The nexus between enterprise risk management and risk-adjusted bank performance: evidence from South Africa

Abstract

Risk-adjusted bank performance provides an objective performance measurement framework by adjusting profits for risk, unlike historical and arbitrary accounting performance measures, which do not account for risk. While substantial empirical evidence exists on the impact of enterprise risk management (ERM) on bank performance, few studies, if any, have focused on the nexus between ERM and risk-adjusted bank performance using robust measures. The computation of risk-adjusted bank performance measures remains an area in need of new knowledge development and further empirical exploration. The purpose of the study was to determine the nexus and impact of ERM on risk-adjusted bank performance in South Africa. The study examined the effect of ERM sophistication (ERMS) from both a general bank performance and risk-adjusted bank performance perspective. It also investigated the impact of the ERM Index (ERMI) from both a bank performance and risk-adjustment perspective. ERMS was used to gauge the level of advancement of a bank’s ERM capabilities and their impact on bank value creation and sustainability. The study sample consisted of 10 South African banks over a 21-year period (2002–2022). Panel data, covering both the global financial crisis (GFC) of 2007 to 2009 and the Covid-19 period of 2020 to 2022, were used for the study. Secondary data were sourced from published audited financial statements. Panel data multiple regression analysis was used to test statistical relationships. Dependent variables included return on assets (ROA), return on equity (ROE), Tobin’s Q, risk-adjusted return on capital (RAROC) and the modified z-score (M_ZScore). Independent variables included financial slack, interest rates, inflation, gross domestic product (GDP) and foreign exchange rate. Using Hausman’s (1978) test, a fixed effects model (FEM) rather than a random effects model (REM) was selected for the study. The study proposed a risk-adjusted ERMI that combines qualitative bank-based ERM themes and quantitative bank-focused indicators from the CAMELS bank performance measurement framework. Capital adequacy ratio (CAR), RAROC and M_ZScore variables were used to evaluate ERM from a bank risk-adjusted performance perspective. The empirical results show that the risk-focused performance measures, RAROC and M_ZScore, are positively associated with improved risk-adjusted bank performance. The accounting performance measure, ROA, and the financial market measure, Tobin’s Q, were also found to be positively associated with improved bank performance. However, an inverse relationship was found between another performance measure, ROE, and bank performance, indicating that empirical outcomes depend on the specific measure used. The study makes several contributions. Unlike traditional studies that focus on ROA and ROE, this study strengthens the theoretical link between ERM and risk-adjusted performance measures, reinforcing the concept of risk-return trade-off in banking. Empirically, the study contributes to literature and research by developing and empirically testing ERMI, thereby providing a structured approach to measuring ERMS using both qualitative and quantitative data instead of binary ERM indicators. Methodologically, the study goes beyond the traditional approaches of assessing bank performance through measures such as RAROC and M_ZScore to account for banking risk in performance evaluation. The empirical outcomes offer valuable new insights for prudential regulatory authorities and banking executives, including chief risk officers (CROs), to strengthen both national and global financial systems and to enhance stability and certainty in financial markets.