BFF5902 Lecture W3 S2 2018.pdf - BFF5902 Introduction to...

BFF5902
Introduction to Risk Principles
Lecture 3 – Risk Management Architecture

Learning objectives
2
1. Explain why firms manage risk
2. Explain the concept, benefits and trends in Enterprise Risk Management
(ERM)
3. Identify reasons for ineffective risk management
4. Explain the concept of risk architecture and discuss how it assists an
organisation to manage risk
5. Identify and explain risk principles and discuss how they relate to risk
management
6. Explain the purpose and contents of a Risk Appetite Statement
7. Explain the following concepts
• Risk capacity
• Risk tolerance
• Risk appetite
• Risk culture

Why do firms manage risk?

Risk management involves balancing costs and benefits
Accepting risk is necessary for a firm deliver on its objectives. Internal and external
factors create uncertainty.
The risk of failure in achieving it’s objectives (including remaining financially solvent)
carries costs that impact the firm’s value. Financial distress costs include:
Ø increased funding costs (debt and equity) and reduce access to capital thereby
restricting ability to invest in future profitable investments as they arise
Ø diversion of management attention, damage to reputation with customers and
stakeholders, failed investments and strategies, lost market share, poor trading
terms, fines and penalties, breaches of debt covenants, unexpected changes to
business plans and strategies, lack of flexibility and foresight to take opportunities.
However, the cost of performing the activity of risk management is significant for a firm:
Ø Direct costs of the risk management function (e.g. people, data and technology,
compliance, audit fees, reporting, etc.)
Ø Indirect costs arising from the limiting of some potentially profitable activities (i.e. the
opportunity cost of foregoing certain investments that are outside risk appetite)
4

Why do firms manage risk?
Under the assumption of perfect (i.e. “frictionless”) markets (including no financial
distress costs) there is theoretically no shareholder benefit to risk management.
BUT, in the real world of transaction and financial distress costs , the most compelling
argument for managing financial risks is that bad outcomes can lead to financial distress,
and financial distress can be very costly . Large companies have scale and access to
information and sophisticated risk management tools that individual investors do not.
When companies get into financial trouble, they lose their ability to carry out their
strategies effectively and find it more difficult and expensive to conduct their businesses.
As a result, the value of a company’s equity today is reduced by the present value
of the expected future costs of financial distress (remember that the share price
today values in future expected growth in earnings).