Enterprise Risk Management and Default Risk

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Table of Contents

Introduction
Methodology
Results and Conclusion
Reference

Introduction

The article looks at the relationship between the implementation of enterprise risk management, commonly referred to as ERM, and credit default swaps (CDS). The authors’ conclusion gave insight into how financial institutions can reduce the perils associated with the non-remittance of premiums. The introduction takes the reader through the article’s topic, elaborating on the significance of studying the relationship between administration and repayments. According to Lundqvist and Vilhelmsson (2018), ERM has proven to be a framework for reducing risks in management, not only in a holistic approach but also through an integrated one. The authors argue that an integral part of ERM is the improvement it brings to internal control and efficient governing in any given risk management system.

The above assertions are realized when relevant stakeholders are forced to embrace better governance in addressing corporate failings and reported financial crises. Efficient organizations realize better revenues and profits compared to companies with incoherent leadership. According to Lundqvist and Vilhelmsson (2018), better governance is best realized through ERM advancement, as recorded in other research studies. The underlying argument is that ERM should create room for long-run competitive advantages by practicing best practices in administration. However, this is only realized through a holistic approach to measuring and managing a given institution’s risk. Additionally, for managers to own and implement the new procedures, organizations should provide lucrative incentives, necessary updates, and adequate information. Indeed, there is no doubt that motivated and prepared executives yield better results.

The article established that ERM follows the principles of traditional risk management care systems. For instance, the ERM framework incorporates the necessary levels of perils identification alongside hedging. It further incorporates risk governance in management which has three elements: organization, structure, and monitoring (Lundqvist & Vilhelmsson, 2018). Furthermore, the article acknowledges the need to have a competent Chief Risk Officer. In that line, the article’s objective entailed uncovering the presence of the relationship between default risk and the level of extent of ERM implementation in any given organization.

Addressing the above objective saw the article complemented in empirical scholarly works previously done on the effects of ERM implementation in a firm. However, it is worth noting that previous studies have paid attention to the total value effect that ERM implementation has on Tobin’s Q. The article asserts that previous studies have proved that a well-implemented system will greatly reduce the overall cost of capital. However, as for the current research, Lundqvist and Vilhelmsson (2018) shifted their focus towards a specific channel impacting value: minimized default risk. Indeed, this was a noble course when it comes to comprehending the process by which ERM creates value.

Methodology

Sample

The article developed a novel measure of the rate of ERM implementation by employing various test-based searches of relevant reports. The authors developed a proxy of default risk alongside CDS spread and the relevant credit ratings while incorporating two partially overlapping samples. The researchers chose 78 banks from the leading financial institutions. The selection was primarily based on their respective default risks and ERM in the whole sector.

Measuring Default Risk

The authors settled on two variables after the necessary mathematical computations. The first one was the credit ratings, with the other one being the spread of CDS. The CDS spread evaluated insurance premiums against possible defaults in all the financial institutions in the sample. According to Lundqvist and Vilhelmsson (2018), the CDS reveals a given company’s default risk, credit quality, and extent of exposure which cannot be determined by observation. Therefore, the ERM will inform the financial institution on the best practice to implement and how to minimize the risk of loss.

Results and Conclusion

The correlation study results revealed that the extent or level by which ERM is implemented across organizations is negatively correlated with the likelihood of CDS spread when the control variables, including the ratio of non-performing loans and how have a strong positive correlation with the extent of CDS spread. The study further established that an ERM implementation degree has no significant relationship with reported credit rating cases. The article is in line with previous scholarly works which confirmed how ERM effect CDS. For instance, the study findings confirmed that increased ERM implementation by players in the finance sector reduces the risk of default and minimizes cash flow volatility. Players in the financial sectors are highly recommended to pursue further implementation of ERM.

Reference

Lundqvist, S. A., & Vilhelmsson, A. (2018). Enterprise risk management and default risk: Evidence from the banking industry. Journal of Risk and Insurance, 85(1), 127-157. Web.

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Enterprise Risk Management and Default Risk

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