Faith in the theory of efficient markets was probably destroyed forever by the events of 2008 when market volatility spiralled out of control, overwhelming major financial institutions and spreading contagion throughout the financial system.
This has sparked a reassessment of the way companies, across all sectors, analyse and manage risks, a process that puts finance professionals centre stage. However, the financial crisis has not been the only catalyst for change. Political risk monitoring also failed to anticipate the democratic uprisings that toppled dictators in Tunisia and Egypt this year, and the domino effect across the Middle East and north Africa.
The earthquake that hit Japan in March was another illustration of the uncontrollable forces that we face. Although the country was better prepared than almost any other to cope with such an intense shock, the force of the tsunami that followed still had devastating effects and the damage to the Fukushima nuclear power plant was unforeseen.
At times, this turbulence has no doubt left some companies, governments and communities feeling completely impotent to control the world around them. More importantly, though, it is encouraging organisations to spend a lot of intellectual energy trying to understand how to better predict and mitigate future crises. Strategic risk management is also becoming an integral part of everyday business and financial processes.
In 2006 Paul Woolley, former banker, economist and founder of fund manager GMO Woolley, set out to explain why economies blunder from one bubble and recession to another with such frequency – and why these cycles are getting shorter.
The answer, according to the Paul Woolley Centre for the Study of Capital Market Dysfunctionality at the London School of Economics, is that we have come to believe that markets can be relied on to squeeze out inefficiencies and to correctly value assets such as commodities, stocks, bonds, human talent and intellectual property.
“Financial markets are often significantly mispriced,” says Woolley. “And yet all the risk models we use are based on the assumption that capital markets and markets in general are efficient. They aren’t. Most of the time they are pointing in the wrong direction altogether.”
There were a few voices that predicted the financial crisis, but they were largely dismissed by the herd. Greed and fear can make people do strange things, such as rushing to buy over-hyped commercial property portfolios and then dumping the same assets in the ensuing bear market.
Woolley is concerned that another asset bubble may already be building. “The worst thing that can happen in the next five years is commodity prices rising and creating inflationary pressure,” he says. “That would lead to a contraction in GDP, which would erode the economic recovery and result in low interest rates. That, in turn, would encourage investments in high-risk sectors of the market. And that’s where we are right now.”
As a result, strategies for hedging inflation, currency and commodity exposures are becoming a vital part of effective risk management. A commodity-driven crisis is not inevitable, but Woolley says that institutional investors need to recognise the need to change the way they value assets.
“There is an incentive for giant funds to change their strategies because the way they are acting results in lower returns,” he says. However, history shows that it is better not to rely on market efficiency to deflate potential bubbles.
Avoiding the herd
It’s not just in financial markets that a herd mentality can be destructive. Companies need to have an open culture in which people are able to raise issues before they become a problem, rather than simply toeing the line.
Risk management is most effective in an environment in which people are encouraged to voice concerns, challenge the approach of the business and feed ideas into the strategic decision-making process. Similarly, senior management should be able to change direction without being condemned for lacking a long-term strategy.
Finance professionals have a particular responsibility to challenge management where it looks like a financial, operational or strategic imbalance is developing. For example, is the company’s capital level sustainable relative to its exposures? Does it have the right resource allocation between mature and emerging markets, and the right split between established brands and new, higher-margin products? Are customers and suppliers handled with equal care?
Prepare or die
Black Swan events, named after Nassim Nicholas Taleb’s 2007 book, The Black Swan: The impact of the highly improbable, have three prevailing characteristics: they are a surprise to the observer, they have a major regional or global impact and, in hindsight, they seem to have been inevitable. But extreme events are almost never predictable.
What companies can do is try to work out which risks pose the greatest threat and make sure they are in a position to react well when disaster strikes. “No one is ever ready for the worst disasters,” says Adam Bates, UK head of risk & compliance at KPMG. “The trick is to react to events and deal with customers so that you come out of the situation in better or at least similar shape.’”
In the early seventies, an executive at oil giant Royal Dutch Shell, Pierre Wack, was instrumental in creating a process called “scenario forecasting”, using strategies based on military planning. Perhaps this explains why Shell has been better than most at handling overcapacity and kinks in global oil production.
But forecasts are fallible – no one in the industry, Shell included, forecast the rise of the OPEC group of oil-exporting nations in the seventies or the rise in influence of environmentalism.
The approach to risk management should be different for every business, but certain elements will help whatever the situation. For example, a contingency plan is needed to keep the business operating as normally as possible, and a communications plan is needed to minimise reputational damage. In addition, a strong balance sheet is a huge advantage in a crisis. Although BP could have been better prepared to cope with the Gulf of Mexico oil spill last year, its ability to shed assets quickly and dip into its cash reserves to pay for the clean-up was a major strength.
On the other hand, the oil giant’s handling of the public relations side of the disaster left a lot to be desired. When it becomes clear that a company isn’t able to cope with a crisis, it can severely dent trust in a whole industry or the business community in general. The full impact of the Fukushima disaster on the nuclear industry is still uncertain, but governments have come under pressure to temper or roll back their nuclear energy plans.
It has also made the job of the industry’s lobbyists, such as Lady Barbara Judge, former chairman of the UK Atomic Energy Authority, that much harder. “Maybe the Japanese government and workers should have been ready for Fukushima, but they weren’t despite a very close relationship between Tepco [the Japanese utility that managed the plant] and the government,” she says.
The failings at the plant have severely undermined Japan’s proud nuclear safety record but Lady Judge does not believe that it will stop governments investing in nuclear technology. “The standards of nuclear power plants are high and getting higher every year,” says Judge. “The plants that were going to be built in China, India, France, Turkey, Jordan and the UAE are still going to be built. The ones that won’t be built will be in countries where the governments were skittish, and they have a strong Green party – places such as Germany and Italy.”
No industry is without risks; in fact, uncertainty creates business opportunities. However, it is important to maintain a strategic focus and ensure that resources, notably human and financial capital, don’t get stretched too thin.
Also, don’t go into new business areas or geographies unless you are fully prepared. In some industries, companies inevitably have to work harder to convince the public or investors that the risks are worth taking.
Take the resources sector, where the upfront capital investment is colossal, often demanding a multi-decade commitment. An iron-ore mine may only turn a profit for its owner ten years after the soil is first broken, but it might generate substantial amounts for cash for the next decade. In this environment planning is everything. Bob Broadfoot, who set up Hong Kong-based advisory firm, Political and Economic Risk Consultancy (PERC) in 1975, says there are three risk priorities for any ultra-long-term investor.
The first is to ensure the asset exists, which is the easy part. The second, far harder part is to predict the scale of the political and regulatory risks to a project in some jurisdictions.
“The biggest question a resources companies can ask is: ‘Are my mines or my oil wells going to be nationalised five years down the road?’,” says Broadfoot, who points to examples of this in Russia and Venezuela.
“The second is: ‘Will a huge national disaster shut down my operations temporarily or for good?’.” Broadfoot’s third priority – the issue of whether the commodity will sell at a price guaranteed to turn a profit – comes much further down the list of risks, particularly given soaring demand for resources such as oil, copper and gold.
Whatever the sector, companies must be constantly aware of country-specific risk. China, for instance, may appear to be open to foreign direct investment – and it is. But it is important to be aware that Beijing is creating its own national champions and may be suspicious of commercial and human interests that it cannot control.
This explains the travails of a diverse range of institutions in China including the dispute between Beijing and US search engine Google over hacking and censorship.
One piece of good news is that people generally accept that we must live with a degree of risk. This helps businesses, and even countries, to rebound from crises.
Barely a decade after the horrific Bali bombs of 2002, which killed 202 and injured 240 more, tourists have returned to the country in droves. Tourism is double the level it was nine years ago. “Look at how long it takes for tourists to come back after a disaster – it’s getting faster and faster,” says PERC’s Broadfoot.
“As the number of events rises, the more people are getting accustomed to, and accepting of, risk.” This doesn’t mean that past crises should be forgotten. “Our weakness is that, as human beings, we tend to live in a cycle where we make the same mistakes every 20 to 25 years,” says Thomas L. Jones, Hong Kong-based managing director and co-head for Asia, at global advisory and restructuring specialist Alvarez & Marsal.
“This is part of the human condition, which is why we are so bad at predicting things.” Finance professionals have a central role to play in ensuring that lessons are learned.
Although there was a failure to anticipate the financial crisis, or the pro-democracy movements in the Middle East and north Africa, these events provide valuable information that finance professionals can use to improve the systems they use for forecasting future risks. History, as we know, rarely repeats itself, but it often chimes.
Elliot Wilson is a regular contributor to publications including The Spectator and Asiamoney
‘No industry is without risks: in fact, uncertainty creates business opportunities. But you have to keep a strategic focus and ensure that resources don’t get stretched too thin’
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