Eight to Late

The illusion of enterprise risk management – a paper review

with 5 comments

Introduction

Enterprise risk management (ERM) refers to the process by which uncertainties are identified, analysed and managed from an organization-wide perspective. In principle such a perspective enables organisations to deal with risks in a holistic manner, avoiding the silo mentality that plagues much of risk management practice.  This is the claim made of ERM at any rate, and most practitioners accept it as such.  However, whether the claim really holds is another matter altogether. Unfortunately,  most of the available critiques of ERM  are written for academics or risk management experts. In this post I summarise a critique of ERM presented in a paper by Michael Power entitled, The Risk Management of Nothing.

I’ll begin with a brief overview of ERM frameworks and then summarise the main points of the paper along with some of my comments and annotations.

 ERM Frameworks and Definitions

What is ERM?

The best way to answer this question is to look at a couple of well-known ERM frameworks, one from the Casualty Actuarial Society (CAS) and the other from the Committee of Sponsoring Organisations of the Treadway Commission (COSO).

CAS defines ERM as:

… the discipline by which an organization in any industry assesses, controls, exploits, finances, and monitors risks from all sources for the purpose of increasing the organization’s short- and long-term value to its stakeholders.

See this article for an overview of ERM from actuarial perspective.

COSO defines ERM as:

…a process, effected by an entity’s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives.

The term risk appetite in the above definition refers to the risk an organisation is willing to bear. See the first article in the  June 2003 issue of Internal Auditor for more on the COSO perspective on ERM.

In both frameworks, the focus is very much on quantifying risks through (primarily) financial measures and on establishing accountability for managing these risks in a systematic way.

All this sounds very sensible and uncontroversial. So, where’s the problem?

The problems with ERM

The author of the paper begins with the observation that the basic aim of ERM is to identify risks that can affect an organisation’s objectives and then design controls and mitigation strategies that reduce these risks (collectively) to below a predetermined  value that  is specified by the organisation’s risk appetite. Operationally, identified risks are monitored and corrective action is taken when they go beyond limits specified by the controls, much like the operation of a thermostat.

In this view, risk management is a mechanistic process.  Failures of risk management are seen more as being due to “not doing it right” (implementation failure) or politics getting in the way (organizational friction), rather than a problem with the framework itself. The basic design of the framework is rarely questioned.

Contrary to common wisdom, the author of the paper believes that the design of ERM is flawed in the following three ways:

  1. The idea of a single, organisation-wide risk appetite is simplistic.
  2. The assumption that risk can be dealt with by detailed, process-based rules (suitable for audit and control) is questionable.
  3. The undue focus on developing financial metrics and controls blind it to “bigger picture”, interconnected risks because these cannot be quantified or controlled by such mechanisms.

We’ll now take a look at each of the above in some detail

Appetite vs. appetisation

As mentioned earlier, risk appetite is defined as the risk the organisation is willing to bear. Although ERM frameworks allow for qualitative measures of risk appetite, most organisations implementing ERM tend to prefer quantitative ones. This is a problem because the definition of risk appetite can vary significantly across an organization. For example, the sales and audit functions within an organisation could (will!) have different appetites for risk.  As another example, familiar to anyone who reads the news, is that there is usually a big significant gap between the risk appetites of financial institutions and regulatory authorities.

The difference in risk appetites of different stakeholder groups  is a manifestation of the fact that risk is a social construct – different stakeholder groups view a given risk in different ways, and some may not even see certain risks as risks (witness the behaviour of certain financial “masters of the universe”)

Since a single, organisation-wide risk appetite is difficult to come up with, the author suggests a different approach – one which takes into account the multiplicity of viewpoints in an organisation; a process he calls “risk appetizing”.  This involves getting diverse stakeholders to achieve a consensus / agreement on what constitutes risk appetite. Power argues that this process of reconciling different viewpoints of risk would lead to a more realistic view of the risk the organization is willing to bear. Quoting from the paper:

Conceptualising risk appetising as a process might better direct risk management attention to where it has likely been lacking, namely to the multiplicity of interactions which shape operational and ethical boundaries at the level of organizational practice. COSO-style ERM principles effectively limit the concept of risk appetite within a capital measurement discourse. Framing risk appetite as the process through which ethics and incentives are formed and reformed would not exclude this technical conception, but would bring it closer to the insights of several decades of organization theory.

Explicitly acknowledging the diversity of viewpoints on risk is likely to be closer to reality because:

…a conflictual and pluralistic model is more descriptive of how organizations actually work, and makes lower demands on organizational and political rationality to produce a single ‘appetite’ by explicitly recognising and institutionalising processes by which different appetites and values can be mediated.

Such a process is difficult because it involves getting people who have different viewpoints to agree on what constitutes a sensible definition of risk appetite.

A process bias

A bigger problem, in Power’s view, is that the ERM frameworks overemphasise financial / accounting measures and processes as a means of quantifying and controlling risk. As he puts it ERM:

… is fundamentally an accounting-driven blueprint which emphasises a controls-based approach to risk management. This design emphasis means that efforts at implementation will have an inherent tendency to elaborate detailed controls with corresponding documents trails.

This is a problem because it leads to a “rule-based compliance” mentality wherein risks are managed in a mechanical manner, using bureaucratic processes as a substitute for real thought about risks and how they should be managed. Such a process may work in a make-believe world where all risks are known, but is unlikely to work in one in which there is a great deal of ambiguity.

Power makes the important point that rule-based compliance chews up organizational resources. The tangible effort expended on compliance serves to reassure organizations that they are doing something to manage risks.  This is dangerous because it lulls them into a false sense of security:

Rule-based compliance lays down regulations to be met, and requires extensive evidence, audit trails and box ‘checking’. All this demands considerable work and there is daily pressure on operational staff to process regulatory requirements. Yet, despite the workload volume pressure, this is also a cognitively comfortable world which focuses inwards on routine systems and controls. The auditability of this controls architecture can be theorized as a defence against anxiety and enables organizational agents to feel that their work conforms to legitimised principles.

In this comfortable, prescriptive world of process-based risk management, there is little time to imagine and explore what (else) could go wrong. Further, the latter is often avoided because it is a difficult and often uncomfortable process:

…the imagination of alternative futures is likely to involve the production of discomfort, as compared with formal ‘comfort’ of auditing. The approach can take the form of scenario analysis in which participants from different disciplines in an organization can collectively track the trajectory of potential decisions and events. The process begins as an ‘encounter’ with risk and leads to the confrontation of limitation and ambiguity.

Such a process necessarily involves debate and dialogue – it is essentially a deliberative process. And as Power puts it:

The challenge is to expand processes which support interaction and dialogue and de-emphasise due process – both within risk management practice and between regulator and regulated.

This is right of course, but that’s not all:  a lot of other process-focused disciplines such as project management would also benefit by acknowledging and responding to this challenge.

A limited view of embeddedness

One of the imperatives of ERM is to “embed” risk management within organisations. Among other things, this entails incorporating  risk management explicitly into job descriptions, and making senior managers responsible for managing risks.  Although this is a step in the right direction, Power argues that the concept of embeddeness as articulated in ERM remains limited because  it focuses on specific business entities, ignoring the wider environment and context in which they exist. The essential (but not always obvious) connections between entities are not necessarily accounted for. As Power puts it:

ERM systems cannot represent embeddedness in the sense of interconnectedness; its proponents seem only to demand an intensification of embedding at the individual entity level. Yet, this latter kind of embedding of a compliance driven risk management, epitomised by the Sarbanes-Oxley legislation, is arguably a disaster in itself, by tying up resources and, much worse, cognition and attention in ‘auditized’ representations of business processes.

In short: the focus on following a process-oriented approach to risk management – as mandated by frameworks – has the potential to de-focus attention from risks that are less obvious, but are potentially more significant.

Addressing the limitations

Power believes the flaws in ERM can be addressed by looking to the practice of business continuity management (BCM). BCM addresses the issue of disaster management – i.e. how to keep an organisation functioning in the event of a disaster. Consequently, there is a significant overlap between the aims of BCM and ERM. However, unlike ERM, BCM draws specialists from different fields and emphasizes collective action. Such an approach is therefore more likely to take a holistic view of risk, and that is the real point.

Regardless of the approach one takes, the point is to involve diverse stakeholders and work towards a shared (enterprise-wide) understanding of risks. Only then will it be possible to develop a risk management plan that incorporates the varying, even contradictory, perspectives that exist within an organisation. There are many techniques to work towards a shared understanding of risks, or any other issues for that matter. Some of these are discussed at length in my book.

Conclusion

Power suggests that ERM, as articulated by bodies such as CAS and COSO, flawed because:

  1. It attempts to quantify risk appetite at the organizational level – an essentially impossible task because different organizational stakeholders will have different views of risk. Risk is a social construct.
  2. It advocates a controls and rule-based approach to managing risks. Such a prescriptive “best” practice approach discourages debate and dialogue about risks. Consequently, many viewpoints are missed and quite possibly, so are many risks.
  3. Despite the rhetoric of ERM, implemented risk management controls and processes often overlook connections and dependencies between entities within organisations. So, although risk management appears to be embedded within the organisation, in reality it may not be so.

Power suggests that ERM practice could learn a few lessons from Business Continuity Management (BCM), in particular about the interconnected nature of business risks and the collective action needed to tackle them. Indeed, any approach that attempts to reconcile diverse risk viewpoints will be a huge improvement on current practice. Until then ERM will continue to be an illusion, offering false comfort to those who are responsible for managing risk.

Written by K

July 25, 2012 at 10:31 pm

5 Responses

Subscribe to comments with RSS.

  1. Thank you for clarifying – so helpful!!

    O

    October 14, 2012 at 11:34 pm

  2. A nice overview of the risk any model faces beyond the numbers

    sashi2sense

    February 2, 2014 at 6:09 pm

    • Thanks for reading. It is truly surprising how often modelers fall in love with their models to the point where they even forget the assumptions that underlie them. To a large extent, many of the financial crises of the last two decades can be traced back to this (unfortunately, all-too-human) tendency.

      Regards,

      Kailash.

      K

      February 2, 2014 at 9:32 pm

  3. In my exposure to ERM, I can only draw the conclusion that, unless it produces protective action (that is, we find a risk, then change systems to eliminate or reduce probability of the risk event or reduce its effects) then it is ceremonial; almost a ritual of the religion of the corporation. The input of ERM to corporate governance and practice should be the same as risk mgt in projects: find a risk and address it. So in a construction project foundation stability is always a risk, so we do ground tests and design for the conditions. Thus the risk produces a project response to deal with the risk. In an enterprise example, fraud is a risk, so we design accounting systems that will expose any fraud and therefore either prevent or staunch it.
    I participated in a ERM ritual with the officiating priest being a consultant from one of the big5 who know nothing of our business. At no stage was this point made, instead we shuffled around about risk appetite (uncalibrated for our business and therefore a meaningless charade), then tried to force ‘risks’ into a meaningless matrix. (Cox would have been amused).

    Davyd

    April 18, 2014 at 10:27 am

    • Hi David,

      Thanks for your comment. Methodology and process-driven risk management is generally used as a “security blanket” in organisation-land. Those who use it feel that all will be well if the requisite boxes are ticked. There is no residual doubt (humility?) that questions whether anything has been overlooked….and as Taleb repeatedly reminds us (in his often over-the-top way), what has been overlooked can come back to bite you. In his latest book (which you may have read) he talks about developing strategies that are not only robust in the face of uncertainty, but actually gain from it – a property he terms antifragility. I’m working out some thoughts on the notion of antifragility as it applies to corporate IT and hope to post something on it in the coming weeks.

      Thanks again for reading and commenting!

      Regards,

      Kailash.

      K

      April 20, 2014 at 9:02 pm


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Follow

Get every new post delivered to your Inbox.

Join 272 other followers

%d bloggers like this: