Tools and Techniques of Enterprise Risk Management, Part 1

I’m going to go through Robert Chapman’s ERM book.  Based on the table of contents, the first part of the book what ERM is. Part II is about ‘The Appointment’ or what I think is a discussion of the engagement process.  The table of contents covers topics about interviewing the client, preparing the proposal, and implementation (of what, I am not sure yet).

Part II covers the Risk Management Process.  It seems to be about a fairly standard process: Analysis of the Business, Risk Identification, Risk Assessment, Risk Planning, and Risk Management.

Part IV covers ‘Internal Influences’ which I think is about internally generated risks.  The table of contents says it covers Financial Risk Management, Operational Risk Management, and Technological Risk.

The final part covers ‘External Influences’ which seems like about risks generated externally.  It discusses Economic, Environmental, Legal, Political, Market, and Social risks.

Finally there are 14 short Appendixes which discuss techniques like SWOT, PEST, VRIO analysis, Change Management, among other topics.

Ten Rules of Effective Language

One of the challenges risk professionals wrestle with is how to convince stakeholders to take specific actions,  such as proactively identifying risks. These stakeholders can be individuals, or they can be organisations.  While these stakeholders are not necessarily reluctant to comply with the requirements of proper risk management, they do have to deal with their own realities, including other demands on their energy,  or simply a perception that risk management is a waste of time.

Perception is reality, as the saying goes.  If you want to change reality, you have to change perception.  And one way to change perception is through communication.  A risk professional often needs to organisational action through reports and recommendations and also through interpersonal communication.

Dr. Frank Luntz, who apparently is a highly sought political speech writer, provides ten rules for effective language in his book, “Words that Work”.   I think when he came up with these rules, he was thinking in the in the context of public speeches, political messages,  and media relations.  But his rules seem a useful guide for a launching  a coordinated approach to getting your message across. 

In summary his rules are:

1. Use Small Words.  Use only words that you are certain your audience understands.  Don’t risk getting your message misunderstood. 
2. Use Short Sentences. If you can deliver the same message using a dozen words, do not do so with a thousand.  Not only are fewer words easier to remember, you stand a better chance at having your writing  read.
3. Credibility is as Important as Philosophy. Make sure you are telling the truth.  Very catchy marketing of something false will fool some people for a little while, but not for long, and not again. 
4. Consistency Matters. This is a nice way of saying: repeat the message over and over, using the same words if possible.  Drill the message in. Repeat until it becomes the truth.  And don’t change your message. Don’t change what you are trying to say.
5. Novelty: Offer Something New. Add a new twist on the language or coin a new phrase that capture the message vividly and clearly and memorably.  Definitely avoid clichés. Avoid it like the plague ;-).
6. Sound and Texture Matter. A slogan that makes sound (like ‘Snap, Crackle, Pop!’) helps make the slogan memorable.  Alternatively, come up with combinations of words that make a distinctive sound (‘Melts in your mouth…’)
7. Speak Aspirationally. Show the way to an ideal place. He gives the example of Crest toothpaste’s “Look ma, no cavities”. Tap into the audience’s aspirations and ideals.
8. Visualize.  Paint a picture with your words.
9. Ask a Question. Engage the listener by asking a relevant and memorable question.  Note that it is a single question, not several.
10. Provide Context and Explain Relevance. Make it very clear ‘why’ you are telling them what you are going to tell them. Give context to your message.

Luntz summarises these ten rules with ten words: simplicity, brevity, credibility, consistency, novelty, sound, aspiration, visualisation, questioning, and context.

You don’t have to follow all his rules for every message you want to get across.  I don’t think that’s possible, nor is it Luntz’s intention.  However, the list is useful as a guide for formulating a memorable message.

A Framework for Risk Management

Froot, Scharfstein, and Stein

The purpose of risk management for an organisation is to ensure availability of funds for financing investments.  Risk management does not create new wealth; investment does. Wealth-creating investment is only possible if there are funds available to finance it. Risk management must be used to ensure the organisation has enough funds to finance its wealth-creating investments should events arise that threaten the availability of funds.

The best funds to use for funding investments are funds created internally.  Funds obtained through debt make the company less attractive for further debt, which may result in a dangerous spiral where it cannot obtain debts when it needs them.  Funds raised from equity raise the problem of investors knowing that organisations sell equity when they know it is overpriced.  So despite Modigliani and Miller, who posited that how the funds are obtained is generally irrelevant, internally generated cash is best for funding further investments.

Hedging is one way to insulate the organisation from fluctuations of funds availability.

To determine what to hedge, think about events you wish to hedge against, and understand the impact of that event to your cashflow requirements for funding wealth-creating investments.  For example, if your company manufactures in Europe (Euro) and sells in the USA. Suppose the Euro appreciates thus making sales in the USA slower. Then cashflow is lessened because a) there is less product demand in the USA and b) the value of dollar sales has decreased comapred to Euro, therefore, there is little incentive to further increase production capacity in Europe, therefore there is lessened need for cashflow during the time.  Thus there is little need to hedge.

However, if opposite occurs, and the Euro depreciates, then sales to the US can be expected to increase (cheaper products), however,

Risk management “lets companies borrow from themselves” by shifting funds to when they are more needed.

The goal is to align the internal supply of funds with the demand for funds. The goal is not to insure against the events (such as exchange rate fluctuations) but to ensure the company has the cash it needs during such times.

The company shouldn’t need to worry much about its own stock prices.  That is a problem for individual investors. They can mitigate that risk through diversification.

Choices of which financial instrument to use must not be left to financial engineers. Managers must align the instrument to the corporate goal – which is to ensure availability of cash appropriate to the environment it is hedging against.

Two key issues in derivative features is mark-to-market vs over the counter. In the former, you need to top up daily to compensate for short term losses. In the latter you only need to pay at maturity date.  The other feature is linearity vs non-linearity. Futures and forward contracts may have no floor. There is symmetry in your gain or loss. Options allows setting a floor to loss, while keeping the option to benefit from the event.