Risk Management for Senior Executives
The lack of risk management decreases a company's value and can have disastrous RoE, RoA, and cashflow consequences. My industry complicates the concept and its supporting theories with misguided implementation approaches.
The Problems of Risk Management
The finance industry and academia have made tremendous strides in addressing and characterizing many of the aspects of risk management. These characterizations have defined risk management as the practice of optimizing accounting and market values. This perspective is too vague and narrow. Yet, the ongoing research in risk management is generating a variety of new perspectives on VaR, variance, EVaR, Conditional Risk, Coherent Risk, etc. These analytics rely on historical data to produce information from data analysis. This approach offers no contextual synthesis, just information. Decisions should never be based on opinion, data, or information, but rather the intelligence produced by the synthesis of the information. This lends substance to any decision making.
Sole reliance on tactical and historical productivity risk management leaves the company's assets at strategic risk. Strategic risk management allows for the long term stability and growth for the company through systematic value creation based on your markets. Many risk management models and efforts fall short of helping senior executives to effectively manage capital assets and people because they lack qualitative metrics to support decision making. Most risk management models do little to assist senior management to make more effective decisions. Quantitative and qualitative risk management solutions are not mutually exclusive.
The lack of risk management has led far too many companies into a series of the unrecoverable financial situation with disastrous consequences. Symptoms of a lack of risk management include too many executive meetings, crisis du jour, missed corporate objectives, troubled products and services, as well as a lack of cash to exploit strategic opportunities. Strategic opportunities are situations with appreciable positive leverage for the company. New risk management perspectives and approaches are needed to better fit senior management’s time and demanding schedule.
Executives and Risk Management
The challenges of running a business are generally met with internal financials and staff meeting updates. Reports are at best status quo and historical data presentations with no written discussion from the “brain trust” on risks. Much of what we learn from these reports rely on quantitative measures. Rarely does senior management discuss or challenge the accounting data ability to truly characterize operations. Additionally, absent are the executive summaries from the Controller, CFO, or COO impact assessment on objectives met and value creation. Risk management should be thought of as the integrated tactical and strategic management of assets, as well as the creation of value (Merton, 2008). The president rarely asks “are we creating value or losing it, as well as which objectives are in trouble or likely to be compromised.” In competitive environments, risk and opportunities are rarely static. Data and its analysis must be tied to the company’s markets that are served to determine whether value is being created or lost. This process requires the integrating of quantitative with its qualitative synthesis.
Often overlooked are the critical qualitative aspects of risk management. These can be seen in the management assumptions on operations and the markets served. We serve markets through the continuous process of the value creation for customers. Assumptions about the sustainability of business operations, market trends, sales growth, competitors, capital markets, and data are rarely scrutinized once quantitative data reports are presented. Examining just numerical data or its analysis can be misleading. Sales can be growing at 20% with increases in profitability in decreasing or higher risk markets. You can be managing risks in the wrong markets, or not committing adequate resources to manage value creation in your most important markets.
Examining assumptions reflects perspectives on are one’s reality. I recommend that each financial report include a management discussion and analysis (MD&A) relative to the target value creation objectives. Brief and tight MD&A writing is cathartic; it clarifies; it is reflective. It is an opportunity to align thoughts with value creation performance of the company for the markets it serves.
Both internal and external market assumptions need to be examined and tested prior to quantitative risk management assessments. This way analysis is placed into context. Questions as to what are the new and current markets as well as operating realities assumptions must be challenged to address qualitative risks. New risk management approaches that create value must use strategies that reflect the new demographic, geographic, and behavioral probabilities and certainties as part of the analysis. Examples of such certainties are the realities associated with demographic and customer preferences changes, competitor’s movements, emerging disruptive technology etc. Management must seek to leverage economic and market changes rather than manage them using more agile organization structures to facilitate quicker communications of actionable information. Lastly, every functional department within the company should have a risk management program; to not do so can invite disastrous consequences. Executives should see every corporate department as a portfolio of investments that can be modeled for risk-return and strategy implementation.
Executive Risk Management
My profession often attempts to over complicate the concept of risk assessment and its management. As a senior executive, you are concerned with the uncertainty of outcomes in your company’s most sensitive value creating areas. The numbers in Financial Reports will never tell the whole story and have the potential to be misleading. Practiced risk management increases business effectiveness, adds value, and long term growth. It can increase revenue, profitability, and ROE. Risk should be managed using both quantitative and qualitative approaches. The executive’s priority list should include specific and more meaningful decision making qualitative and quantitative value creation metrics to more effectively manage the full risk of the company.
Hiram Willis
Ph.D. Finance
