September 2012 Bermuda Re/insurance
53
W
e encounter risks each and every day as we pursue our daily
activities—crossing the road, missing an important meeting, making a purchase. While we cannot completely eliminate any potential risk, we can adopt appropriate proactive measures to help mitigate each risk, for example by purchasing insurance or having regular medical examinations. The way in which we view and control these risks varies from individual to individual—each of us has adopted our own philosophy or attitude towards risk-taking and decided, usually in an implicit way, our appetite to take on risk.
Further, our individual risk mitigation plans tend to be dynamic, changing regularly to reflect our current priorities, longer term goals and the dependencies which are implicit between risks. We automatically rank the risks which are most important to us and work to mitigate them as a priority.
The same concepts apply to the financial services industry. Enterprise- wide risk management (ERM), the process by which organisations identify, assess, control, exploit, finance and monitor financial and non-financial risks from all sources for the purposes of increasing the organisation’s short and long-term value to its stakeholders, has arrived. But why now? And why is ERM here to stay?
The carrot and stick: two essential
motivators Many hypothetical models and theories in the financial world, such as the Modigliani-Miller theorem of corporate finance, suggest that a firm’s value is not affected by capital structure choices or corporate risk management. However, firms are run by human beings and we are ‘bundles of desires and fears’.
These emotions are fairly easy to manipulate in an organisational
setting and the drive to develop an effective ERM framework is influenced by both push and pull factors.
Push factors Evolving and escalating levels of regulation
ERM is not a new form of risk management, it is simply a recognition that risk management means total risk management, not simply a subset of risks. This, in itself, is not a new concept. Risk needs to be viewed as a holistic group-wide issue with upside benefits and downside consequences. Financial institution regulations issued over the past decade or so reflect this.
It was back on June 3, 1999, that the Basel Committee on Banking Supervision issued a consultative proposal for Basel II. The proposal outlined a regulatory regime based on three mutually reinforcing pillars that allowed banks and supervisors to properly evaluate the various risks faced by banks.
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