Enterprise Risk Budgeting - Bringing Risk Management into the Financial Planning Process

Abstract:     
Enterprise Risk Management (ERM) is a holistic, integrated approach to managing a company's risks, in contrast to the so-called "silo-approach" prevalent in many firms in which risks are managed independently of each other. Yet for all the risk exposures that are brought under the corporate umbrella in an ERM-initiative, it may be inadequate for addressing the firm’s aggregate risk in terms of the probability of failing to meet important corporate objectives, such as implementing the business plan or protecting debt covenants. In this paper we present a quantitative approach to risk management in the non-financial firm that retains the integrative, enterprise-wide mindset, yet also equips Corporate Management with the ability to evaluate financial distress-probabilities by incorporating ideas related to the concept of a firm's Economic Capital. We term such an effort Enterprise Risk Budgeting (ER-B). ER-B makes possible an ongoing re-assessment of the firm's expected financial position and overall risk profile, and in particular how these change as a result of corporate policy decisions, for example relating to capital expenditure, acquisitions, dividends, and hedging. The transparency created by such a tool increases the likelihood that Management makes sound proactive decisions with respect to its risk profile, rather than reacting to challenging circumstances once they occur. We illustrate using the experiences of Norwegian aluminium producer Norsk Hydro.

Number of Pages in PDF File: 30

Keywords: Enterprise Risk Management, Risk Budgeting, Economic Capital, Risk Measures

JEL Classification: G30, G32

Accepted Paper Series