Question

Enterprise Risk Management. The enterprise risk management (ERM) framework was developed by COSO to provide managers a formalized methodology to evaluate risk in their businesses.

Required: Explain how management would use the ERM framework to manage business risk.

Answer 1

Business manages its risk either all together or separately. Enterprise risk management helps business to manage its risk in cohesive manner.

The process of setting ERM framework requires identifying the risk of the firm and developing a consistent method to assess the exposure of the firm’s risk.

Firm wide VaR analysis should be performed. The proper culmination of three risks broadly i.e. Market risk, credit risk and operational risk should be aggregated. The risk aggregation captures the risk interaction between all three risks and helps appropriately determine the risk capital requirements.

ERM framework helps business determine following:

1)      Business should be able to define its total acceptable risk and risk tolerance

2)      Taking risk into the view the firm should determine its capital buffer that would require to stand against the risk associated with business

3)      Capital buffer should be well defined because that plays major role in rating of the firm

4)      Desired or targeted firm’s debt rating is achieved when proper mixture of risk and capital is appropriately done

5)      Managers at different decentralized nodes should be given incentives for maintaining risk and capital trade off

Economic capital of the firm should be employed to earn appropriate return so that investor’s interest is protected. Firm should avoid to take such projects which multiplies the risk of the firm or bring firm to financial distress.