Asia Connect - Can Boards Take A Leading Role In Risk Governance

Board’s role in risk management in Singapore 

Dr. Grace Wu,
Principal Researcher, Aon Consulting Global Research Center

In this article

Huge losses suffered by AIG, Citic Pacific, and other financial institutions in 2008 and 2009 are seen as resulting from a lack of risk oversight. More broadly, the media, regulators and politicians have blamed the credit market meltdown and resulting financial crisis on inadequate risk management supervision by companies and their boards of directors.

"Risk management" has become a critical component of corporate governance. The public and political perception that undue risk-taking was central to the breakdown of the financial markets has fueled an extensive legislative, regulatory, and even judicial focus on risk management and risk prevention.

For example, in the UK, the government-commissioned Walker Report found that governance failures contributed materially to excessive risk-taking in the lead up to the financial crisis. In the US, the SEC in December 2009 approved rules that require disclosures in proxy and information statements about the extent of the board's role in risk oversight and the relationship between a company's overall employee compensation policies and its risk management practices. Regulators are requiring corporate boards of directors to aggressively address the perceived problem of "excess risk" generally.

Boards of directors are now expected to take a leading role in overseeing risk management structures and policies in addition to their responsibility of keeping an eye on the implementation of corporate governance procedures and guidelines. Given the heightened importance of risk oversight due to the recent financial crisis, boards must now reconsider their role in risk management oversight and determine how their effectiveness in risk governance can affect corporate outcomes.

The Aon Consulting Global Research Center analyzed responses made by 316 directors of Singapore companies in order to assess corporate boards' implementation of risk management governance and its performance consequences in Singapore. Of the respondents, 153 were directors from companies nominated for the Singapore Best Managed Board Awards in 2007 and 2008, and the rest were directors from Singapore companies that engaged Aon Consulting to conduct board evaluation projects during the period 2007 to 2009.

The analysis focused on five different aspects of risk management. The analysis looked at the extent to which:

1. The board has an ongoing process to identify risks and measure their potential impact;
2. Board members know and understand which risk management system has been established by management;
3. The Board reviews the company's risk portfolio and accepts their accountability in managing risks across the company;
4. The Board is apprised of significant risks and the management's response towards them; and
5. The Board devotes attention to striking a balance between steering business growth and managing risks effectively.


Table 1 presents directors' responses regarding the effectiveness of the board under their care in each of the five areas noted above. A five-point scale is used to gauge each director's response to the various questions with "1" indicating "needs significant improvement" and "5" indicating "outstanding". 

Table 1 Can boards play an effective role in risk governance?

The Board… Needs significant improvement Needs improvement Acceptable Consistently good Outstanding
Has an ongoing process to identify risks and measure their potential impact  2%  13%  12% 62%  12%
Puts in place a system which facilitates adjustments to the company's risk profile 3% 14%  17% 59% 7%
Recognizes accountability in managing risks across the company 0%  3%  7%  62%  28%
Is apprised of the most significant risks and management's responses 1% 
7%  6%  55%  32%
Is able to steer business growth while ensuring necessary risk management 0%  5%  1%  62%  33%


Fifteen percent of the directors participating in the survey reported that their board needs improvement to a great or very significant extent in establishing an ongoing process to identify risks. Seventeen percent of the directors reported that their board needs improvement or significant improvement in putting in place an effective risk management system.

These responses suggest that current structures and processes are deemed inadequate because effective risk management requires ongoing attention to inculcate a risk management mindset into the corporate culture. As the business environment changes continuously, directors cannot take comfort from simply the existence of a risk management system. Without constant attention, the system will crumble when surprises hit the company.

While directors have an important role in the oversight of risk management, the board should not be involved in the day-to-day activities of risk management. Instead, board members need to satisfy themselves that risk management processes are adapted to and integrated with the company's business growth strategy, and that management has taken the necessary steps to foster a culture of risk-adjusted decision-making.

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Board effectiveness in risk governance

Can board implementation of risk governance effectively enhance the overall level of board effectiveness, mitigate company risks for investors, and generate value for shareholders and other stakeholders? In our survey of Singapore directors, we found that the board's implementation of different risk governance activities uniformly and significantly associates with higher overall effectiveness of the board.

Table 2 below presents the correlation between board effectiveness on five risk governance activities and board/corporate outcomes.

Table 2 Consequences of board risk governance activities

The Board… Board effectiveness Net profit margin Total Shareholder return over 1 year Total Shareholder return over 2 years Business risk
Has an ongoing process to identify risks and measure their potential impact +++ ++ + +  
Puts in place a system that facilitates easy adjustments to the company's risk profile ++ +++ + +  
Recognizes accountability in managing risks across the company +++        
Is apprised of the most significant risks and management's responses +++ + ++ +++ ++
Is able to steer business growth while ensuring necessary risk management +++ ++     ++

 

+++ - Highly significant positive correlation at 0.1 percent level (two-tailed test, p<.001)
++    - Highly significant positive correlation at 1 percent level (two-tailed test, p<.01)
+       - Significant positive correlation at 5 percent level (two-tailed test, p<.05)

The first row of Table 2 presents different dimensions of board/corporate outcomes:

  • Responses regarding current board effectiveness were collected from this survey, indicating the overall effectiveness of each board compared to other boards the director has served/is serving.
  • Net profit margin is a ratio comparing net profit after tax to revenue.
  • Total shareholder return (TSR) over a period is defined as the net stock price change plus the dividends paid during that period1
  • Business risk covers risk factors such as business risk, operating risk, strategic risk, asset risk, size and diversity2

These correlation results show that board excellence in four out of the five risk governance activities that we identified can significantly augment net profit margin. Excellence in three out of the five activities can generate more value for shareholders, as measured either by one-year total shareholder return or two-year total shareholder return.

These results demonstrate that risk management is not an impediment to the conduct of business; in fact, it is an integral component of the company's strategy and value generation process.

Aon's analysis also indicates that the level of business risk can be significantly reduced if the board can balance the company’s growth needs vs. risk management requirements and is apprised of the most significant risks.

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Conclusion

Given the current unprecedented and huge market fluctuations, ineffective risk management impacts a company's competitive position and even its viability. Regulatory reform may soon raise the risk management bar for all organizations and require new mechanisms to control irresponsible risk-taking activities. In fact, companies should not resist, but rather embrace, these efforts. Our research clearly shows that effective risk governance oversight increases the effectiveness of the board and reduces the level of business risk faced by the company.

About this research

The author's analysis of information in the corporate boardroom is based on an extensive review of the literature on governance and boardroom dynamics globally and on interviews with directors, senior executives, government regulators, board association leaders, financial analysts and institutional investors in Singapore. Additional, the Global Research Center at Aon Consulting hosted a roundtable discussion among independent corporate directors in August 2010 to solicit feedback on existing and potential boardroom concerns on risk governance.

Contact

For more information on risk management and corporate governance, please contact Dr. Grace Wu, Principal Researcher in the Aon Consulting Global Research Center at grace_wu@aon-asia.com.

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Notes:

1 Data on net profit margin, TSR over 1 year period, and TSR over two years' period were collected from corporate annual reports.
2 Data on business risk was obtained from World Vest Base Business Risk

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