Achieving Enterprise Stability Based on Economic Capital
Enterprise stability and a company’s chance for survival can be improved by applying a modified approach to the role of equity as “economic capital.”
In a highly competitive environment, companies can focus too much attention on maximizing profits in the short term, while neglecting basic principles of the risk management process. Many bankruptcies, including those of big and successful companies listed on the New York Stock Exchange (NYSE), have stemmed from a failure to plan for the downside of risk. Enterprise stability and a company’s chance for survival can be improved by applying a modified approach to the role of equity as “economic capital.” This article presents an overview of the principles of economic capital for facilitating stability and survival of the company and contends that Survival Enterprise Risk Management by Economic Capital (SERMEC) can effectively create a new organizational culture based on Risk Employment for Enterprise Development (REED).
Role of Equity in Default Risk Hedging
Equity is a part of the long-term funding used by a company to support fixed and current assets necessary to run business operations and ensure an appropriate level of liquid assets for continuous operating activity. Most frequently, the capital is there as a source for purchasing assets needed for business operations. That is of course an important function of capital, but companies must ensure that they have enough capital to survive a downturn as well.
Most enterprises know very well how to estimate and evaluate sales, production, and marketing projects, but often fail to account for the risk that these activities generate. For example, a company that engages in a risk such as decreasing price below the average market level, establishing a new production facility, closing 20 percent of all service offices, or extending a loan, has to be aware that, at some point, that risk is going to be realized in gains and losses. In such a case, appropriate funds have to be available to cover the potential losses. Considering the role of equity as a hedging tool against default risk offers a different approach to allocation and usage of that form of capital. Since equity has to cover the potential losses, then equity should be readily available because we don’t know when risk could precipitate loss. This suggests that some part of equity should be invested in very liquid assets.
Economic Capital Allocation
Economic capital can be defined as a level of equity that is adequate to cover losses incurred during risk realization. An enterprise should be able to identify major risk sources and monitor their impact on profit and loss. Risk sources should be perceived not as a danger or enemy, but as a driver of company value. This statement is validated when the option model is applied to estimate equity value. Calculated equity value in that model reflects higher risk as measured by volatility of rates of return. They could have both negative and positive impact. Therefore identification, measurement, and control of risk sources and risk drivers becomes critical for business success. To allocate appropriate economic capital, we have to quantify negative outcomes of risk realization based on the mapped risk matrix within the organization. More general examples of risk sources are shown in Fig. 1.
Fig. 1: Examples of main risk sources to be covered by Economic Capital.
For each segment of business shown on Fig. 1 several risk drivers should be identified and their impact quantified. To calculate the demand for economic capital, each risk type should be assessed by sources and risk drivers, type of risk events, frequency and probability of a risk event, impact of a risk event, and profit or loss as an outcome of the risk event. This kind of risk decomposition is presented in Fig. 2 and could be called a five-dimensional space of risk. The risk management process requires appropriate controls in place to monitor the frequency of events and losses or gains. The magnitude and frequency of events are used in the control process as feedback to adjust risk drivers and risk sources up to the level of the risk tolerance of the company. The risk tolerance can be estimated using the utility function concept and corresponds to the level of economic capital. This means that assumed risk at any time cannot exceed the level of available capital even if the company has an opportunity to extend business by increasing sales or production activity.
Fig. 2: Five-dimensional space of risk
Decomposed risk can be reflected using the following measures:
|AR =Annual Rate of Event||PD = Probability of Default|
|EAD = Exposure at Default||LOC = Level Of Control of a Risk Event|
|RR = Recovery Ratio||LGD = Loss Given Default|
Quantification of economic capital can be supported by a technical tool known as the Monte Carlo Simulation and its concept is presented in Fig. 3. Probability distributions have to be determined by experts and managers involved in a particular business since this requires knowledge of the fundamentals.
Fig. 3: Quantification of economic capital
Probability distribution of losses has two basic components. The first component is related to the expected losses denoted by EL, and the second one is called “unexpected loss” denoted by UL. These two components result in total losses for the company. Expected losses have to be covered by a risk premium included in the price margin of the product. This premium cannot be consumed, but should be kept on the balance sheet as a provision to cover losses up to the average level of total losses. Unexpected losses have to be reflected in capital called economic capital, which cannot be frozen in fixed and risky assets, but has to be invested in very liquid assets.
Risk Employment for Enterprise Development (REED)
Risk is inherent in any business activity and it cannot be ignored. Just like a start-up business, an enterprise undertaking new projects incurs costs and investment outlays before an income is generated. In each case, additional economic capital should be allocated based on an earlier calculated default probability and exposure at default. Determination of economic capital should be considered from the perspective of modern portfolio theory, which contends that correlations between particular risk components can decrease the value of the economic capital when new components of the portfolio are added.
Avoiding risk or costs can lead to missed opportunities for value creation and impede development of the company. Profit as a measure of company efficiency is a very poor indicator and, for more than a decade, there has been too much focus on efficiency measures based on the company profit instead of value. From this perspective the question arises: What are the sources of company value? Risk is a major “source” of company value. The best way to increase the value of the company is to be focused on “risk undertaking.” However, not all risks should be undertaken unless that risk creates value.
Measuring the value resulting from risk is more complicated than measuring profit and requires different and more advanced skills to manage properly. Utilizing economic capital approach allows us to compare, apples to apples, the risk with the company value. Thus, economic capital is a derivative of risk and can be expressed also as “value at risk” (VaR). VaR denotes how much the value of the company is in danger of deterioration. Economic capital serves as a hedge instrument to protect against this deterioration. Without such an instrument, a company’s value can be decimated in the face of risk realization. The cost association with economic capital and hedging is a small price to pay for safeguarding company value.
An Evolution of Risk Management
The concept of Enterprise Risk Management (ERM) sprung from the shortcomings of Value Based Management (VBM). This approach does not take into consideration the relative change between risk dynamic and the dynamic of value. Forgetting this type of analysis led in the past to instances of a very satisfactory and high increase in value, even though the company went bankrupt. Therefore, in the business environment, we have to estimate the value-to-risk ratio to determine if the company condition is improving or deteriorating. To make it real and decline the default risk, a new approach to company risk management has to be assumed, which can be summarized as Enterprise Risk Management (ERM).
There are several specific approaches to ERM because it is very much related to the individual business context of any enterprise, therefore each business has to find an individual “suit.” Enterprise Risk Management can be defined as an integrated and holistic approach to credit risk, market risk, operational risk, business risk, and economic capital management. This includes risk control, mitigation, and risk transfer to maximize value of the company. Successful ERM implementation takes a long time and requires engagement of all the managers within the company. ERM requires advanced tools and analytical methods as well as some different approaches to managerial accounting when reflecting financial results on the balance sheet.
Increasing quality in risk management defrays reputational risk and improves financial results by decreasing volatility of profits. Compared to the traditional risk management process, ERM focuses on a holistic instead of a silo-based approach. ERM is the basis of the Survival Enterprise Risk Management by Economic Capital (SERMEC) model, therefore it is important to understand how the quality of ERM can impact a successful implementation of SERMEC. The first applications of ERM took place in 2004 and were triggered by demand to comply with regulations imposed by the New York Stock Exchange (NYSE) on audit committees. Concepts and principles for implementations of ERM in public companies were derived from the Committee of Sponsoring Organizations of the Treadway Commission (COSO), created in 2004. At the same time, in the banking sector, a set of recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision called “Basel II, were being implemented. It was a big challenge that was associated with moral hazard risk. Three years after commencing ERM implementation, a big crisis appeared making a hit around the world. There is some evidence that enforcement of ERM by regulators did not challenge companies to creative engagement toward good quality of ERM implementation, but rather led to opposite results. Increasing maturity and awareness of managerial resources allocated for the implementation of ERM was a main factor for improvement and increasing quality of ERM, which was observable in company value behavior.
Fig. 4: Correlation between rating of quality of ERM and financial results for companies in Europe.
Unpublished research studies performed by the author on a sample of approximately 120 companies operating in Europe, show that a higher quality of ERM improves financial results and decreases the volatility of business indicators. Fig. 4 presents the correlation between financial results and rating of quality of ERM. Financial results are expressed as a ratio of net profit to total balance. This research study to a certain extent proves that ERM implementation has a positive impact on value creation and increased stability of the company.
The ERM process implements risk quantification to measure value/risk ratio, but it is not a sufficient condition to assure survival of the company. The economic capital reflecting the cumulated level of risk can be considered as a sufficient condition in maximizing probability of the company survival.
Fig. 5: Relationship of proposed SERMEC approach to another in the past developed concepts regarding enterprise development and its growth
Fig.5 presents an evolution from risk management (RM), to value-based management (VBM) and value at risk (VaR) concepts, to the SERMEC model. The SERMEC model combined with appropriate organizational structure and different then in the past organizational behavior can lead to REED concept, which is basically the new enterprise culture focused on employment of risk for company development.
Application of SERMEC Concept in Modern Business Management
The SERMEC concept utilizes past developments in finance theory and practice single tools, models, and measures which were previously applied separately. SERMEC at the final stage utilizes two important measures to steer the company development. First is Effective Probability of Default (EPD) and the second is Adjusted Weighted Average Cost of Capital (AWACC). SERMEC can be decomposed into three steps. First, where the ERM process has to conclude with determining value to risk ratio (V/σ), then based on this, in the ERMEC stage, the economic capital is estimated, which concludes with calculation of EPD. Value of economic capital is utilized to create appropriate capital structure composed of equity and debt and as well in this stage we calculate adjusted cost of capital. This leads to the conclusion that SERMEC ensures optimal enterprise development through establishing the appropriate structure of capital, which is most effective from the perspective of optimal level of financial and business results and remoteness of enterprise bankruptcy. Establishment of capital structure and adjusted cost of capital is derived based on economic capital estimation which could be called a hedge fund protecting the company against default. Finally we approach the main thesis, that enterprise stability based on economic capital could be realized through implementation of the SERMEC concept.
In the past decade, very little consideration has been given to the relationship between company value and the risk dynamic. Any increase in company value has to be related to an increase in risk level to make sure that the value to risk ratio is not declining. Many bankrupted companies around the world did not have adequate capital to cover the losses incurred when risk was realized. Many theories of risk management have been developed as a result, but the most advanced is the SERMEC concept, which establishes good fundamentals for creating the new organizational culture based on risk employment for enterprise development.
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About the Author(s)
Zbigniew Krysiak, PhD, is an associate professor at the Warsaw School of Economics, and 2011 visiting professor of finance at Graziadio School of Business and Management of Pepperdine University. He gained a PhD in economics from Warsaw School of Economics for his research into the application of options and real options in default risk assessment and company valuation and he holds an MBA in Banking and Financial Engineering from University in Toulouse in France. He is the author of more than 70 publications and books concerning finance, risk management, financial engineering, and banking and he serves as a chairman of the council board for the quarterly issued Journal of Property Finance.