financial institution to effectively adopt a risk culture, supervisors will have to take responsibility and be accountable.

It is encouraging to note that, for the most part, financial institutions across global regions have taken a proactive stance towards risk assessment as they continue to plug the perceived gaps in their risk controls. There is ample evidence that regulatory and compliance issues have become top-of-mind for top management.

Risk officers, who are becoming increasingly empowered as a result, would do well to continue driving deeper engagements across various business units, which should in turn manage and maintain the risk they assume.

Many banks do not have extensive historical data and suffer from disparate systems, manual processes and missing or incomplete customer data. Unfortunately, risk analysis depends on a solid data foundation and financial institutions need to enhance the capture of robust data, reinforce data ownership rules and establish ongoing processes to track data quality.

Financial institutions can look to supplement internal data with external sources, either by establishing country data bureaus so that a critical mass of quality data can be developed and shared by industry participants or simply by purchasing vendor-based models.

Financial institutions are advised to utilize in-house development for proprietary risk models that would give them a competitive edge, while purchasing vendor-based applications for readily available and well-established solutions.

When purchasing such off-the shelf solutions, IT teams should verify that short-listed candidates offer risk products that effectively cover the organization’s existing portfolio, accommodate future updates and are basically in synch with the business vision.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2012 Oseme Group

Balancing Risk To Improve Performance Part I

By M. Isi Eromosele

Business is all about taking risks. Risk management aims not to eliminate disadvantage risk, but to control it at a satisfactory level. The salient reason for risk management is to establish, defend and improve a company’s value through the management of inherent uncertainties that could positively or negatively affect the attainment of the firm’s business objectives.

This often requires the establishment of an Enterprise Risk Management system.

As an organization grows in complexity as it serves manifold markets, it is faced with the challenge of fully understanding how its multiple business units interrelate with one another and as such, how business risk cuts across them.

Rather than managing risk within separate units, effectual risk management needs a holistic approach. The components of an advanced risk management program include:

• Concentrating on opportunities, obstructions and threats wholesomely
• Measuring the possible effect of recognized threats
• Ensuring risk clever decisions
• Enabling the firm to pursue opportunities while tackling obstructions and threats

In formulating an overall strategy on enterprise risk management, most organizations are confronted with the challenge of balancing two opposing goals: Set up a universal approach and put into effect a system for quantification, analysis and reporting of risk or sustain each business unit as they set up individual risk management rules for their respective areas.

In other words, organizations need to delineate between the needs of the entire firm and those of the individual business units.

At Oseme Finance, our recommended approach to designing a risk management solution is to deliver a flexible platform that would support enterprise-wide processes and requirements, while also concurrently meeting the specific risk management requirements of individual business units.

These diverse requirements are met through the creation of a common risk management base with robust capabilities, including risk and control management as well as incident and issue management. This solution will leverage a universal set of implements for audit planning and scheduling, risk assessments and surveys.

This unique platform methodology enables shared rules, work re-use, effectiveness and cost savings, while specifically supporting the unique needs, processes, information as well as security requirements of each respective business unit.

The unique platform and proprietary built modules will support specific initiatives within the firm, ensuring that each business unit can reconfigure these modules to fit their needs. This avoids the imposition of a one-size-fits-all approach that could reduce the value of specialized processes developed for individual risk requirements.

The major payoff for a firm in adopting a wholesome approach to risk management is the ability to discover the interdependence among the various risks inherent within the various business units that make up the firm. In the absence of such discovery, the firm would implement mitigating steps that could be based on false information and analysis.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2011 Oseme Group

Balancing Risk To Improve Performance Part II

By M. Isi Eromosele

To align and integrate risk management into its existing internal processes, a firm must establish a risk management framework and translate its guidance into tools and processes.

This would provide the firm with a better structure for risk identification and resource allocation in addition to efficient decision-making process. The Oseme Finance solution runs through five phases:

Phase I - Risk Context

The basic parameters within risk management are defined here and management perimeters are formulated by the risk manager. The key goal here is to ensure that the firm is wholesomely prepared to mitigate any series of risks that may be identified moving forward.

As such, within the risk context that is set up, a strict plan is set up to protect assets and/or systems that are vital to the firm’s business operations.

The risk context is set up to determine the risk criteria under which the firm would be assessed. Different levels of criteria would used to make decisions as to which kind of risk mitigation action would be needed for various business units within the firm.

Phase II - Risk Identification

Sources of risks and other negative events that may affect business operations are identified. Risk managers then identify risks by utilizing specific libraries of pre-defined risks associated with business functions within the industry the firm operates in.

Automated work flows are set up to authenticate proposed risks through appropriate review and approval channels. In order for the firm to identify its true risk profile, a wholesome top down approach to risk identification and tracking is formulated and put in place.

Phase III - Risk Analysis and Evaluation

The level of risk vulnerability is analyzed and the likelihood of potential damage is determined. User scalable qualitative and quantitative analysis models are used to score risk against context specific criteria.

Once risk is analyzed, the findings are evaluated, using comparison of the level of risk found during the analysis stage with the risk criteria that has been established when context was defined.

This exercise allows managers to ascertain which risks would need priority attention, enabling them to establish treatment priorities.

Phase IV - Risk Response

After the important risks have been identified, treatment plans are formulated for each one. This is a necessary proactive move that prepares the firm for whenever a risk incidence occurs.

This phase enables the firm to create an incident and response history. This is vital because widespread absence of historical data limits the applicability of data-driven risk diagnosis tools such as regression analysis or Monte Carlo solutions.

Phase V - Risk Monitoring and Review

Continuous reviews and evaluations are necessary to ensure the long-term relevance of the formulated treatment plan. Control indicators will act as early warning signals that serve as alarms to alert managers when risk events are approaching.

Unparalleled levels of instability and uncertainty in the business world exposes firms to a high level of risk events. Despite high levels of investment, many firms have failed in their attempts to predict the impact of risk on their business operations. It is time to try a new approach.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2011 Oseme Group

Dynamic Risk Management

By M. Isi Eromosele

Dynamic risk management involves a procedure which enables investors to adjust the risk profile of their portfolios based on clearly defined parameters. This procedure is particularly suited to institutional investors where success or failure of investment strategies can be succinctly analyzed.

As such, dynamic risk management procedures facilitate risk taking when the funding positions is within particular limits where risk taking is acceptable. However, when the financial scenario changes making risk taking less of an option, this dynamic process would slowly lower the risk outline of the investment strategy.

This is done by swapping out of risky assets into liability-matching assets to prevent the funding position from deteriorating.

Dynamic risk management procedures take place in many variable guises. The first is a one-way switching procedure where straightforward rules are put in place to sell risky assets and once sold; there are no recourse processes to reinvest in these risky assets if market conditions change.

A two-way switching procedure facilitates the sale of risky assets to be reversed.

An alternative recourse to the management of a switching strategy is the purchase of over-the-counter option strategy (OTC) through an investment bank. This arrangement calls for the bank to guarantee the payoff in all scenarios that may crop up during investment transactions.

In return for a premium, the fund is able to move the risk and governance overhead of managing the investment strategy to the bank. The result is dynamic replication which is a much more effective form of two-way switching.

This involves reproducing the expected pay-off by implementing an option strategy through trading futures, which are highly liquid instruments on a frequent basis.

The first step for a fund investment committee to overcome is how much difficult it is to take remedial action in real time as an unfolding financial situation occurs. One important issue to be resolved is the points (strikes) at which risk needs to be managed.

For an insurance fund which is subject to solvency requirements, the strikes may be well defined, but for a pension fund with a reasonably strong sponsored covenant, it may be less obvious where the strikes may be set.

Also to be considered are two key questions: Should the strategy be in put in place to work for the upside as well as the downside or just to protect the downside? Additionally, at what point should the strategy take effect or should the risk strategy always be operating in the background?

The size of the fund should have a bearing on how fast changes can be made to the risk strategy and this will have to be considered during the risk management design.

A derivative strategy may require the fund committee to sell the upside or pay a premium to also obtain downside protection. This provides more certainty in terms of implementation and desired results.

Dynamic risk management can be implemented in variable forms. To be successful, it is imperative for fund committees to reach agreement on certain crucial questions. It is vital to put a risk strategy in place that would help to improve the governance and decision making of investment committees.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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Calculating Corporate Risk Management

By M. Isi Eromosele

If a company suffers a cash flow shortfall, it is forced to use its liquid assets instead. Nevertheless, to carry such a buffer stock of equity capital is expensive. Through a reduction of risk, a company can lower the buffer stock of equity capital it requires to thrive.

As a result, companies face a tradeoff between equity capital and risk. This tradeoff needs to be quantified, enabling the firm to optimize it.

In a scenario where a company lacks an unlimited buffer stock of equity capital, a drop in the value of the firm leads to a state of affairs where the company will be unable to implement the projects that it needs for growth because of its financial constraints. Financial distress is a conditional circumstance where a firm has to give up positive net present value (NPV) actions because of financial constraints.

There are various degrees of corporate financial distress. For example, if financial distress is moderate, a company will be forced to give up only marginally profitable projects, but not projects requiring large NPVs. As the financial distress increases, the company will finally get to a state of affairs where it is unable to invest in new projects.

Generally, companies should focus on a shortfall level that they can control because exceeding that shortfall level will result in high negative costs for shareholders that would exceed the shortfall itself. For example, if that shortfall level is $200 million, a shortfall of $300 million decreases shareholder wealth by more than $300 million because it also costs the shareholders the loss of positive NPV projects.

Factually, a company cannot guarantee that it would never incur a shortfall that exceeds the threshold it has set for itself. As long as the company earns more than the risk free rate, it has to take the risk of having shortfalls. The company must trade off the probability of large shortfalls and the costs associated with them with the expected gains from taking or retaining risks to optimize its risk portfolio.

The level of resources below which a company is in distress is the financial distress threshold. This threshold would correspond to a level of capital below which the company is in financial distress. It is often instinctive for upper management to think of a bond rating below which the company is in financial distress.

Taking a company’s current rating into consideration, rating agencies data is used to estimate the standard probability of its achieving its desired ratings. Such a probability may be too high for some companies and too low for others.

Ratings are good proxies for estimating a company’s financial health. As such, a company can use a rating agency transition matrix to estimate the amount of capital it would need for a given level of risk. The transition matrix identifies the regularity with which companies are moved from one rating level to another within a specified period of time.

Analysis and management of probability and probability of downgrade should be done in separate and related frameworks. Probability of default is anchored to a company’s target ratings and the corresponding default history. Probability of downgrade is influenced by the management of risk concentrations, such as natural disasters and equity markets.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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Compliance And Risk Management In Global Finance

By M. Isi Eromosele

In global finance, compliance and risk management is always in constant fluctuation. As such, risk managers need to understand current risks as well as developing ones. One of the key challenges for risk managers is developing the ability to define the full extent of the risks that their respective organizations face and how they should manage these risks.

A new approach to risk management is clearly needed that brings compliance and other risks into a structure that enables upper management at financial firms to measure, prioritize and manage them effectively and efficiently. Such an approach requires that the full spectrum of risks within the institution be taken into consideration.

In order to be most effective and successful, defining compliance and risk management must be done through an enterprise-wide approach. As of now, risk management in many financial firms is till a work on development. Only 40 per cent of financial firms have established concrete risk management programs. Many have considerable work to do in reaching Basel II standards. Even more telling, only 25 per cent have capable operational risk management systems in place to report and gather data.

An enterprise-wide approach to risk management does pay dividends. During periods of market instability, financial firms that had established enterprise-wide management systems outperformed those without one. Given the recent global financial recession, financial institutions are under increasing pressure to exponentially improve their compliance and risk management abilities.

Compliance

A narrow definition of compliance management would be compliance with all rules and codes of Basel II or the Bank Secrecy Act. Conversely, a broader definition would include compliance with all external and internal regulations and requirements. It might also include separation of roles and responsibilities concerning banks systems, encompassing operations and technologies.

A typical structure for risk management in a financial institution would include a single risk manager, the Chief Risk Officer and each division over which compliance risk management extends would have their own respective managers. This traditional approach often results in a fragmented process that usually leads to considerable gaps in the compliance and risk management performance.

Risk Management

Risk Management has undergone profound change within the past decade because of the following drivers:

• Extraordinary growth in the number and complexity of risks
• Continued consolidation and diversification of banking institutions
• Continued globalization of the industry
• Greater scrutiny by government regulators
• Heightened business unpredictability with systems repercussions

The above factors make the identification and measurement of risks more difficult within the global financial industry. Meanwhile, they accelerate the exposure and effects of unforeseen developments on financial institutions.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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Integrated Compliance In Global Finance

By M. Isi Eromosele

The current financial environment should definitely place compliance and risk management at the forefront of global financial markets. Well applied new regulatory rules will force financial institutions to reevaluate their lackadaisical compliance of existing compliance regimes, most of which failed to keep pace with ever rising levels of risk. There is absolutely a need to create and implement a new approach to enforcing regulatory compliance at a global level.

Some new regulatory schemes are imminent. New measures have been proposed by the Basel Committee on Banking Supervision that involves new measures for stronger risk protocols and improved procedures for valuing and disclosing assets, including the capital treatment of complex structured products.

The Institute of International Finance has made recommendations for improvement in risk management practices based on analysis of leading banks and securities firms, while the United States Treasury has recommended the overhaul of the U.S. regulatory structure. It is to be expected that as new regulations and requirements are put in place, the cost of compliance will continue to grow. Conversely, the cost of non-compliance will definitely be much higher.

Today, global financial services institutions manage compliance is a disjointed manner. This has resulted in redundancy, overlap and increased cost to the firms. Financial organizations tend to comply with jurisdictional regulatory orders rather than globally coordinated ones. This kind of cherry picking needs to stop.

Additionally, compliance management at these financial institutions is typically handled outside the traditional risk management process. The result is a fragmented approach that separates the management of compliance risk from management of other risks.

The above inefficient process is further stressed by the high cost of compliance for many financial institutions, which continues to grow. Regulatory compliance costs for larger U.S. financial services companies increased an average of 130 per cent between 2003 and 2008. For these same firms, regulatory compliance management costs between $200 million and $400 million a year. With these high levels of cost, any kind of savings would be significant for these institutions.

Financial services institutions need to increase the effectiveness of their compliance management, thereby reducing their costs. They can achieve this by simultaneously streamlining their compliance and risk management, while taking a risk-based integrated enterprise-wide approach to compliance.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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Global Role of Risk Management Part I

By M. Isi Eromosele

The role of risk management within global corporations has considerably changed in recent times. During the past decade, global corporations have factored in extra kinds of risks. These include operational risk, reputation risk and strategic risks.

Corporations can manage risks in two basic ways: one risk at a time or take a holistic approach where all risks are managed collectively. Corporations that manage their risks holistically tend to develop a long-term competitive advantage over those that manage theirs individually. For the holistic management of risks to be successful, the following overarching actions must be taken:

• Establish a process that measures the risks systematically throughout the enterprise
• Synchronize incentives for employees to achieve excellence in performance

When properly implemented within a global corporation, Enterprise Risk Management (ERM) produces value both at the worldwide level as well as the local corporate level. At the worldwide level, it enables the corporation to assess their risk-return tradeoff, guiding them to better utilize and manage the resources they have towards achieving their corporate business objectives. The benefits of implementing enterprise risk management at the local corporate level include the integration of risk management policies into the culture of the corporation. This helps to increase productivity and efficiency within the firm.

The value of a firm depends on its total risk. Cash flow is an important element of maintaining liquidity. When a corporation’s cash flow shortfall is too large, it affects the financial market’s expectation for its future growth. This would usually result in the lowering of the company’s market value.

A cash flow shortfall means that the corporation has inadequate funds in hand to implement forward looking strategies. It would have to either raise supplementary funds or reduce the scope of its planned strategy implementations. Raising added funds is expensive. If the firm has adequate debt capacity, it can issue debt.

However, acquiring debt to fund cash flow shortfalls is also very expensive. If the corporation possesses the best possible amount of influence preceding the shortfall, it has the option to raise mixed equity and debt to maintain the best possible amount of financial leverage. Firms that are forced to take the above actions sacrifice future growth and profits.

Through the appropriate management of risk, a corporation can anticipate and forestall the likelihood of financial shortfall that would inevitably affect their cash flow. A good way to achieve this is through hedging, which can help them eliminate their exposure to various risks in a cost-effective way. The firm could implement a foreign exchange hedging plan by using forward contracts, which would incur low transaction costs.

It is imperative that a corporation hedge the economic risks it faces if there any possibilities that it would encounter cash flow shortfalls which could force it to abandon planned growth projects. While the firm incurs little costs in hedging its risks, it raises the likelihood that it will be able to implement all of its development and growth schemes.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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Global Role Of Risk Management Part II

By M. Isi Eromosele

As they conduct global business, corporations are open to many risks. These are risks that they cannot pass onto the capital markets of risk transfer markets. A corporation that decides to expand its global market cannot hedge its risks cheaply because of the risks inherent in its expansion plans. The firm would be expected to have excellent knowledge of the risks involved in its plans. However, if it looks for a way to hedge those risks, the costs would be elevated as possible counterparties seek to be compensated for creating models to assess the risks they are expected to hedge.

Typically, insurance companies do not provide contracts that offer total coverage for shortfalls in earnings. It is assumed that the insured firm, who knows all about the distribution of its earnings, could influence the spreading of the earnings to raise the value of the insurance policy. In the process of taking business risks, a corporation faces the possibility of cash flow shortfalls that could affect the implementation of their future plans.

Every corporation faces risks that are unique to them and specific to the industry they are in. As such, it would be difficult for them to decrease their contact with these risks. This makes it very important for the corporation to avoid risks that are not relatively exclusive to their business or industry. This would enable them to more focus on the complicated risks and tough to hedge business risks they may face.

As the risks to be hedged become more relative to the corporation, the costs of hedging them are elevated higher. On a global project, a corporation can hedge the exchange rate risk in their exposure to foreign exchange currency receivables. It is considered a commoditized transaction to hedge against Euro receivables.

In costing total risk management, a corporation has to create a risk-return tradeoff. To implement a large scale project, for example, it would have to be highly profitable in order to pay for the elevation in total risk hedging. All the decisions made during the project must be assessed on the basis of the established risk-return algorithms.

Establishing the process of risk-return assessment corporate-wide can be achieved by three methods:

• In measuring total risk, the corporation must ensure that all substantial risks are thorough evaluated. If a sub project is to be implemented, its impact on the main project in terms of material risk would have to be thoroughly assessed. A project’s return relative to minor risk to the corporation will engender the best possible results. The assessment of risk and return must be carried out in totality in regards to the entire project, not merely at the specific project level.
• If a centralized assessment organization is set up within the corporation to scrutinize the risk-return on every project, the process will literally grind to a halt. Flexibility has to be the rule of the day here. Every business unit within the corporation should be given the autonomy to factor in risk-return tradeoff in its project implementations. This facilitates smooth, fast and efficient implementation process that would ultimately benefit the corporation and its shareholders.

• The performance input of every business unit to the overall corporate business goals has to be taken into consideration in assessing total risk to the corporation. This provides the factual financial accomplishments of each business unit. Additionally, it provides incentives to business unit managers to succinctly focus on managing the risk-return tradeoffs and avoid taking other overly unnecessary risks.

The implementation of the above actions is imperative to the success of a corporate wide risk management programs. Collectively, they facilitate collective responsibility for assessing project risks to avoid starting projects that could turn out to be a disaster for the firm. When all corporate staff is made to feel that they own part of the risk, they are more liable to make the program a success for the corporation.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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Global Enterprise Risk Management

By M. Isi Eromosele

All organizations are in the business trying to make profit by placing capital at risk in building global ventures. They are all in pursuit of strategic goals and they allocate valuable resources in trying to achieve them. Because these organizations face a certain level of uncertainty in achieving their respective goals, they all face risk.

Enterprise Risk Management is about optimizing internal processes to mitigate the possibility of catastrophic losses as a result risk occurrence. Leverage does not only magnify market risk. As margins for error contract, other risks increase, including credit risk, liquidity risk, operations risk and legal risk. Organizations need to focus on all these. Through enterprise risk management, they should seek comprehensive solutions, not because the problem is new, but because the consequences of failure can be enormous.

Organizations should embrace enterprise risk management because it makes good business sense. Among other actions, they need to change the way they take risks. They need to implement new innovative procedures. They should install new technologies. They should actively realign their corporate culture to facilitate better risk taking.

There are three fundamental components that comprise any risk management strategy:

• Corporate culture
• Procedures
• Technology

Corporate Culture

An organization will manage risk only if its staff wants to manage risk. While regulators can mandate a bank to install a value at risk system and require an insurance company to implement hundred of pages of new procedures, they cannot realistically force these institutions to effectively manage the systems. It is individuals who decide whether or not they are going to manage organizational risk.

While individual initiative is crucial, it is the corporate culture which facilitates the process. Corporate culture defines what behaviors the members of an organization will condone and which they will ignore. Corporate culture plays a critical role in risk management because it defines the risk which an individual must personally take if they are going to help managing organizational risks.

Procedures

The purpose of procedures is to empower people. They specify how people can achieve what needs to be done. The success of procedures depends critically upon a positive risk culture. Hundreds of pages of procedures are useless if no one use them. Even a simple set of procedures can make a great difference for an organization if people believe in them and take personal responsibility for upholding them.

Procedures make a system out of the process of risk management. Consider market risk management. They are a form of procedure which regulates oversight of trading risk. They are explicit in stating how much risk is to much risk for any given segment of a portfolio. Every organization should supplement regulatory procedures with their own procedures that embrace a process of risk optimization.

Technology

For many organizations, such as banks, investment management firms or insurance companies, technology is a critical component of any risk management initiative. Technology can impact how people work and interact with one another. Technology can reshape corporate cultures and facilitate innovative procedures. The major area where technology comes to the fore in risk management is in data aggregation, where information flow is controlled.

Today, technology makes it possible to effectively communicate information  across desks, departments and globally in real time. This technology solution is data aggregation.

Risk management oversees and ensures the integrity of the process with which business risks are taken. To maintain objectivity, risk management cannot be a part of the risk taking process. Enterprise risk management should be viewed as an ongoing process which needs continual oversight, planning and modification as needs evolve.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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Governance Risk And Regulations Compliance In Global Banking

By M. Isi Eromosele

Global financial institutions view regulatory compliance and risk management as unnecessary expenses. As such, they often take on a method of meeting the minimum requirement stipulated under the law. This is a serious miscalculation. Rather, financial institutions should strive to make enterprise risk management a source for achieving competitive business advantage. To attain this, the institutions would need to continuously assess their business processes. By making these processes more well-organized and effective, these organizations would enhance their capability to implement strategies that would increase shareholder value.

In meeting the demands that regulatory and risk management rules require, a strategic approach is needed that balances conformance with performance. Done appropriately, this would engender the attainment of short-term and long-term business benefits for these institutions. A Capability Model, which would include people, processes and systems, is the centerpiece to achieving these benefits. Inherently, a flexible and adaptable framework would be formulated to incorporate disjointed systems, weaving end-to-end processes into a seamless one, enabling company-wide strategies to be implemented with greater efficiency.

Regulatory compliance has always been a thorn on the side of financial institutions. These regulations have become more complex, with non-compliance resulting in financial and criminal penalties. As such, it is imperative for the top management at financial institutions to realize that their firms’ reputation and value is closely aligned to their compliance with these regulations. Because of lax compliance, many institutions have had to conduct restatement of financial results, which can lead to lost value.

The stakes have been raised with the promulgation of new regulations and financial executives are aware of serious consequences related to illegal and unethical business conduct. It is vital that these top executives strive to set up compliance objectives within their institutions backed up with strict written policies. An appropriate tone and culture should be encouraged within each financial firm which would ensure that all employees understand the importance of compliance with financial and risk management regulations.

Banking

The assessment and identification of risks have been a long term activity within global banks. However, they are facing increased challenges, including that of aggregating these risks. Risk is not uniform among the multiple units in a bank. The risks present in retail banking are different from that inherent in investment banking. These necessitate the implementation of a flexible enterprise wide risk management system that could meet the requirement of each financial sector unit while meeting the needs of the entire institution.

The global banking environment is a dynamic one where business processes constantly change. With this in mind, institutions have to set up systems that will enable them to constantly monitor, measure and manage these processes. There will be no more instances of business units dealing with compliance in isolation. This type of decentralized compliance model added complexity to meeting compliance requirements and wasted resources through excessive duplications. With disparate systems that did not communicate with each other, banks could not obtain reliable and properly merged information that identified where risks are present across the organization.

Financial institutions, including banks need to adopt a centralized compliance and risk management system that is more flexible, adaptable and efficient in enabling them to comply with present and future regulations. This would be more cost effective because key components can be reused across the enterprise.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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Determining The Right Amount Of Corporate Risk Management Part II

By M. Isi Eromosele

A firm should maximize its shareholders’ wealth by targeting an A agencies rating. Equity capital provides a financial buffer that absorbs adverse shocks, forestalling a company’s default. For any company, a probability of default corresponds to the level of equity capital. As such, as the company chooses a specific level of equity capital, it selects its possibility of default. A company with an A rating has a probability of default of 0.16 percent during a one year period of time. To achieve that rating, a company must have enough capital to maintain its default probability at 0.16 percent. If the company defaults, all of its equity will be burnt up. As such, the probability of default provides a company with a way to determine the amount of equity to have in light of its current risk.

The probability of default is usually a complex function of a company’s individuality, including its amount of equity. A company will become bankrupt if the it’s value at the end of a fiscal year falls below a set threshold level. Subsequently, the company would need a certain amount of equity capital to forestall the probability of its value falling below the 0.16 percent threshold. If that percentage corresponds to the principal amount of the firm’s debt plus interest due, then the amount of equity capital the firm would require is an amount such that there is still a 0.16 percent chance the company value will fall by more than this amount, give the risk it is currently carrying.

It is possible for a company to go beyond a particular rating threshold. First, it should identify various scenarios that are considered expensive to the company. These components could include volatility of earnings and capital and other key risk indicators that may not materially influence ratings but affect the overall risk and ultimately, the necessary level of capital. Target probability levels should be set for these scenarios and acceptable tolerances identified. The company can then manage its volatility risk to maintain the probability of the various scenarios at the set probability levels.

At the end of this process, the company could find that its present company value volatility requires it to have an equity capital of, say $8 billion to achieve its target probability of default. It needs to be stated that reducing risk has costs. A company’s decision to reduce risk through hedging will have it incur hedging costs. If the company seeks to reduce risk through the elimination of certain projects, it gives up projected profits forecasted to result from these projects.

Equity capital also has its costs. To acquire less equity, a company could increase its leverage to benefit from that increase. A decrease in equity capital may increase the shareholder value because they would be less exposed to the possibility that the company could use its equity capital to finance poor investments. At the margins, the company has to be oblivious to choosing between decreasing risks and increasing capital. This approach to risk management would enable the company to assess the possible impact of risk of default and financial distress on projects. As project risk increases, the company would require more capital to hold up the risks. The cost for additional capital is a measure of how the project contributes to the company’s total risk.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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Determining The Right Amount Of Corporate Risk Management Part III

By M. Isi Eromosele

The capital required to hold up the contribution of specific actions to the risk of the company is a measure of risk. This measure of risk can be measured across actions or across risks. Strategically, the company will need to decide on the issue of the probability of financial distress that maximizes shareholder wealth. This decision influences all the actions that follow it.

At a conceptual level, Enterprise Risk Management (ERP) is clear-cut. Implementing ERM is very challenging. To successfully implement ERP, it is imperative that it be driven into the organization that Enterprise Risk Management will create value. Employees should be made to understand risk management is a significant instrument that would enable the company to better implement its business strategy. Subsequently, ERM needs to be successfully sold to all levels of the organization.

The cornerstone to implementing ERM is the identification of the risks the company is exposed to. These risks would be categorized and measured. There will be a focus on market and credit risks as well as operational risks. Financial institutions would need to classify risks into market, credit and operational risks. In order for this scheme to be successful in catching all the risks the company is exposed to, operational risk has to include all risks that are not associated with market or credit. For financial institutions, operational risk as defined in THE Basel II Accord is a lot thinner in scope as it does not include reputational risk. As a result, there will be a conflict between the measurement of operational risk for regulatory purposes and the measurement of operational risk from the ERM viewpoint.

Companies could advance beyond simply measuring market, credit and operational risks. Companies should also measure liquidity, reputation and strategic risks. In general, risk measurement has to be customized to the organizational uniqueness of various industries and their respective marketplaces. Evaluating risks in banking does not correspond well to the risks faced by insurance companies. Insurance companies face risks on their assets area - their investment portfolio as well as on their liability area, which represent insurance payouts they may never have to make.

Enterprise risk management creates values for company shareholders, despite the practical issues that arise during its implementation. In the past, a lot of inordinate notice had been paid to the measurement of tail risk. A better process requires a more complete understanding of the distribution of the company’s value. The implementation of enterprise risk value has made a great deal of progress in the past decade, benefiting companies and their shareholders. It is time to take it to the next level with implementation improvements through better understanding corporate risks, thereby increasing gains for companies as well as shareholders.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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