In their book, Surviving And Thriving In Uncertainty: Creating The Risk Intelligent Enterprise Funston and Wagner shed to light how a conventional approach to risk management has failed many businesses.
In the book, the authors exhibit a situation where businesses have failed to identify the differences between conventional wisdom and unconventional realities when it comes to managing business risks.
They go on further to argue that, a traditional approach to risk management is misguided as it assumes that:
- Factors affecting events will remain equal.
- Events are mildly random.
- Extreme events are rare and should be treated as anomalies.
- Forecasts are accurate and reliable.
- Events are independent of one another.
- Markets are efficient and rational.
Instead, Funston and Wagner believe organizations should take an unconventional approach to risk management which takes into consideration unconventional realities based on a random walk with hops, skips and jumps.
By taking this approach, the authors believe managers will be able to learn that:
- Factors affecting events will change.
- Events can be wildly random.
- Extreme events are more common than we think and should be treated as such.
- Forecasts can be misleading and unreliable.
- Events interact.
- Markets are neither efficient nor rational.
The events of the past decade such as: the 1997 Asian Financial Crisis, 1998 Russian Financial Crisis, September 11 attacks, 2004 Asian Tsunami, 2010 Haiti Earthquake and the 2007 Global Financial Crisis all prove that we live and work in a world full of uncertainty.
A number of organizations were completely caught unaware and unprepared by these events and suffered huge loses.
As no one person or business can accurately predict the future, planning for the worst case scenario in advance and developing early warning systems will reduce the severity of an extreme event.
A number of causes have been levelled on the 2007 Global Financial Crisis, chief among them being lack of information to guide decision making and poor risk management by financial institutions.
In pursuit of higher salaries and bonuses, managers and their employees became very much innovative and risk-taking.
They developed complex financial products carrying a lot of risk too difficult to understand for the layman and the developers themselves.
What started as a housing bubble in the US economy ended up crippling the entire global economy.
Those managers who followed the conventional thinking of risk management, misguided by the notion that events are independent of one another, were never alerted by what was happening in the US and how this could have an impact on their bottom-line.
As the events unfolded, reality that events interact, hit home. By then it was too late to react as much damage had been done.
Events in one function of the organization can have a crippling effect on the entire organization.
For example, a breakdown in IT infrastructure will not only affect IT operations, but will also affect the operations of the marketing, finance, human resources , production and other functions that rely on the infrastructure functioning to achieve their goals and targets.
A product recall due to wrong design and poor quality will affect the reputation and sales revenue of the entire business and not only the production department.
Supply of incorrect customer information by the sales and marketing functions will have a huge impact on the cash flow forecasts prepared by the finance function.
Improving alignment among risk management, finance and operations is key to achieving organizational strategic objectives.
Organizations wanting to improve their competitive position should therefore move away from the narrow approach of viewing functions as silos with own goals and targets to achieve, and embrace the fact that they are part of an ecosystem.
Improving alignment among risk management, finance and operations involves:
1. Collaboration: In some organizations, the internal audit function and the finance function are independent. The internal audit function is tasked with monitoring and managing risks that affect the business.
Managers should promote collaboration through regular meetings among the finance, risk management and other business units to discuss business trends.
This collaboration and close communication among finance, risk management, and the business units is critical to striking the appropriate balance between risk and reward.
2. Integrating the financial planning process with risk management: During the budgeting and business planning process, questions should be asked, even if they sound basic and silly, about the risk appetite of the organization.
If one of the goals is to create future growth, you must talk about the risks that must be undertaken and managed to successfully create and sustain growth.
The discussion of value creation and risk should not be separated. If the goal is to protect existing assets, you must also talk about risks to those existing assets.
You should be able to identify where and how you are overexposed to risk.
3. Top management participating: Participation, commitment and leadership of senior personnel is critical to embedding a risk management culture across functional areas and other business units.
The message of change (creating a risk management focused workforce) should start from the top and communicated down the hierarchy.
Information about risk exposure should also be clearly, accurately and transparently communicated to business stakeholders.
This will give a coherent picture of what risk management plans the organization has implemented or plans to implement, thereby help calm and reassure nervous stakeholders.
4. Focusing on the future: Traditional risk management looks at historical events as the basis of sound decision making. There is nothing wrong in learning from the past.
However, managers should spend much time and resources trying to anticipate the future and developing early warning systems. Thus, it is essential that you understand the lagging and leading indicators critical for driving business success.
This not only involves assessing the internal environment, but also the external environment.
5. Focusing on processes, information content, communication and technology: The recent Global Financial Crisis has shown us how reliance on quantitative risk models alone is not enough for strategic risk management.
Managers should improve both quantitative and qualitative analyses. Where information is lacking, judgement informed by experience can make a difference between riches and ruin.
In some organizations, there is a tendency of making information accessible via different IT platforms. This can be very costly and sometimes causes misalignment in data.
A better approach would be to have an integrated platform which has the advantages of efficiency, improved data quality and promotes visibility of what’s happening across the entire organization.