Why Play Safe if You Can Take a Risk and Manage it?
It is close to impossible for any firm to reduce risk to zero, so knowing how and why to manage it in advance is crucial. The factors which determine why firms invest valuable time and money in enterprise risk management, be they ailing structures in need of a boost or flourishing firms wishing to plan ahead for the challenges that growth presents? Any firm embarking on the process of implementing enterprise risk management (or “ERM”) practices is faced with a choice – the cost of such a procedure may not be welcomed by all but, on the other hand, integrating an internal control framework may reap considerable benefits in the long run.
The key is to be aware of the external and internal drivers of such an approach, in order to ensure that a fragile firm can make the necessary provisions to improve performance and that a firm on the up is sensitive to the extra challenges posed by expanding their activity. Firms of all shapes, sizes and financial health face this dilemma and so it is crucial to correctly identify not just the potential takeaways at the end of the process but also the necessary conditions in which ERM should be conducted in the first place. First of all, the DNA of the firm in question needs to be made crystal-clear.
External pressure, internal make-up
The willingness of a firm to embark on such a process is in part dictated by the nature of the external market. The global financial crisis has brought this into even sharper relief – firms want to send out a positive message to the markets but if those same markets are unstable then the temptation to make potentially risky investment decisions will diminish, unless the correct procedure is respected in order to anticipate less profitable scenarios. Risk management practices also shift, which may also dissuade firms from going down such a route. Regulatory pressure exists, especially in the more volatile financial and banking sectors, which goes a long way towards explaining why those particular sectors have been the quickest in embracing ERM in the face of external pressure to do so.
From a more internal perspective, there are a number of determining factors that will encourage a firm to properly integrate risk assessment and management before committing to new projects and strategies. The probability and expected costs of financial distress (meaning the firm’s evaluation of its ability to meet financial obligations) weigh heavily in the balance, as do the existence of growth opportunities, the level of R&D investment, its capital structure and market performance, and the level of independency of the governing board. These drivers of ERM have so far been overlooked in research circles, hence the extra need to test them empirically. The case of CAC 40-listed French firms is an especially good place to start. Given the generally conservative nature of French business, the impetus for ERM is more likely to come from within the firm rather than due to the general state of the external market.
Tracking the evolution of ERM
In order to explore the issue of why firms engage in ERM a recent study focussed upon a sample of 23 CAC 40-listed French companies, as well as analysis of 315 corporate news announcements identified by the Dow Jones Factiva database published by firms seeking to recruit first-time Chief Risk Officers and consultation of publicly available annual reports to identify firms initiating ERM over the period 1999-2008. The results were revealing not just in terms of the motivations behind and conditions in which firms adopted such practices but also the sectors where adoption of such an approach was the earliest and most prevalent.
On a sectorial level, the industries displaying the highest level of financial opaqueness and regulatory pressure (finance, banking and insurance) emerge as those to have embraced ERM to the greatest extent, along with the more technical and specialised areas of telecom, engineering and energy. The finance sector also proves to have been the quickest in taking on board such an approach to anticipating and planning for risk. ERM adopters are also characterised by being larger in size, have larger debt obligations, more volatile cash flows and stock prices and more independent boards, meaning that the CEO does not also chair the board of governors. ERM adopters also have high leverage, weak stock performance and profitability problems, suggesting that such an internal practice is good for businesses in rude and more fragile health.
Delving deeper into the issue
On a conceptual level, the study offers encouragement to firms of all types, whether they are going through financial distress or seeking to build upon recent success. However, the results also offer a cautionary tale in terms of internal set-up, so such a procedure is only advisable once firms wishing to go in such a direction get their house in order. Even in the case of ailing firms, the mere fact of engaging in ERM sends out a positive signal to the markets. However, what needs to be explored from now are the actual benefits of the proces
This article draws inspiration from the paper Why do firms adopt enterprise risk management (ERM)? Empirical evidence from France, written by Majid Jamal Khan, Dildar Hussain, and Waqar Mehmood and published in Management Decision Vol.54 No.8 (2016).
Dildar Hussain is an associate professor of Marketing and the programme manager for the MSc in International Luxury and Brand Management at Rennes School of Business, France. His research interests include franchising, strategic networks, entrepreneurship, and luxury and brand management.