Introduction to Enterprise Risk Management
ERM: Learn what it is and how it can work in under 3 mins
Enterprise Risk Management (ERM) refers to the idea of risk management of an entity as a whole, rather than looking at its individual risk categories as standalone. That is, rather than treating Credit Risk, Market Risk, Liquidity Risk, Operational Risk, etc. as distinct areas, ERM is challenging risk management to think of them holistically.
To understand how any of this would work, we should refresh our memory of what the main different types of risk are.
Types of Risk
Credit Risk
Credit Risk is generally known as counterparty risk. That is the risk that your counterparties will not be able to meet their financial obligations and default.
Market Risk
Market Risk is the risk associated with losses derived from the movement of prices in the market. Market Risk includes things like Equity Risk, Interest Rate Risk, Currency Risk and Commodity risk.
Liquidity Risk
Liquidity risk generally refers to two different types of risk:
- Funding Liquidity: The risk that as a company, you will not be able to find the funds to meet your financial obligations.
- Market Liquidity: The risk that assets will not be able to be sold as there are not enough buyers in the market.
Operational Risk
The risk a business runs every day through the possibility of a mistake from an internal or external process, people and systems.
ERM in Practise
Traditionally, each area of risk would have its own management teams, processes, metrics, and reporting practises even though they all work for the same firm. This becomes expensive very quickly, as each area would attempt to diversify their own risks (through derivative or insurance contracts) without looking at the full picture.
To address this problem, a single person needs to have complete oversight of all different types of risk within an organisation. This person is generally the Chief Risk Officer (CRO), who reports both to the Board of Directors of the company as well as the CEO.
Having a single person with a cross-enterprise oversight will enable the board and CEO to align the risk appetite and strategy across divisions. This will allow the management of related risks and reduce costs. Further to that, operational surprises and losses will be reduced due to the broad oversight, which will also enhance risk response decisions.
Finally, by considering the full portfolio of risks, management will be better equipped to seize opportunities and improve the deployment of capital.
Sources:
- Committee of Sponsoring Organisations of the Treadway Commission (COSO)
- Foundations of Financial Risk: An Overview of Financial Risk and Risk-based Financial Regulation (Wiley Finance)
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