ABSTRACT
Risk management has grabbed more attention due to the recent financial crisis. Firms have started investing significant amount of money in implementing enterprise-wide (integrated) risk management programs. Despite increased attention on enterprise risk management (ERM) and its wide usage, we know very little if ERM is value adding to firms. This chapter provides evidence from listed Nordic firms on value relevance of ERM by investigating the impact of ERM adoption on firm value. It also advances prior studies by introducing a new, sound measure for ERM process. ERM is measured by using a unique dataset which is constructed by a survey conducted on how listed Nordic firms organize their risk management programs. Accordingly, we are able to introduce more dimensions into ERM measurement, as well as capture its complexity and distinguishing features – thanks to valuable inside information on firms’ risk management programs, most of which otherwise would not be obtainable through publicly available information. The main finding of the chapter is that value creation of ERM is not supported after controlling for other determinants of firm value and endogeneity bias. The findings are highly consistent over different specifications.
A well-known definition of enterprise risk management (ERM) is provided in ERM framework of Committee of Sponsoring Organizations of the Treadway Commission (COSO, 2004):
A process, affected by an entity’s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives.
(COSO, 2004, p. 2)390Another definition of ERM is stated in the following way by Casualty Actuarial Society (CAS) Committee:
ERM is the discipline by which an organization in any industry assesses, controls, exploits, finances, and monitors risks from all sources for the purpose of increasing the organization’s short- and long-term value to its stakeholders.
(CAS, 2003, p. 8)ERM process or discipline 2 is a centralized and integrated approach suggesting a high level of oversight of risks on a portfolio basis. It has been developed as an alternative approach to traditional silo-based (disintegrated or fragmentized) risk management where various types of risks are managed in different units in a firm. 3 Implementation of an enterprise-wide approach to risk management has risen recently (Hoyt and Liebenberg, 2011) due to great emphasis put on robust risk management by external corporate governance mechanisms (country-level), 4 stock exchange regulations, 5 internal (firm-level) corporate governance structures, 6 as well as rating agencies. 7
It is argued in the literature – and is elaborated on later – that ERM could be a value-creating activity for firms thanks to enabling objective capital allocation as a result of risk–return trade-off assessments, as well as thanks to mitigating financial risks and facilitating to exploit business risks which in turn leads to gaining and/or maintaining competitive advantage (Lam, 2001; Meulbroek, 2002; Nocco and Stulz, 2006; Hoyt and Liebenberg, 2011). However, these argued benefits of ERM would come at a cost. Implementing an ERM program potentially has (high) costs since it requires a substantial change in how the company organizes their risk management process and deals with risks; such as appointing a chief risk officer (CRO), establishing a risk committee at the board level, establishing a centralized risk management department, developing a formal statement on the firm’s risk appetite and so on.
Given these cost-benefits considerations, we know little if ERM creates value for firms. Only a few empirical studies have been conducted on value relevance of ERM, and the evidence provided by those studies is inconclusive. Two papers find that ERM is value-creating (Hoyt and Liebenberg, 2011; Baxter, Bedard, Hoitash and Yezegel, 2013) while Lin, Wen and Yu (2012) show that it is value-destroying for firms. The remaining four articles either suggest that the benefit of an ERM program is firm-specific or find no support for value creation of ERM (Beasley, Pagach and Warr, 2008; Gordon, Loeb and Tseng, 2009; Pagach and Warr, 2010; McShane, Nair and Rustambekov, 2011).
In addition to this inconclusive evidence, the methods used in those studies to measure ERM have some drawbacks. Most of them are unable to capture the complexity of an ERM process; 8 instead they use very simplistic measures. For example, most of the previous studies use CRO hiring announcements as a proxy for ERM. However, some firms may not have ERM, yet have the position due to its popularity. Or, firms might have ERM in place but have another position with the same responsibilities as a CRO has.
The objective of this chapter is to provide evidence on value relevance of ERM. The chapter investigates if ERM increases firm value by introducing a well-developed measure for ERM process than those used by the prior studies. ERM is measured by exploiting a unique dataset which is constructed by using survey responses on how firms organize their risk management programs. Thanks to the survey, we are able to introduce more dimensions into ERM measurement – compared to the prior studies – enabling us to capture the complexity and distinguishing features of an ERM process. The survey, directed to firms’ chief executive officers (CEOs), chief financial officers (CFOs) or any other equivalent person who has adequate knowledge about 391risk management process in the firm, provides valuable inside information on risk management programs of the firms, most of which otherwise would not be obtainable through publicly available information. For example, information about “risk appetite” (which is one of the elements of ERM 9 included in this chapter) of a firm is not publicly available for many firms.
Overall, this chapter contributes to the literature in two ways. First, it provides evidence on value relevance of ERM by testing the hypothesis that ERM is value-creating for firms with a new dataset formed by listed Nordic firms. Second, we attempt to develop a new, sound measure for ERM process that could be further used in the ERM literature – with possible adjustments and improvements.
The unique dataset just mentioned comes from a survey conducted to all listed Nordic firms. Our results from such a broad sample is relatively more generalizable compared to industry-based samples, such as those in Hoyt and Liebenberg (2011), McShane et al. (2011) and Lin et al. (2012), who focus on insurance companies; and Baxter et al. (2013) who focus on banks and insurance companies. Despite the fact that the survey is directed to senior executives, the total response rate is 23%, which is better than the comparable study by Beasley, Clune and Hermanson (2005) (10.3%). To estimate the impact of ERM on firm value, as our main estimation technique we employ instrumental variables estimation where endogeneity between ERM and firm value is taken into account. The main finding of the chapter is that ERM does not increase firm value, which is in line with McShane et al. (2011) and Pagach and Warr (2010) while conflicting with Hoyt and Liebenberg (2011) and Baxter et al. (2013). Our insignificant finding suggests that ERM is an investment with zero net present value (NPV). Investors value ERM implementation neither positively nor negatively. This finding is consistent with Beasley et al. (2008), who find no significant market reaction to ERM implementation.
The chapter proceeds as follows. First, we review the literature, develop our hypotheses, and discuss theoretical arguments on how ERM increases firm value in comparison to traditional risk management approaches. Then we present our sample, data and methodology and discuss the empirical results. Finally, we draw concluding remarks, and mention the limitations of the study and give some suggestions for future research.
