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April 6, 2006 4:46 pm

Ranking risk and finance

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As professors, we are used to giving grades, but managers give grades, too. Through the use of performance measurement tools such as the balanced scorecard, executives rank and grade their businesses according to a range of criteria.

In this spirit, last year, we conducted a survey of CFOs of major non-financial companies. The respondents were given complete confidentiality; neither we, nor our research partners, can link a CFOs’ responses to their companies. In total, 334 public and private businesses from 39 countries responded. (The full results can be found at

We asked the CFOs to grade the performance of their finance units using a natural but subjective measure: what fraction of your company’s value would you attribute to the finance function? Given the novelty of the question, we suspected that responses would vary wildly. In fact, there was more consistency than we could have imagined.

The report card

The average CFO in our sample judged that the finance function contributes approximately 10 per cent of the value of the company. While responses varied from business to business, there was relatively little variation by region, industry or between public and private companies.

Starting from this high level evaluation, we asked each CFO to grade the specific finance sub-functions along a number of dimensions: which functions are most valuable, which work well, and which need the most additional resources? We then drilled down to explore capital structure, liability management, liquidity management, distribution policy (dividends and share repurchases) and risk management.

At the highest level, the risk management function received mixed marks. When asked to judge how valuable the various finance functions are, risk management was ranked eighth out of 19 listed finance activities. This ordering of responses was fairly consistent across industries and between listed and unlisted companies.

However, Asian companies tended to appreciate risk management more than non-Asian businesses. Overall, this response indicates that the risk management function is seen as a solid contributor to corporate value across the board.

When we asked about their satisfaction with various finance functions, risk management scored slightly lower, at 10th. Again, the responses were fairly consistent across different groups of companies, except for CFOs of North American companies and listed companies who were slightly more satisfied than CFOs of companies located elsewhere, or those of unlisted companies.

Risk management stood out, ranking first by a large margin, when the CFOs were asked whether it needed additional resources. This judgment was particularly pronounced in certain regions, such as Latin America and Asia, and in specific industries, such as automaking and natural resources.

Why spend more on risk management?

Nearly a third of the survey dealt with the risk management function, and our discussions with hundreds of corporate finance managers gave us a greater insight into why risk management presents the strongest need or opportunity for many companies.

We propose two related explanations:

The opportunity Companies are buffeted by a large number of risks, risk management provides many benefits, and risk management offers a solid “bang for the buck” in terms of value creation relative to costs.

The need While risk management potentially offers benefits, it also has some serious defects and CFOs need more resources to get it right.

The case for risk management

The CFOs in our survey did not consider their companies to be especially risky. We asked them to gauge their company’s riskiness relative to peers in their sector and only 16 per cent saw their company to be either “more risky” or “substantially more risky”.

Nevertheless, the CFOs see their companies buffeted by a large number of risks. Despite the fact that the survey was completed by finance executives, the respondents judged non-financial risks to be as important, if not more important, than financial risks.

We asked respondents to rank native risks. Of the top ten risks, four were financial and six were broader business risks. The financial risks and their rankings were: foreign exchange (1); financing risk (3); commodity price risk (8); and interest rate risk (10). The prominence of foreign exchange risk reflects the global nature of the participating companies, while the relatively low ranking of interest rate risk is due to the exclusion of financial services businesses from the survey. In practical terms, the anxiety over financing risk manifests itself in companies holding substantial amounts of excess cash.

We asked the CFOs to assess the costs and benefits of risk management. The direct costs of purchasing risk management products, opportunity costs (such as locking in the price of an input but seeing input prices decline afterwards) and the difficulty of explaining risk management to the board of directors were judged more severe than the costs of running a risk management group, compliance and reporting, explaining the activity to investors or minimising rogue trading.

The overwhelming benefit of risk management was its ability to “improve company-wide decision making”. Whereas academic theories of risk management focus on sustaining investment programmes, avoiding costly financial distress and minimising taxes, the executives in the survey see risk management as helping them make better decisions.

This perspective is supported by our discussions with executives. Companies are in the business of taking risks to earn returns and a well-functioning risk management regime improves the ability to make the trade-off between risk and return.

For example, at the annual meeting of the Global Association of Risk Professionals in February, a panel of chief risk officers (CROs) underscored this proposition. Rather than thinking of risk management as a form of policing or viewing the CRO as the “chief paranoid officer”, they saw risk management as informing the strategic and tactical decisions made throughout the company.

Where this works, it can be quite effective. In a series of questions, we asked CFOs to judge the specific value of the risk management function, along with the fraction of the finance budget it consumed. Only a relatively small proportion (20 per cent) felt comfortable making these two assessments. When they did, they felt that risk management was a cost effective investment, contributing a larger proportion of the value created in the finance function than the costs it incurred.

Room for improvement

Approximately 40 per cent of respondents were unable to estimate the value of the risk management function. We believe that this reflects CFO frustration in companies where they do not have a handle on risk or the risk management function itself. Indeed, we estimate that in 20-40 per cent of the companies in our sample, the risk management function is not centralised. While it is beneficial for all executives to be sensitised to risk issues, without appropriate co-ordination, risk management will be ineffective or, worse, counterproductive.

Even more troubling, nearly half of the companies acknowledged that they do not explicitly measure the performance of their risk management activities. Risks must be measured before they are managed, but in these cases, such rigour is apparently not applied to risk management groups.

The failure to measure performance was explained in various ways. First, the mandate of the risk management group is not always clear. Even companies that articulate performance measures for their groups identified multiple measures. If these goals come into conflict – for example, stabilising earnings versus mitigating cost increases – performance measurement is complicated. Second, finance executives bemoaned the sheer difficulty of measuring success. However, without such mechanisms, it may be difficult, if not impossible, to tell how the group is doing.

These concerns were voiced more concretely when we asked the CFOs to identify areas for improvement in risk management. The factors that were mentioned frequently included better measurement of quantifiable risks, coverage of a broader set of risks, better appreciation of unquantifiable risks and generally improved risk management. These are all mainstream elements in risk management programmes. While it is natural to strive for sustained improvement at the core of the function, the mediocre satisfaction ratings for risk management and the high scores for additional resources suggest many opportunities are not met.

Part of the reason has to do with the wider organisation. The top area for improvement in risk management identified by CFOs was for greater and broader employee understanding of risk. And, while less pronounced, for better board-level understanding of the risk management function.

If risk management is to help companies make better decisions, this is essential. Our survey suggests that this broad appreciation of risk is infrequent outside of risk management groups. For example, when asked how they consider risk in their strategic planning processes, 10 per cent of companies admitted that they neither consider nor quantify risks. Another 55 per cent said that they consider risks, but do not quantify them in their strategic planning processes.


Judged against the potential for risk-based thinking to inform key decisions, the failure of risk analysis to penetrate the corporate level strategic decision-making process suggests opportunities for improvement. From our reading of this survey and regular discussions with executives, many CFOs seem to be giving risk management a less-than-honours grade, but encouraging the student to stick with it, because the potential payoff is huge.

Henri Servaes is professor of finance at London Business School. Peter Tufano is the Sylvan C Coleman Professor of Financial Management at Harvard Business School.
Their research was conducted in collaboration with Deutsche Bank and the Global Association for Risk Professionals.

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