Expanding the risk management landscape

The global risk environment is becoming more complex and precarious, and “we are drifting into problems from which we will struggle to extricate ourselves”, according to the World Economic Forum’s Global Risks Report 2019, and that means that businesses will have to pay closer attention to a wider range — and size — of risks, including many unrelated to their core missions, than ever before.

Global risks are converging with social and political trends in new ways, while “the collective will to tackle them appears to be lacking”, according to the report, released in January. Catastrophic climate change and weather events, global macroeconomic conflict, cyber insecurity, and geopolitical tensions are being exacerbated by economic inequality, nationalism, cyber dependency and polarisation, according to the report.

We are now living in a global risk environment in which an event in one part of the tightly coupled global system ripples and cascades in unexpected ways: A flood in Asia can disrupt US supply chains, which can negatively impact the European financial system; a populist movement in a single country can disrupt an established continental order, throwing global business into chaos; a trade conflict between two countries can create painful, and costly, uncertainty around the world.

“The big issue that has changed over the last 20 years is the interdependency of risk,” said Professor Howard Kunreuther, James G. Dinan Professor and co-director of the Risk Management and Decision Processes Center at the Wharton School at the University of Pennsylvania and a contributor to the WEF report. “It’s a global environment, which is why global risk has become such a critical issue.”

Risk management is becoming an “everything and everywhere” condition, and finance professionals are at the vanguard of this tenuous situation, according to Chris Clearfield, another risk expert. That also holds true not just at a global level but also within companies, as businesses become more dependent on opaque technology, far-flung supply chains, and complicated processes.

“We shifted to a place where, because of complexity, because of all this interconnectedness, really small errors can have big consequences,” said Clearfield, co-author of Meltdown: Why Our Systems Fail and What We Can Do About It, founder of risk consultancy System Logic, and contributor to the WEF report. “Stuff that nobody even would’ve noticed ten, 15 years ago can really now blow up and be a money loser or a huge distraction for a firm.”

Accordingly, risk managers can no longer look at individual risks but must take a more systemic approach. The forum’s report offers some tips on how finance professionals can take a more holistic view of the increasingly fragile global risk environment to protect their businesses.

Talk to outsiders. It’s easy to develop myopia to risk in our complex systems, especially when dangers are not explicitly related to core business goals, but missing risk doesn’t mitigate it. Broadening one’s understanding of complexity means breaking out of our usual feedback loops and introducing new perspectives, and it can help flag risks that may get missed by groupthink.

“It’s really easy to just talk to people in your firm, or peers at firms in the same industry, but there’s real value in trying to incorporate the input of outsiders,” Clearfield said. “Make sure you’re receptive to the information that’s out there from the outside world.”

Hard-wired biases, reinforced by internal echo chambers, make it harder to recognise risk and finance professionals need to confront them, according to Kunreuther.

Try meeting with experts in completely unrelated fields, forming regular information exchanges with finance professionals working in unrelated industries, or engaging with researchers working on key global issues to expand your frame of reference.

But you don’t always have to look outward either. Often, people in your firm whom you may not always interact with hold a key perspective, according to Clearfield.

“The other great sources of information is what people in the company know,” he said. Seek out people within the firm interacting with the business in a different way and gather their thoughts as well.

Shift your time horizon. The scale of global risks in the WEF report borders on apocalyptic fiction: Devastating climate change rendering parts of the globe inhospitable, massive cataclysmic weather events costing trillions of dollars, the re-emerging threat of the use of weapons of mass destruction, state collapse, or a new global pestilence. The incomprehensible nature of the risks renders them unimaginable in the short-term.

But Kunreuther cautioned against that short-term thinking and noted that a shift in the time horizon used to consider risk can significantly alter long-term risk strategy.

“For example, instead of saying that there is a one-in-100 chance of this disaster happening within the next year, try saying that over a 25-year period there is a greater than one-in-five chance of that event happening,” he said. “There is a tendency to be overly optimistic and to say that this is below the threshold of concern but firms pay a lot more attention when you tell them one-in-five chance over 25 years.”

That simple exercise can help finance professionals drive more integrated risk mitigation investments and decisions within their firms, he added.

Invest in transparency. Complexity breeds opacity, which in turn magnifies risk. The less we understand about how the different parts of the whole interact — whether it is in the architecture of our cyber dependency, cross-border political movements like global populism, or company outposts in different parts of the world — the more likely it is that we will miss red flags.

“The antidote to complexity isn’t necessarily simplicity, it’s transparency. I think you can invest in things that increase transparency in your operations in the world that you’re in now,” said Clearfield. “That can help clarify where some of your risks might be and where those investments will pay off.”

That also means being clear and strategic about your risk tolerances, according to Kunreuther.

“The most important thing is firms have to prioritise what the risks are and they have to really think about their risk appetite and tolerance,” he said.

Pay attention to near misses. With transparency comes input, but finance professionals will have to pay close attention to more than just the obvious disasters, according to both Kunreuther and Clearfield. Weak signals, or near misses, are a key indicator of risk and essential to mitigating it. Weak signals are changes or trends that flag potential risk, whether it is an increase in negative social media reviews of your products, consistently late deliveries in the supply chain, or more safety issues in a plant than usual.

“You can use certain exercises that help you think about it, but really to understand how you are going to be affected, you need to be attending to these weak signals of how they’re actually affecting your business already,” Clearfield said.

That means building internal feedback processes that note not just failure, but things that almost failed, and empowering people to act on those weak signals. Catching these red flags is an opportunity to make adjustments before disaster strikes.

“When you look back on a crisis or a big event, you often see that that information was there. And the question is, well, you know, why was it missed?” Clearfield said. “And so often it was missed because the right people didn't get it at the right time. Or if they did get it, they didn’t know what to do with it.”

Drew Adamek is an FM magazine senior editor. To comment on this article or to suggest an idea for another article, contact him at Andrew.Adamek@aicpa-cima.com.