ABSTRACT
We study the effect of adoption of enterprise risk management (ERM) principles on firms’ long-term performance by examining how financial, asset and market characteristics change around the time of ERM adoption. Using a sample of 106 firms that announce the hiring of a chief risk officer (an event frequently accompanied by adoption of enterprise risk management), we find that some firms adopting ERM experience a reduction in earnings volatility. In general, however, we find little impact from ERM adoption on a wide range of firm variables. While our results could be due to lower power tests, they also raise the question of whether ERM is achieving its stated goals. Overall, our results fail to find support for the proposition that ERM is value creating, although further study is called for, in particular the study of how ERM success can be measured.
Enterprise risk management (ERM) is an increasingly popular strategy that attempts to holistically evaluate and manage all of the risks faced by the firm. In doing so, ERM uses the firm’s risk appetite to determine which risks should be accepted and which should be mitigated or avoided. While there has been a considerable increase in practitioner attention on ERM in recent years, little academic research exists about ERM, and in particular about the consequences of ERM on firm performance. This is true even though the Conference Board has found that a large number of companies are now starting to use ERM as a strategic management tool (Gates and Hexter, 2005). In addition, Standard and Poor’s introduced ERM analysis into its global corporate credit rating process starting in the third quarter of 2008 (S&P Ratings Direct, 2008).
This purpose of this chapter is to examine the effect of ERM implementation and to establish whether firms adopting ERM actually achieve observable results consistent with the claimed benefits of ERM. Put another way, we seek to establish whether ERM works in increasing firm value and performance. We believe that our work is important and timely because although many surveys have stated the benefits of adopting ERM (Marsh and McLennan Companies, 2005), there has been little empirical evidence on how ERM affects firms. We argue that the primary goal of ERM is to reduce the probability of financial distress and allow firms to continue their investment strategies by reducing the effect lower-tail outcomes, whether earnings or 362cash flow, cause by unexpected events. Having smoother, steadier earnings and cash flow performance allows the firm to increase leverage, pursue more growth options and perhaps be more profitable. However, these changes are potential consequences of a successful ERM program, and not necessarily evidence of the program itself.
Our research focuses on the following questions. First, do firms experience a change in earnings volatility around ERM adoption? This research question examines the proactive nature of ERM and whether companies adopting ERM are able to protect themselves from severe earnings events and generate smoothed earnings. The COSO (Committee of Sponsoring Organizations of the Treadway Commission) ERM framework states that ERM aids in reducing operational surprises and losses by allowing managers to better identify potential events that cause such surprises. Firms can then establish responses to reduce the effects of these surprises (COSO, 2004).
Second, do firms adopting ERM improve financial performance relative to past performance and after controlling for industry performance? This research question provides evidence on the view that ERM has value creating ability, captured in the following statement: “There is clearly a heightened awareness of the need to manage risks more strategically in order to achieve expected shareholder value” (The Conference Board, July 2005). Under this view ERM creates value by identifying and proactively addressing risks.
Third, do firms’ financial characteristics, such as leverage, growth and asset opacity, change after ERM implementation? This research question examines the effect that ERM has on the firm and whether ERM processes change-critical risk interdependencies. Proponents argue that an additional benefit of initiating ERM is that it allows firms to seize opportunities by allowing managers to better identify and more effectively assess capital needs and improve capital allocation (COSO, 2004).
Understanding whether or not ERM is achieving its stated goals is an important question. First, significant resources, both corporate and governmental, are being expended on understanding, developing and implementing ERM programs. Second, even if ERM provides a consistent process for risk identification it is possible that the benefits are not significant enough to become evident in the firm’s financial performance. ERM is not a costless activity, and as such, if it fails to deliver observable benefits, its implementation may be called into question.
As a preview of our results we find that very little evidence that ERM results in many significant changes in the sample firms. However, when we examine a subset of firms for whom the market perceived ERM adoption in a positive light, we find some evidence of risk reduction.
This chapter proceeds as follows: first hypotheses are developed based on a review of the literature, then method and data are described, results are presented and analyzed, and conclusions and limitations are offered.
