What Is Enterprise Risk Management for Financial Institutions?

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Running any type of business or organization involves risk. How a business manages that risk could mean the difference between success and failure. That’s precisely what enterprise risk management is. It’s a comprehensive and structured approach to managing risk. And while enterprise risk management is used in all industries, financial institutions have unique risks and responsibilities, which make their ERMs equally unique.

Key Features of Enterprise Risk Management

An important feature of a solid enterprise risk management framework is that it’s both strategic and holistic. In other words, rather than each department of a firm having its own approach to assessing and mitigating risk, an ERM is a company-wide, top-down approach to assessing, anticipating and addressing potential hazards to the organization’s objectives or profitability. 

The Enterprise Risk Management Framework

As with other company-wide protocols for large entities, enterprise risk management can get complex. For this reason, they are usually constructed with a guiding framework which covers four key factors.

1. Risk identification: All risks to a financial institution must be identified and categorized. These could include such things as potential crises, legal issues, financial risk exposure and others. These need to be communicated to the appropriate leadership teams.
2. Risk strategy: Organization leaders must develop a clear strategy on how the company will deal with each type of risk. This includes establishing tolerance levels that are acceptable.
3. Risk decisions: The approach to each type of risk is often unique. For this reason, once risks are assessed, leaders need to decide how to handle. This could include accepting the risk, hedging against it, transferring it or finding ways to prevent before the problem becomes too too large.
4. Risk organization: Well-defined internal risk management teams and processes need to be established company-wide to monitor and manage threats as they arise. This includes identifying key personnel and setting clear protocols, milestones and goals.

Why Enterprise Risk Management Is Vital for Financial Institutions

Because they are entrusted with individuals’ and businesses’ finances, banks, insurers, investment institutions and other financial institutions have a particularly important and often outsized role in our economy. 

Example

The Global Financial Crisis of 2008 to 2009 (often referred to as The Great Recession) was in large part due to the lack of financial institutions to adequately assess risk. This led to major institutions, such as Bear Stearns and Lehman Brothers, collapsing and others having to be bailed out by the U.S. government, i.e., the American taxpayer. Millions of people were directly affected. This led to tighter government regulation of financial institutions and financial institutions placing a greater emphasis on risk management to avoid financial, legal and other risks.

6 Major Benefits of a Robust Enterprise Risk Management System

There are many ways that a good enterprise risk management program can benefit a financial institution. Not all of them are specifically risk-related. Here are six ways a good ERM can pay off.

1. Loss minimization: A well-structured enterprise risk management system can identify potential monetary losses early enough to allow a financial institution to mitigate or even avoid them. An ERM allows the institution to be proactive toward the many financial risks they face.
2. Regulation compliance: As stated above, especially post-Global Financial Crisis, financial institutions are closely regulated. As such, the penalties for noncompliance can be costly. A robust enterprise risk management program can help its company remain compliant and avoid both monetary fines and disruptions to their operations.
3. Efficiency improvement: Unforeseen challenges occur in every industry, including the world of finance. An enterprise risk management program can help a large organization respond to unexpected challenges quickly and appropriately, minimizing disruptions to operations. This results in greater efficiency.
4. Growth maximization: A strong and well-defined enterprise risk management system can result in increased consumer and customer trust. This is vital to financial institutions, which are entrusted with individuals’ and businesses’ finances.
5. Profitability improvement: The logic goes that minimizing any chances of risk leads to improved profitability. Therefore, getting ahead to prevent financial loss results in a better bottom line.
6. Strategy adherence: To achieve profitability, minimize loss, remain compliant and more, the company needs to have a clear strategy. An enterprise risk management system looks at every risk that a business could face and ensure that its approach helps reach those big-picture goals.

Enterprise Risk Management Best Practices

To be truly effective, there are certain attributes an enterprise risk management program must have and do. First and foremost, companies need to implement a holistic system across its entire organization. The program must identify, assess and prioritize any and all risks it might encounter.

Next, it must compose action plans that mitigate or eliminate the biggest threats to its business. It also must put systems in place to monitor ongoing risk or risk mitigations, as well as enforce risk management policies. Finally, it should assign specific roles and responsibilities to employees, with clear instructions on how to handle different threats.

Communication is key to a robust and effective enterprise risk management program. This includes fostering a culture of honesty about risk throughout the company.

Unique Challenges for Financial Institutions

As discussed above, due to their unique role in the economy, financial institutions can have an added burden when it comes to enterprise risk management best practices. Financial institutions are heavily regulated and closely monitored. They are often required to undergo stress tests and other audits. Businesses may have certain regulations to follow, such as holding a minimum amount of money. By not following the regulations, a business could be penalized, which is another reason to have a proper risk management system in place.

The Bottom Line

While every business could benefit from an enterprise risk management system, banks, insurers, brokerages and other financial institutions should implement one. Because of the added responsibility and risk surrounding the current economy, along with strict regulations, financial institutions that do not do all they can to protect the company’s assets and long-term growth and profitability.

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