Asset Liability Management (ALM)
Risk is a fact of business life. Taking and managing risk is part of what companies must do to create profits and shareholder value. But the corporate meltdowns of recent years suggest that many companies neither manage risk well nor fully understand the risks they are taking. A company’s board of directors should understand and oversee the major risks it takes and ensure that its executives have a robust risk-management capability in place. To assure appropriate oversight, the board must address a few key issues. Reports to the board and its committees must go beyond raw data by setting out, for example, what the key risk-return trade-offs might be.
Boards need to review the effectiveness of their own risk-management processes periodically. They should look at committee structures and charters, how well board members understand risk policies, and the value of their interactions with management on risk. Some companies use a formal self-assessment tool that allows directors to rate the effectiveness of board-level risk-management processes in areas such as risk transparency and reporting, and risk expertise. Reviews should take place about once a year.
Managing Third-Party Risk: Three Lines of Defense
A typical approach to risk management is to establish three lines of defense. Although elements of this concept exist implicitly in many corporates, a more formal approach might further improve risk management by clarifying roles and responsibilities. This would help to avoid a “blame game” arising when risks materialize.
The three lines typically include the following:
- Frontline management. In nonfinancial companies, frontline management is typically closest to most risks, including operational, project, or counterparty risks. Consequently, it plays a key role in managing risk, both with respect to which risks to take and the amount of risk to assume. This almost always includes trade-off decisions that go hand in hand with managing these risks. Assessing these and deciding on the path forward is one of frontline management’s core competencies, though the front line often thinks of these decisions as entrepreneurship rather than risk management. These trade-off decisions can be clearer in some areas and more blurry in others, but it is frontline management’s duty to make these decisions with a conscious consideration of the risks involved.
- Risk-management experts. The second line of defense usually encompasses two key tasks: setting the frame for management and monitoring compliance. The first task is typically performed by the risk function. It strives to identify key elements to build the company’s risk-management framework, supports the risk committee in establishing this framework in the form of policies and standards, and monitors frontline management in several ways. Depending on the risk type and the corresponding risk-management archetype, a variety of tools can help.
- Executive risk committee and business-unit leadership. The third line of defense bears the ultimate responsibility for risk management across a company. Its responsibility is to guarantee the proper functioning of the risk wheel, ensure that the company is aware of its key risks, define the appetite with respect to these risks, and cascade this down into the organization via an appropriate framework to promote sound implementation of processes, organization, and culture. It must also ensure through the internal-audit function that this framework is adhered to properly.
There is no single approach to enterprise risk management that can be considered the holy grail for all companies in all sectors. The application of risk management must take into account the biggest risks a company faces alongside specifics such as its current risk culture. By carefully tailoring the approach to a company’s individual characteristics, however, risk management can become an extremely powerful tool to help senior management reach its objectives.
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