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Risk Management and the Global Credit Crisis
When we look back at the global banking system as it faced a major credit crisis one has to wonder, what role, if any, did risk management play in the decision-making processes of those financial institutions, which wrote off a reported $400 billion. One can easily argue that a company’s success or failure is closely linked to the role risk management plays in its culture.
In Owning the Right Risk, published in the September edition of the Harvard Business Review, authors Kevin Buehler, Andrew Freeman, and Ron Hulme introduced a dynamic five-step process for better risk management. I will highlight the major points of each of the five steps as presented by Buehler, Freemen and Hulme in their effort to guide companies down the road to better risk management.
Owning the Right Risk insists that companies who understand their risks can easily identify those for which they have a natural advantage. Once this is achieved, the company is in a better position to assess its capacity and appetite for risk. “Companies with a strong culture of risk-adjusted decision making are better positioned to identify and understand changes in their risk profiles, triggering the cycle again," these authors have stated.
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Step One: Identify and Understand Your Major Risks
The first step in the process is to identify four to six key risks that typically account for a majority of your organization’s cash flow fluctuations. To achieve this you must begin by taking stock. Buehler, Freeman, and Hulme assert that, “You must be able to specify the risks you run and have some sense of how they might play out, whether for or against you." The key is to consider the full range of likely outcomes instead of focusing on the risk that is mostly likely to occur, or the risk that you fear the most. Employing an arsenal of decision-support tools such as scenario planning, statistical trend analysis software, in-depth data analysis, agent-based modeling, and Delphi method surveys can assist management in calculating risk probabilities.
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Step Two: Decide Which Risks Are Natural
In step two, it is imperative that you understand which risks your company can own and turn into a competitive advantage, and which risks you should transfer or mitigate. Performing a natural-ownership assessment can carve out a risk strategy for your company. The authors affirm this notion, “Risks for which the company has a natural advantage create superior returns and should not be hedged or transferred to others." Loading up on those advantage-gaining risks--those which your competition is likely to discount--will lead to an increase in your company’s competitive advantage
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Step Three: Determine Your Capacity and Appetite For Risk
Running a Monte Carlo simulation can help you assess your company’s risk capacity by quantifying your operating-cash-flow risk. A Monte Carlo simulation offers an efficient way to run numerous what-ifs across multiple variables. The authors point out that, “Once the simulation has been run, the probability of cash shortages or surpluses over the coming years can be quantified."
By developing a strong risk-analysis process your company can avoid gravitating toward the two extremes most companies follow, which are an unwarranted appetite for risk with too few provisions made for negative scenarios, or a too-small appetite for risk. Linking analysis of your risk capacity to your company’s risk appetite can give you a holistic view of where you stand.
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Step Four: Embed Risk in All Decisions and Processes
In step four of the five-step process for better risk management, the focus is ingraining risk management into the culture of the organization. They key decision-making areas in your company include investment decisions, commercial decisions, financial decisions and operational decisions. Taking a risk-informed approach to those areas can be of great benefit to your organization. “A highly motivated CEO who understands the power of managing both risk and returns can inspire an entire management team and corporate culture," Buehler, Freeman, and Hulme insist.
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Step Five: Align Governance and Organization Around Risk
The last step stresses a centralized risk-management model. This is one in which strategic risk management is aligned from top to bottom with a common understanding of the company’s key risks and overall level of exposure. In this ideal model, risk is embraced for the opportunities it creates, and not for the obstacles it can create.
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Not a Game of Cat-and-Mouse
Risk is to be managed like any other aspect of business. It is not merely a game of cat-and-mouse. In order to survive, companies must now evaluate their risk-management processes and their ownership of risk. Evolving into a risk-aware company means assessing risk in every decision that the company makes. The five-step process in Owning the Right Risk can help point a willing company in the right direction to better risk management.