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CAPITAL ALLOCATION: A FREQUENTLY MISSED PART OF THE ERM FRAMEWORK AND RISK TREATMENT

One of the key issues in ERM is the allocation of capital based on the identified risks. The capital at risk or capital on risk (CoR) in financial institutions is called the economic capital and is estimated based on the value at risk approach (Jorion 2007). This capital should play an important role in protecting the enterprise against the default risk. The allocation of the capital for risk, based on the quantification of the potential risk impact, may be called a risk budgeting process. The ability to assess the capital based on risk may be perceived as a kind of maturity in the evolution of ERM. One of the important standards of ERM in supporting the development

Examples of Main Risk Sources to Be Covered by Capital on Risk

Exhibit 33.12 Examples of Main Risk Sources to Be Covered by Capital on Risk

Source: Author research, Z. Krysiak.

of the strategy is the identification of the most important risks (e.g., the top 10) out of the dozens or hundreds inherent with the enterprise's activities. From that perspective, the identification of risks and the quality of the budgeting process impact the accuracy of the estimated capital required.

The study of the risk profiles within the enterprises in Poland involved 36 types of different risks. These risks have been characterized by measures like the probability of risky events, the exposure from risky events, and the level of control over risk drivers or risk sources. Exhibit 33.12 displays the classification of the studied risks. At the bottom there are 12 subgroups of risk. Each subgroup was further subdivided into three detailed risks, so that we finally obtained 36 specific risks.

The study was performed at the end of 2010 by obtaining information from approximately 300 managers from different types of companies. We think that the only approach to modeling of the economic capital underestimates its value because models do not consider decision-maker perceptions about the risks. We assumed that managers as the decision makers have appropriate business understanding and that they provide substantial information about risk characteristics regarding all business processes. The collection of the data from the managers across the different businesses and functional areas of activity demonstrated an adequate knowledge about the risky events, the importance of particular types of risks, relationships between the risk outcomes, and the level of risk control. Based on this research, we determined the expected average risk impact across industries in Poland and the value of the economic capital.

Exhibit 33.13 shows the 10 most important risks and the level of control assigned to each risk. The level of control of 5 would be the highest control, while 0 would mean that no control is in place. The most important risks within the top 10 perceived by managers in Poland are shareholder and stakeholder relations, cost structure, and solvency and cash flow. At the very bottom of that list are investment projects' strategy, business continuity and downtime, and fraud, theft, reliability, quality.

The research confirms also how an important part of the risk management process in ISO 31000 is communication and consultation with stakeholders. We have to implement very efficient controls here, such as high managerial competencies

Exhibit 33.13 Top 10 Risks in Enterprises in Poland in Respect to Level of Risk Control

Top Risks

Level of Risk Control

Shareholder and stakeholder relations

3.80

Cost structure

3.76

Solvency and cash flow

3.53

Quality of products and services

3.47

Products and services offered

3.47

Credit capacity and creditworthiness

3.44

Liquidity of funding sources

3.44

Investment projects' strategy

3.40

Business continuity and downtime

3.36

Fraud, theft, reliability, quality

3.36

Source: Author research, Z. Krysiak.

and communication skills in order to properly manage board perceptions (see the 10 key points listed earlier in the section titled "Board Perception of ERM."

The assessment of the probability of risks, exposures, and level of controls was used to calculate expected losses, as presented in Exhibit 33.14, which afterward served to calculate the capital on risk. Based on the data obtained from the study, the expected value of the capital on risk should be three to five times that of the net income (N1).

This implies that by increasing the equity by the value of capital on risk, which should be invested in liquid and risk-free assets, the return on equity (ROE) would be reduced. Assuming that current ROE equals 20 percent, return on risk-free assets equals 5 percent, and there is no change in the net income, then the increase of the equity to between three and fives times N1 would drop the ROE down to between 14.5 percent and 12.5 percent, respectively. The other consequence of that is the change in the structure of the capital, which potentially could lead to the increase in the weighted average cost of capital. The risk inherent in the enterprise

Exhibit 33.14 Top 10 Risks in Enterprises in Poland in Respect to Expected Losses

Top Risks

Value of Expected Losses in Relation to Net Income

Cost structure

0.14

Management of malfunctions

0.14

Business continuity and downtime

0.13

Liquidity of funding sources

0.12

Account receivables

0.12

Fraud, theft, reliability, quality

0.12

Solvency and cash flow

0.12

Shareholder and stakeholder relations

0.11

Management and responsibilities

0.11

Products and services offered

0.10

Source: Author research, Z. Krysiak.

is not cheap. This example shows that, on one hand, an enterprise pays approximately one-quarter of ROE, but on the other hand, this expense could save the enterprise in case one or more risk events materialize.

 
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