Saturday, June 19, 2010

On Risk Management, Creating the Risk Intelligent Enterprise


The following is an Essay on Surviving and Thriving in Uncertainty, a book by Frederick Funston and Stephen Wagner:

After the housing bust and credit crunch of the past couple years, waves of bank failures and home foreclosures followed. Construction and financial services suffered enormously, and mass layoffs followed suit. One of the downfalls that many of today’s companies share is a failure to prepare for risk in the pursuit of reward. As even more recent events have shown, preparing for risk isn’t just limited to finance or construction. The recent tragedy in the Gulf of Mexico has shown that British Petroleum had not prepared well enough for rewarded risk. Also, those who work in the medical profession will have to adjust to the new regulatory environment in exploiting new opportunities.

Frederick Funston and Stephen Wagner argue in their new book, Surviving and Thriving in Uncertainty, that the current understanding of risk management is limited. Commonly understood, risk management secures, protects, insures or otherwise indemnifies people and business against loss. While it is necessary to guard against loss, it is insufficient. All opportunities entail some degree of risk, and this is something that many enterprises often forget. Describing what the authors refer to as the risk intelligent enterprise, they posit that risk must not be separated from value creation.

The authors separate and make a distinction between unrewarded risk and rewarded risk. Unrewarded risk is what we normally think of in risk management. For example, regulatory compliance, IT security, insurance are all examples of unrewarded risk; preparing for such risks protect us from loss. Rewarded risk, on the other hand, has the potential for an upside. Research and development, breaking into new markets and establishing new relationships are all examples of rewarded risk.

Through their years of experience and education, Funston and Wagner devote ten chapters to ten fatal flaws that will do an enterprise in. Each fatal flaw is described in the beginning of the chapter and then is followed by the authors’ recommendation on how the risk intelligent enterprise would best mitigate each flaw. The greatest takeaway that the risk intelligent enterprise must understand is that the enterprise must be disciplined, resources are limited and the future, as well as the opportunities that the future holds, is uncertain and risky.

For example, many Chief Financial Officers lack discipline because they think too much on a short term basis. Indeed, in March 2007, Duke University and CFO Magazine found that more than three quarters of CFOs would sacrifice long-term earnings for a better quarterly report. Such “short-termism” as the authors describe it, can have detrimental effects. Short-termism leads to taking on high risks in the pursuit of immediate earnings. Such high risks often include levering up and holding onto less liquid assets. When such high risk behavior by management goes south, as it often does, the enterprise will find itself struggling to pay its creditors. Defaulting on the creditors will give the enterprise a front row seat in bankruptcy court much to the chagrin of the company’s shareholders.

Another fatal flaw that many enterprises succumb to is a failure to hold on to adequate reserves. A margin of safety is necessary for any enterprise to be resilient enough to withstand any shocks the environment may throw at you. For example, the book mentions that many businesses, in an effort to become quicker, cut costs and become more efficient firms go beyond lean; they become anorexic. The danger is that a firm will not be resilient enough to withstand any complications from risk if it does. Firms must be cognizant of the future when they are deciding on how lean they should be. There is also a danger in holding on to a margin of safety that is too large. Trade-offs to consider are limited inventory space and maintaining a proper degree of cash reserves. Holding on to too much cash will result in opportunity costs. That is to say an enterprise will forego expanding output, hiring new people and pursuing value creation in lieu of holding onto more cash.

Management should set proper time horizons on attaining their goals. Such timelines shouldn’t necessarily be strict, but management should be disciplined enough follow through on prescribed goals within a reasonable timeframe. Understanding that the future is uncertain and the pursuit of value contains risk should help direct the decision making of all those within the risk management enterprise on how to best deploy limited resources.

The book concludes on ideas on how to best organize a risk intelligent enterprise. So long as management and risk managers are willing to recognize and challenge their assumptions, the costs of employing a risk intelligent enterprise are rather inexpensive. Indeed Funston and Wagner dedicate a whole chapter in arguing that risk intelligence is free. For instance, in his essay, “Risk Management” Joe Nacera describes a situation where risk management need not cost anything. Nacera mentions that the leadership at Goldman Sachs had noticed problems in their value at risk (VaR) model. Due to the problems of the VaR model, Goldman Sach’s senior management made a conscience decision to change course. In Goldman’s pursuit of value, they began to shift out of mortgage backed securities (MBS) as early as 2006. When the crisis hit two years later, Goldman Sachs was able to weather the storm better than its competitors. Such risk intelligence by Goldman Sachs’ leadership didn’t cost anything, but saved them billions. Furthermore, the firm was able to deploy resources that resulted in further value creation for its shareholders.

Without the proper mindset towards risk management, firms will find themselves struggling. The creation of value should never just be assumed. Rather, risk should always be associated with opportunities and value creation. Firms that fail to recognize the relationship between risk and reward, such as Lehman Brothers or British Petroleum, will either struggle or find themselves out of business. Firms that understand the relationship and strike the right link, like Goldman Sachs, will not only survive, but they will thrive in a world of uncertainty.

More on this topic:

Funston, Frederick, and Stephen Wagner. Surviving and Thriving in Uncertainty: Creating the Risk Intelligent Enterprise. Hoboken, N.J.: Wiley, 2010. Print.

Nocera, Joe. "Risk Management." The New York Times Magazine. 2 Jan. 2009. Web. 18 June 2010.

< http://www.nytimes.com/2009/01/04/magazine/04risk-t.html>.

Pfaendler, Shelly “How to Get Smart About Risk Management.” Wall Street Journal, 12 Apr. 2010. Web. 18 June 2010. < http://online.wsj.com/article/PR-CO-20100412-904275.html>.

Duke University and CFO Business Outlook, “Survey: CFO Outlook Improves; Capital Spending, Hiring Expected to Increase,” Office of News and Communication, Duke University and CFO Business Outlook, 7 March 2007,

No comments:

Post a Comment