Enterprise Risk Management and Default Risk: Evidence from the Banking Industry

• Author: Sara A. Lundqvist,Anders Vilhelmsson
• Date: 01 March 2018
• DOI: http://doi.org/10.1111/jori.12151
• Published date: 01 March 2018

ENTERPRISE RISK MANAGEMENT AND DEFAULT RISK:

EVIDENCE FROM THE BANKING INDUSTRY

Sara A. Lundqvist

Anders Vilhelmsson

ABSTRACT

Enterprise risk management (ERM) has emerged as a framework for

more holistic and integrated risk management with an emphasis on

enhanced governance of the risk management system. ERM should

theoretically reduce the volatility of cash flows, agency risk, and

information risk—ultimately reducing a firm’s default risk. We empiri-

cally investigate the relationship between the degree of ERM implemen-

tation and default risk in a panel data set covering 78 of the world’s

largest banks. We create a novel measure of the degree of ERM

implementation. We find that a higher degree of ERM implementation is

negatively related to the credit default swap (CDS) spread of a bank.

When a rich set of control variables and fixed effects are included, a one-

standard-deviation increase in the degree of ERM implementation

decreases CDS spreads by 21 basis points. The degree of ERM

implementation is, however, not a significant determinant of credit

ratings when controls for corporate governance are included.

This is an open access article under the terms of the Creative Commons Attribution-

NonCommercial License, which permits use, distribution and reproduction in any medium,

provided the original work is properly cited and is not used for commercial purposes.

Sara Lundqvist is at Gothenburg University, Department of Business Administration and The

Centre for Finance, Vasagatan 1, 40530 Gothenburg, Sweden. Sara Lundqvist can be contacted

via sara.lundqvist@handels.gu.se. Anders Vilhelmsson is at the School of Economics and

Management, Department of Business Administration, Lund University and the Knut Wicksell

Centre for financial studies. We wish to thank two anonymous referees, Betty Simkins, Tom

Aabo, Niels Hermes, Hossein Asgharian, Lars Oxelheim, and Niclas Andr

en as well as seminar

participants at Lund University for helpful comments and suggestions. Anders Vilhelmsson

gratefully acknowledges research funding from Marianne and Marcus Wallenberg Foundation

[Correction added on 27 June 2017, after first online publication: the research funder has been

changed from “Knut and Alice Wallenberg Foundation” to “Marianne and Marcus Wallenberg

Foundation”.]

#2016 The Authors. Journal of Risk and Insurance published by Wiley Periodicals, Inc. on

behalf of American Risk and Insurance Association. (2016). Vol. 85, No. 1, 127–157 (2018).

DOI: 10.1111/jori.12151

127

INTRODUCTION

Enterprise risk management

1

(ERM) has emerged as a framework for more holistic

and integrated risk management. An integral part of ERM is enhanced internal

control and governance of the risk management system (Committee of Sponsoring

Organizations of the Treadway Commission [COSO], 2004). A call for better

governance in response to corporate failings and the financial crisis (Kirkpatrick,

2009) can be attributed to ERM’s advancement in more recent years.

ERM should be able to create long-run competitive advantages and value through

consistent and systematic measurement and management of firm risks and by

ensuring proper information and incentives for business managers (Nocco and Stulz,

2006). ERM incorporates traditional risk management, such as risk identification and

hedging, and risk governance, such as the organization, structure and monitoring of

the risk management system. The objective of this study is to determine if there is a

relationship between default risk and the degree of ERM implementation.

A firm’s default risk is a forward-looking measure of the firm’s own probability of

default orthe current and future risk facingits creditors. Credit ratingsare a commonly

used proxy for default risk, and many credit rating studies have focused on how

quantifiable and retrospective factors, like financial ratios or macroeconomic factors,

predict credit ratings. While these factors do contain a lot of information, more

qualitativeaspects of the firmare often ignored in defaultrisk prediction despitethe fact

that theymay better capture how the firmwill act in the future. Corporategovernance is

such a qualitative aspect, but only a limited number of studies have investigated the

relationship between corporate governance and credit ratings (Bhojraj and Sengupta,

2003;Ashbaugh-Skaife, Collins,and LaFond, 2006).Surprisingly, theexisting studies on

default riskpredication have overlookedan important qualitativeand forward looking

factor directly related to a firm’s default risk, namely, the firm’s risk management.

Risk management theoreticallydecreases the volatility of cash flows, which lowers the

probability of default and ultimately lowers the expected costs of financial distress

(Smith and Stulz, 1985;Bartram, 2000). Through its risk management component, ERM

should result in the same benefits. In addition, governance mechanisms have been

found to decreasea firm’s default risk by increasing the amount of credibleinformation

available forproperly evaluating the default risk of the firm and decreasing agencyrisk

through monitoring (Bhojraj and Sengupta, 2003; Ashbaugh-Skaife, Collins, and

LaFond, 2006). These same benefits should theoretically also be attained through the

implementation of an ERM system; the risk governance component facilitates

information and communication and provides an additional layer of monitoring but

in the context of the risk management system. There can be varying degrees of ERM

implementation, from superficial to comprehensive, and ERM should be the most

effective when implemented to higher degrees.

There is case-specific evidence that effective ERM reduces risk and can help a firm

maintain or improve its credit rating (Fraser and Simkins, 2007). The practical

1

Sometimes also referred to as enterprise-wide risk management, holistic risk management,

integrated risk management, and/or strategic risk management.

128 THE JOURNAL OF RISK AND INSURANCE