Bcu msc cg week 5 rm framework

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Risk Management Framework

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Bcu msc cg week 5 rm framework

  1. 1. RISK MANAGEMENT FRAMEWORK MSC ACCOUNTANCY & FINANCE : CORPORATE GOVERNANCE & OPERATIONS RISK ANALYSIS AND CONTROL Stephen Ong BSc(Hons) Econs (LSE), MBA International Business(Bradford) Visiting Fellow, Birmingham City University Visiting Professor, Shenzhen University
  2. 2. • Discussion : Corporate Cultures and Governance 1 •Risk Management Framework 2 • Case Presentation: GM3 Today’s Overview
  3. 3. 1. Open Discussion • Mayer, Colin (2002) “Corporate Cultures and Governance: Ownership, Control and Governance of European and US Corporations”, TRANSATLANTIC PERSPECTIVES ON US-EU ECONOMIC RELATIONS:CONVERGENCE, COOPERATION AND CONFLICT ,Conference paper, JFK School of Government, Harvard University, April 11- 12
  4. 4. Corporate Governance Research in Accounting & Auditing
  5. 5. Formal Risk Rating Corporate Risk Rating must reflect a transparent understanding of the risk appetite of the Board IMPACTONBUSINESS Critical 4 4 8 12 16 Unacceptable level of risk exposure, which requires extensive management Major 3 3 6 9 12 Moderate 2 2 4 6 8 4 – 8: Risk management measures need to be put in place and monitored Minor 1 1 2 3 4 Almost Never 1 Unlikely 2 Likely 3 Almost Certain 4 1 – 3: Acceptable level of risk subject to regular monitoring LIKELIHOOD OF OCCURING
  6. 6. Where there is an action.... • Recognise real issues within in organisation • Focus appropriate management attention • Delivery of assurance through review and closure • Need to recognise relationship to achievement of corporate and operational targets. • Relevance to Governance Statements in Annual Reports High Medium Low Low Medium High S I G N I F I C A N C E PROBABILITY Requires close monitoring Manage and monitor Significant focus and action Accept but monitor Management effort worthwhile Manage and monitor Accept risks Accept but periodically review Accept but monitor
  7. 7. Hierarchy of risk reporting Board Executive Management Operational Management • Continuous examination of operational risks • Consideration of material risks within risk definitions • Consideration at meetings • Review of performance against business expectations at EMT • View to risk horizon through effective scanning and intelligence • Relationship with middle management • Commitment to upwards reporting • Review of business critical risks and actions to manage • Relationship with Executive Management • Focus on annual business performance data link to Governance Statement • Setting risk appetite
  8. 8. 2. RISK MANAGEMENT MODELS
  9. 9. COSO Risk Management Model (2004) Committee of Sponsoring Organisations of the Treadway Commission on Enterprise Risk Management (ERM) characteristics : 1. Process 2. Operated at every level 3. Applied in strategy setting 4. Applied across the enterprise 5. Identifies key events and manage their risks 6. Geared to achievement of objectives
  10. 10. COSO FRAMEWORK (2004) 8 COMPONENTS 1. Internal Environment 2. Objective Setting 3. Event Identification 4. Risk Assessment 5. Risk Response 6. Control Activities 7. Information & Communication 8. Monitoring
  11. 11. COSO FRAMEWORK (2004) 4 OBJECTIVES 1.Strategic 2.Operational 3.Reporting 4.Compliance
  12. 12. COSO FRAMEWORK (2004) 4 ENTERPRISE LEVELS 1.Subsidiary 2.Business Unit 3.Division 4.Entity-Level
  13. 13. Benefits of ERM (COSO, 2004) • Alignment of risk appetite and strategy • Link growth, risk and return • Choose best risk response • Minimise surprises and losses • Identify and manage risks across the organisation • Provide responses to multiple risks • Seize opportunities • Rationalise capital
  14. 14. CIMA Risk Management Cycle (2002)
  15. 15. ISO31000 Risk Management Framework (IRM 2010)
  16. 16. ISO31000 Risk Management process
  17. 17. Risk Management policy (ISO31000) • Risk management & internal control objectives (corporate governance) • Statement of the attitude of the organisation to risk (risk strategy) • Description of the risk aware culture or control environment • Level and nature of risk that is acceptable (risk appetite) • Risk management organisation & arrangements (risk architecture) • Details of procedures for risk recognition & ranking (risk assessment) • List of documentation for analysing & reporting risk (risk protocols) • Risk mitigation requirements & control mechanisms (risk response) • Allocation of risk management roles & responsibilities • Risk management training topics & priorities • Criteria for monitoring & benchmarking of risks • Allocation of appropriate resources to risk management • Risk activities and risk priorities for the coming year
  18. 18. Risk architecture at large PLC
  19. 19. WHO is Responsible for Risk Management? (ISO31000) • CEO/ Board • Business unit manager • Individual employees • Risk manager • Specialist risk management functions • Internal audit manager
  20. 20. ISO31000 Risk Management Responsibilities
  21. 21. ISO31000 Risk Management Techniques
  22. 22. FIRM Risk Scorecard
  23. 23. FIRM Risk Scorecard : Financial Risks EXTERNALLY DRIVEN • Accounting Standards • Interest Rates • Foreign Exchange • Funds & Credit INTERNALLY DRIVEN • Internal Control • Fraud • Historical Liabilities • Investments • CAPEX Decisions • Liquidity & Cashflow
  24. 24. FIRM Risk Scorecard : lnfrastructure Risks EXTERNALLY DRIVEN • Communications • Transport Links • Supply Chain • Terrorism • Natural Disasters • Pandemic INTERNALLY DRIVEN • Recruitment • People Skills • Health & Safety • Premises • IT Systems
  25. 25. FIRM Risk Scorecard : Marketplace Risks EXTERNALLY DRIVEN • Economic Environment • Technology Developments • Competition • Customer Demand • Regulatory Requirements INTERNALLY DRIVEN • M&A Activity • R&D Activity • Intellectual Property • Contracts
  26. 26. FIRM Risk Scorecard : Reputational Risks EXTERNALLY DRIVEN • Product Recall • CSR • Public Perception • Regulator Enforcement • Competitor Behaviour INTERNALLY DRIVEN • Brand Extensions • Board Composition • Control Environment
  27. 27. 3. RISK APPETITE, CULTURE AND BEHAVIOUR
  28. 28. Risk Appetite, Culture and Behaviour • Biases in human behaviour which limit human rationality, reduce the quality of corporate governance and cause bad decision making. • Review of biases including excessive loyalty to the CEO by members of the board of directors, excessive risk taking, overconfidence and hubris by managers as well as attitudes towards risk taking according to gender and age.
  29. 29. Learning Outcomes 1. Perform a critique of the key assumption in finance and economics that humans (always) act rationally 2. Evaluate the potential impact of biases in human behaviour on managerial decision making 3. Explain the link between human psychology and agency problems 4. Assess the usefulness and limitations of possible solutions to behavioural biases.
  30. 30. Introduction • Corporate governance theory, such as the principal– agent model, predicts that conflicts of interests result in value destruction or expropriation. • However, it nevertheless assumes that all economic actors concerned behave rationally. • More generally, economics and finance assume that – individuals are value-maximising rational decision makers, and – they make optimal decisions in an uncertain world based on all the information available at the time of the decision.
  31. 31. Introduction (continued) • The efficient market hypothesis (EMH), which is central to finance and essential to valuation models, states that security prices always fully reflect all available information. • Hence, market prices of securities are always a true and fair reflection of their value. • Hence, mispricings should NOT occur – Incidences of short-term mispricing do not necessarily call for the rejection of the EMH – However, long-term, persistent mispricing does.
  32. 32. • The question arises as to whether there are such incidences of persistent mispricings. • The answer to this question seems straightforward – The internet stock market bubble of the late 1990s and the ensuing global stock market crash of 2001/2 is just one fairly recent case where stock markets got things wrong – There are other more regularly occurring incidences of persistent mispricings such as those observed in initial public offerings (IPOs). Introduction (continued)
  33. 33. • The existence of these persistent mispricings has urged academics and practitioners to seek possible explanations. • One such explanation is human psychology. • Contrary to what classical economics and finance assume, humans may not always be fully rational. • Their rationality may be bounded or limited. Introduction (continued)
  34. 34. Bounded Rationality • The concept of bounded rationality was formalised by Herbert Simon in 1947. • Humans are typically not able to analyse all the information available to them due to – time constraints, and – limits to their cognitive resources. • Limits to cognitiveresources include limits to – our intelligence, – our memory, and – our attention span.
  35. 35. Bounded Rationality (Continued) • Hence, humans frequently do not make optimal decisions. • Our brains have been wired by evolution to deal with a complex world and our limited time and cognitive resources. • Hence, our minds use rules of thumb also called – heuristics, – algorithms, and – mental modules.
  36. 36. • As this heuristic simplification is used by all humans, this may cause biases in human behaviour, resulting in systematic mistakes such as persistent mispricing in capital markets. • However, there are at least five other potential sources of bias in human behaviour 1. emotions, 2. social interactions, 3. overconfidence, 4. risk taking according to gender and age, and 5. reflexive loyalty. Bounded Rationality (Continued)
  37. 37. Heuristic Simplification • Given the limited time and cognitive resources, – we focus on subsets of information; – we analyse problems in isolation; – we focus on similarity; and – we only slowly change our beliefs.
  38. 38. Focusing on Subsets of Information • Some of the effects caused by focusing on subsets of the information available include the halo effect. • The halo effect consists of admiring an exceptional characteristic of an individual and then widen this positive assessment to all the other characteristics of this individual. • The halo effect may explain why in certain corporations everybody is in awe of the CEO. • At worst, this effect may prevent other constituencies within the firm from scrutinising the CEO’s decisions.
  39. 39. Analysing Problems in Isolation • We tend to analyse decision problems in isolation, ignoring the broader context. • We tend to compartmentalise decision problems or frame them in a narrow way. • Most problems can be easily and safely compartmentalised. • However, there is a danger of narrow framing or packaging. • The way the information is presented to the decision maker may influence the actual decision.
  40. 40. Analysing Problems in Isolation (Continued) • Examples of compartmentalisation or narrow framing (packaging) include –mental accounting, –the disposition effect, –loss aversion, and –the house money effect.
  41. 41. • Mental accounting consists of most investors keeping two accounts in their brains – one for the gains from their investments, and – one for the losses. • It may explain the so called disposition effect – Investors tend to sell winners too soon and losers too late – The reason why investors treat losses differently may be due to the fact that losses are perceived to be painful – Postponing the sale of the losers avoids the painful realisation of a loss. Analysing Problems in Isolation (Continued)
  42. 42. • Loss aversion consists of the fact that most investors tend to be very risk averse, even when facing very small risks –It may be explained by the fact that we tend to turn a continuous return into a discrete return –We distinguish between two regions, i.e. the region for losses and that for gains –The two regions are clearly separated by the break-even point. Analysing Problems in Isolation (Continued)
  43. 43. • The house money effect is the greater willingness of people to gamble with money they have recently won – This behavioural pattern may be explained by the fact that the recent positive sensation of a gain may cancel out the possible future painful sensation of a loss – A manager may be more willing to take on unnecessary risk after having had one or more highly successful projects. Analysing Problems in Isolation (Continued)
  44. 44. Focusing on Similarities • We tend to give too much attention to information that is perceived to be similar. • Two examples of the focus on similarities are – the representative heuristic, and – gambler’s fallacy.
  45. 45. Focusing on Similarities (Continued) • The representative heuristic consists of determining the probability of an event based on information judged to be typical or similar to that event – This is what statistical analysis is about – Most people tend to draw inferences from small samples that are too strong given the small sample size – Inferences drawn from large samples are too weak – Hence, most people are subject to a systematic bias which can be predicted by the sample size.
  46. 46. • Gambler’s fallacy consists of mistakenly reading patterns into random events that are clearly independent of each other – The classic example of gambler’s fallacy is that a lot of lottery players, when choosing their numbers, tend to avoid those numbers that have come up in recent draws – They turn a random event into a conditional event whose outcome depends on the outcomes from previous events – Hence, they underestimate the probability of some numbers – This phenomenon is also called base-rate underweighting. Focusing on Similarities (Continued)
  47. 47. We Only Slowly Change Our Beliefs • Under certain circumstances, we tend to be conservative, i.e. we tend to change or update our beliefs less frequently than would be rational. • This bias is exactly the opposite of the above base-rate underweighting. • Base-rate underweighting is about overreacting to information whereas conservatism is about underreacting. • Base-rate underweighting is about the excessive reliance on the strength of a signal.
  48. 48. We Only Slowly Change Our Beliefs (Continued) • Conservatism is about underreliance on the weight of the information. • Evidence suggests that we are more likely to suffer from conservatism when the information is cognitively costly to analyse.
  49. 49. Emotions • Emotions, such as anger, resentment and love, are another reason why humans do not always act rationally. • At worst, we may end up suffering from a loss of self- control. • Evidence from experiments suggests that – people who are in a good mood are less critical whereas – those in a bad mood spend more time analysing the information they are presented with.
  50. 50. Emotions (Continued) • There is some evidence that stock market prices are affected by seasonal affective disorder (SAD). • SAD consists of suffering from clinical depression during the winter months when daylight is limited. • Some studies suggest that there is a correlation between the amount of daylight across the seasons and the stock returns. • Stock returns are higher during the winter months in the Northern hemisphere, possibly compensating for the increased risk aversion among investors with SAD.
  51. 51. Social Interactions • An individual’s behaviour and decisions are influenced by the individual’s interactions with their social group. • People tend to conform to the beliefs and behaviours of others. • This conformity effect also depends on an individual’s – culture, – society, and – history.
  52. 52. Social Interactions (Continued) • An important means of social interaction is conversation. • However, conversation tends to be a poor means of communication because 1. The subject of most conversations tends be to information already known to all participants 2. Conversations are subject to time constraints 3. The complexity of the information conveyed is also subject to limits.
  53. 53. • Hence, information conveyed via conversations tends to be sharpened and oversimplified. • As a result, the listener in a conversation will end shifting their beliefs to extremes. • Other effects caused by social interactions include –the fundamental attribution error, –the false consensus effect, and –the curse of knowledge. Social Interactions (Continued)
  54. 54. Social Interactions (Continued) • The fundamental attribution error consists of underestimating external factors and overestimating the importance of a person’s mind set when explaining that person’s actions – For example, the non- executives may think that the reason the executives have granted themselves stock options is to improve their incentives – However, the true reason is that the executives believe that the firm’s stock is undervalued and that the options will be in the money soon.
  55. 55. Social Interactions (Continued) • The false consensus effect consists of people having a tendency to assume that others share their opinions more than they actually do. • The curse of knowledge consists of assuming that others who have less knowledge have similar beliefs than they actually have. • It is important for boards of directors as well as other corporate committees to be aware of these effects as they are likely to bias their assessment of the executives’ performance and intentions.
  56. 56. Self-deception • The two main forms of self-deception are – overconfidence, and – confirmatory bias. • Most of us suffer from overconfidence. • Overconfidence is the tendency of overestimating one’s knowledge and abilities. • Men tend to be more overconfident than women – The difference in confidence increases for tasks that are perceived to be more masculine.
  57. 57. Self-deception (Continued) • Experts tend to be overconfident when the task is complex and the information is highly opaque. • For overconfidence to persist, there needs to be biased self- attribution. • People tend to attribute good outcomes to their own abilities and bad ones to external influences. • Whereas rational learning would make individuals less overconfident over time, biased self-attribution increases overconfidence over TEMASEK LOSSES
  58. 58. Self-deception (Continued) • Richard Roll argues that managerial overconfidence or hubris explains why so many mergers and acquisitions fail to realise the expected gains. • While the majority of mergers and acquisitions are unsuccessful, individual bidding managers may believe that their skills are superior to those of other managers.
  59. 59. Self-deception (Continued) • Confirmatory bias consists of spending too little time on data and other information that contradicts one’s beliefs and discarding it as bad luck or data.
  60. 60. Self Deception • In 1984, The Economist asked: – 4 ex-finance ministers of OECD countries, – 4 chairmen of multinationals, – 4 Oxford University economics students and – 4 garbage collectors to predict several economic factors for the OECD ten years ahead. • In 1994, the magazine revisited the predictions and checked their accuracy. • On average, the forecasts were more than 60 percent too high or too low. • The average forecasted price of oil, for example, was $40 compared with an actual price of just $17. • All the respondents said Singapore’s GDP per capita would never overtake Australia’s, but that had actually happened in 1993. • The most accurate forecasters were the London dustmen and the chairmen of multinational companies (a tie for first place); the finance ministers came in last. • But the performance of every group was quite abysmal. The unpalatable fact is that no one can predict the long-term economic and market environment with any real accuracy.
  61. 61. Risk Taking According to Gender and Age • John Coates and Joe Herbert have found preliminary evidence that human biology, in particular testosterone, drives risk-taking behaviour. • Testosterone in stock-exchange traders may have two contrasting effects – At first, testosterone has a positive effect on performance as it makes traders more persistent, more willing to take on risk and seek novelty – However, if testosterone continues to increase and stays at high levels, traders may seek unnecessary risk, i.e. risk which does not increase expected performance.
  62. 62. Testosterone vs Income (Coates 2009)
  63. 63. Risk Taking According to Gender and Age (Continued) • Testosterone has been shown to decline significantly with age. • This research suggests that board diversity in terms of gender and age may be good in terms of risk management.
  64. 64. How to Address Behavioural Issues? • One way of increasing awareness of these behavioural issues and reducing their impact is to improve managers’ education. • Another way is to ensure that boards of directors are effective and that they rein in bad decision making by managers, in particular the CEO. • However, there is little evidence that boards of directors are effective monitors.
  65. 65. How to Address Behavioural Issues? (Continued) • Why is this the case? – One possible answer is that today’s board composition is not exogenous and is likely to be the result of past corporate governance issues – For example, if a firm performed badly in the past there may have been pressure from shareholders to appoint more independent directors – Hence, one firm with good current performance may have a large proportion of independent directors on its board due to historic reasons whereas another firm with equally good current performance may have a much lower proportion given that its past performance has always been good.
  66. 66. • Randall Morck proposes another possible reason for the observed lack of a relationship between corporate performance and board composition. How to Address Behavioural Issues? (Continued)
  67. 67. Reflexive Loyalty • Morck argues that there are two principal–agent problems and that both can be described by referring to loyalty. • The type I agency problem is the classic agency problem between the managers and the shareholders. • It is caused by the managers acting in their own interest rather than performing their duty. • It consists of managers being disloyal to their principal, i.e. the shareholders.
  68. 68. Reflexive Loyalty (Continued) • The type II agency problem is caused by excessive loyalty to one’s principal (the CEO or large shareholder) rather than a lack of loyalty. • Morck argues the recent corporate scandals of Enron, Hollinger and Worldcom have been caused by misplaced loyalty of directors to powerful CEOs. • This problem is caused by a behavioural bias which consists of a reflex for loyalty to figures of authorities.
  69. 69. The Milgram Experiment • http://www.youtube.co m/watch?v=BcvSNg0HZ wk&feature=relmfu
  70. 70. • During the 1960s, Stanley Milgram, professor of social psychology at Yale, conducted experiments with human subjects. • The subjects were recruited via newspaper ads and paid for their participation. • They were told that the experiments were about the effects of punishment on learning and memory. • The subject would act as a “teacher” who would ask questions to a “learner”. Reflexive Loyalty (Continued)
  71. 71. • The subject would then administer an electric shock of a certain severity to the learner for every wrong answer. • Unknown to the subject, the learner was a professional actor and the machine administering the electric shock a fake. • The electric switches on the machine were labelled from 15V to 450V and were also labelled with the intensity of the pain (“slight” through “very strong” through “danger severe” and “XXX”). Reflexive Loyalty (Continued)
  72. 72. • Each time the learner would give a wrong answer, the severity of the electric shock would increase and the actor feign increasing levels of pain. • A psychologist would be present at the experiments. • More than 60% of the American subjects were happy to go all the way to 450V (“XXX”). • Milgram’s experiments were repeated across other countries and cultures and the results were similar. • The results were also similar across genders. Reflexive Loyalty (Continued)
  73. 73. • Milgram concluded that humans have a reflex for loyalty – Prehistoric men who were loyal to their tribal leader were more likely to survive – Through evolution this resulted in loyalty being hard- wired into the human brain. • Milgram followed up with his subjects and asked them why they had behaved the way they had. • Many were very upset about the experience, but justified it with words such as “loyalty” and “duty”. Reflexive Loyalty (Continued)
  74. 74. • Morck argues that in the boardroom directors have a tendency to be loyal to their leader, the CEO, rather than to ask probing questions and challenge his/her decisions. • This may explain why studies that look at the effects of boards on corporate performance have found very little evidence of such effects. Reflexive Loyalty (Continued)
  75. 75. • Milgram performed many variants of his experiment. • One consisted of having three “teachers”, two dissenting teachers plus the actual subject. • At 150V, the first teacher would walk out. • The second teacher would walk out at 210V. • The two “dissenting peers” caused a huge increase in disobedience. Reflexive Loyalty (Continued)
  76. 76. • Morck argues that boards of directors should be designed in ways that promote disloyalty to the CEO (or large shareholder), i.e. in ways that prevent type II agency problems. • Both the US Sarbanes-Oxley Act and the UK Higgs Report seem to have adopted that approach by stressing the role of non- executives on the board of directors as well as the importance of their independence. Reflexive Loyalty (Continued)
  77. 77. • One way to avoid type II agency problems would then be to reduce the dominance of the CEO. • Remember the narrow framing effect we discussed earlier – The CEO may influence the board’s decision by the way he/she presents the information. • The Higgs Report recommended that the CEO does not chair board meetings – However, this also has costs as it may give too much power to less well informed outsider. Reflexive Loyalty (Continued)
  78. 78. • Hence, there is a trade-off between keeping the power of the CEO in check and ensuring the effectiveness of executive decision making. Reflexive Loyalty (Continued)
  79. 79. How to Reduce Behavioural Biases • These biases may be difficult to address in practice. • Reducing the dominance of the CEO is one way forward. • However, this may increase the power of less well-informed actors. • Board meetings should be conducted in such a way that – They are not dominated by the CEO – The non-executives are able to scrutinise the policies proposed by the executives.
  80. 80. Conclusions • Bounded rationality. • Heuristic simplification. • Emotions. • Social interactions. • Overconfidence and hubris. • Risk taking according to gender and age. • Reflexive loyalty. • Reducing behavioural biases.
  81. 81. Casestudy 2 : General Motors 1. Read and prepare the Casestudy on General Motors (Monks & Minow (2011)) for discussion next class. Identify the corporate governance issues faced. 2. In groups of four members you are required to: • Allocate responsibility to – a non executive director, a CEO, A Health and Safety Manager and a Risk Manager • Analyse the scenario’s in the case study and discuss which are the most critical risks that the organisation faces. • Plot the resulting risk analysis on an appropriate risk map. • Decide what is your group’s response.
  82. 82. Further Reading • Solomon, Jill (2010) Corporate Governance and Accountability 3rd Edition, Wiley, UK. Ch.6 • Goergen, Marc (2012) International Corporate Governance, Pearson. Ch.15 • Larker & Tayan (2011) Ch.6 • CIMA - Performance Strategy: Study Text (2012) BPP Learning Media Ltd. Part B : 2
  83. 83. Additional Readings (1) • COSO (2004) Enterprise Risk Management – Integrated Framework, September 2004, Committee of Sponsoring Organizations of the Treadway Commission • IFAC (2006) Internal Controls : A review of current developments, August 2006, New York : International Federation of Accountants • AIRMIC, Alarm & IRM (2010) A structured approach to Enterprise Risk Management and the requirements of ISO 31000, Institute of Risk Management. • CIMA (2008) Fraud Risk Management: A Guide to Good Practice, Chartered Institute of Management Accountants. • FRC (2004) The Turnbull guidance as an evaluation framework for the purposes of Section 404(a) of the Sarbanes-Oxley Act, 16 Dec 2004, FRC
  84. 84. NEXT Ideas for Discussion • Morck, Randall and Yeung, Bernard (2003) Agency problems in large Family Business Groups, Entrepreneurship: Theory and Practice, Summer 2003. Vol. 27, No. 4: pp. 367 – 382
  85. 85. QUESTIONS?

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