Risk-Based Performance Management - Making It Work: Gary Cokins
Risk-Based Performance Management - Making It Work: Gary Cokins
Risk-Based Performance Management - Making It Work: Gary Cokins
Page 25
Journal of Risk Intelligence
Many observers view operational risk The four step sequence includes direc- manageable projects and select core
as the key lever for enterprise risk man- tion setting from the executive leader- processes to excel at that will help it
agement (ERM), where organizations ship – “Where do we want to go?” – as attain the multiple strategic objectives
can match their risk exposure to their well as the use of a compass and navi- causally linked in the strategy map.
risk appetite. This is where they can gation system to answer the questions This is also where research and devel-
wager the big bets. These include the “How will we get there?” and “How well opment, plus innovation projects are
potential benefits from risks taken and are we doing trying to get there?” incubated.
from missed opportunities of risks not
taken. Should we enter a market we 1) Risk Management – Here the exec- 3) Investment Evaluation – Resources,
are not now participating in? Should utives stand back, identify and assess financial or physical, must always be
we offer an innovative product or ser- the market and environment, a process considered as being scarce, so they
vice-line while unsure of the size of the that includes the identification of their must be wisely chosen. The capital
market or competitor reactions? How key risk indicators (KRIs). Formulating markets now ultimately judge com-
much should we rely on technology to KRIs is essential to understand the root mercial companies on their future net
automate a process? But organizations causes of risk. They include a predic- positive free cash flow. This means that
need to first measure their operational tive capability, so that by continuously every incremental expense or invest-
risk exposure and appetite, in order to monitoring variances between expected ment must be viewed as contributing to
manage it. against re-forecasted KRIs, the organi- a project requiring an acceptable return
zation can react before rather than after on investment (ROI), including recover-
A Risk-based Performance a future event occurs. Firms need to ing the cost of capital. Spending con-
Management Framework utilise a combination of qualitative and straints exist everywhere. That is, cus-
The premise is to link risk performance quantitative techniques. tomer value and shareholder value are
to business performance. As it is popu- not equivalent and positively correlated,
larly described in the media, perfor- 2) Strategy and Value Management but rather they have trade-offs with an
mance management, whether defined – A key component of the portfolio of optimum balance that companies strive
narrowly or ideally more broadly, does Performance Management methodolo- to attain. This is why the annual bud-
not currently embrace risk governance. gies is formulated here: the organiza- get and the inevitable rolling spending
It needs to. The figure below illustrates tion’s vision, mission, and strategy map. forecasts, typically disconnected from
how risk management and performance This is how the executive team both the executive team’s strategy, must be
management combine to achieve the communicates to and also involves its linked to the strategy.
ultimate mission of any organization: to managers and employee teams. Based
maximize stakeholder value. on the strategy map, the organization 4) Performance Optimization – In this
collectively identifies the vital few and last step, all of the execution compo-
nents of the Performance Management
��������������������������������� portfolio of methodologies kick into
↵ �����������������
gear. These include but are not limited
to: customer relation management
(CRM), enterprise resource planning
↵
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������������������ with its predefined key performance
→
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of the total universe of KPIs), at this
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stage becomes the mechanism to steer
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Journal of Risk Intelligence
the organization. The balanced score- • Value at Risk (VaR) – the idea of • Economic Value Added (EVA) – looks
card includes target-versus-actual KPI VaR stems from the question “how at the creation of value in excess
variance dashboard measures, with much might we lose when things go of the required return on capital (or
drill-down analysis and colour-coded against us? – The question can be hurdle rate).
alert signals. Scorecards provide answered in the form “we are X% EVA = profit – (capital x hurdle-rate)
sure that we will not lose more than
operational and financial performance
$V over the next N days”. $V is then
feedback so that every employee, who • Risk-adjusted return on capital
known as VaR. Regulators gener-
is now equipped with a line of sight (RAROC) - is defined as EVA/capital
ally want to see the value of V when
to how he or she helps to achieve the X=99% and N=10 days, while, for
executives’ strategy, can daily answer internal control purposes, institutions There are in fact, many other risk-based
the fundamental question, “How am can choose whatever values they feel performance measures used in the
I doing on what is important?” The comfortable with. financial services industry, but these are
clockwise internal steps – “Improve, not always clearly defined, for example:
Adjust, Re-Monitor” – are how employ-
Value at Risk (VaR), has become
ees collaborate to continuously re- a very popular risk measure since ROA: Return on assets
align their work efforts, priorities, and the introduction of new regulations ROC: Return on Capital
resources to attain the strategic objec- (Basle 1996 Amendment, CAD2). It is RORAA: Return on risk adjusted assets
tives defined in step 2. accepted by the regulator for calcu- RAROA: Risk adjusted return on assets
lating minimum capital charges.
RORAC: Return on risk adjusted capi-
The four steps are a continuous cycle, Also in this context, Return on VaR tal
where risk is dynamically re-assessed (RoVaR) can be defined as:
and strategy subsequently adjusted. RoVaR = expected return/VaR Increasingly, such measures are used
for a number of business applications,
Risk-based performance for example:
For non-normally distributed assets,
measures • Ranking and deal profitability
RoVaR has the advantage of concen-
There has been some debate in recent trating on the size of the downside • Pricing of risky assets and deals
years about which measures to use risks • Capital allocation decisions
for risk-based performance manage-
• Compensation schemes
ment and what a “good” performance
• Risk-adjusted Profitability (RAP)
measure is. As ever in this field, the
=Profit / Risk Capital - this can be From theory to practice
1
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Journal of Risk Intelligence
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