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

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 empirically investigate the relationship between the degree of ERM implementation and default risk in a panel dataset 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 spread (CDS) 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.