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Is your risk framework adequate? Questions Directors, Investors and the C-Suite should ask.

Monday, May 31, 2010

Key points

  • Despite significant investment in risk management, it still falls short in dealing with disruptive change

  • Regulatory changes seem unlikely to get to the heart of what really matters in avoiding significant destruction of shareholder value in the future

  • In looking through the standard disclosures on risk management, there are seven areas investors, boards and the C-Suite should be looking for

In the months leading up to the global financial crisis I was having a casual conversation with the head of audit and risk for a large listed organisation about life, the universe and everything. We discussed the usual topics – Were we making a difference? Were we fulfilling our duties and responsibilities? Were our organisations engaged?

Every now and again there’s a pregnant pause, and someone says something that needs to be said. This conversation had one of these. “I know this sounds terrible but... sometimes I find myself hoping for a near miss or a minor catastrophe. There’s some complacency setting in at all levels of the organisation, nothing short of a shock will snap them out of it.”

Well as the old saying goes, be careful what you wish for. Twelve months on from the collapse of Lehman and the global credit crunch, we’re through our darkest hours, back to business as usual and investing in risk management again. The newspapers tell us that “risk is the new black”, and at the same time we’re bracing ourselves for the next wave of regulatory reforms, and trying to anticipate what they might be.

I’ve been lucky enough to participate in some of the discussions and consultations in Australia and abroad on what could and should be done in the regulatory reform process, particularly with regard to risk management and the lessons out of the GFC.

On the one hand, increasingly there’s an understanding that overly specific regulatory responses can create bigger problems than those they are attempting to solve This is particularly the case when different jurisdictions put different solutions in place as it can create needless complexity or encourage “regulatory arbitrage” between jurisdictions. As a result, deep thinking is required, and meaningful progress is slow, particularly when multiple jurisdictions are involved.

On the other hand, there is a need to move forward, take action and deal with the local political environment. And we have seen some activity in this space in Australia and abroad. Unfortunately, what we’ve seen so far looks more like tinkering at the edges and dealing with peripheral issues rather than getting to the heart of things. My personal view is that most of these solutions would have done little to prevent the enormous value destruction we’ve just experienced, let alone the next round.

Let’s be frank, around the world organisations had invested in risk management, had assured investors and stakeholders that their risk management systems were effective, only to make significant earnings downgrades or discover more significant issues which shot to the core of their future viability. When quizzed on this, the standard line from Chairmen and CEOs was that “no one could have reasonably foreseen these circumstances”. A sad indictment indeed – damning of their investment in risk management and a response which is unacceptable to stakeholders and shareholders. It’s no coincidence that we’ve just been through an abnormally high turnover in CEO ranks.

A number of taskforces I’ve been involved with are asking the question – how do we know that a company’s risk framework is delivering the right outcomes, and is not just bureaucracy gone mad? Here’s some views drawing on the collective wisdom of institutional investors, directors, internal auditors and professional advisors on what directors, managers and investors should be looking for to move beyond compliance and deliver risk approaches that we can really rely on.

1. Wood for the trees

Do you ever get the feeling that despite being assured that best practices are being implemented, the risk reporting you are receiving is missing the point? Chances are you’re right.

Risk management approaches are often an aggregation of data from individual business units, with the aim of providing overall picture of the whole. If you’ve invested in a risk system or enterprise risk management, and implemented the latest standards, there’s a good chance you are swimming in “aggregated minutia”.

While there is enormous and often untapped power in “wisdom of crowds”, the reality is that if people don’t understand the big picture, they don’t have the context to comment on it. You could be getting great information on what’s happening with the deckchairs on the ship, but not know whether the ship is heading for any icebergs.

As the ASX Corporate Governance Council rightly said, the focus must be on understanding the material business risks rather than an enterprise-wide risk management approach which is bottom-up only.

2. Foresight

When Al Gore was last in Australia he made the following statement, “We have a habit of confusing the unprecedented with the unlikely.”

This statement is particularly relevant in risk management and points out one of the big challenges for risk management.

Risk process and risk participants tend to be very good at hindsight. If something is happening now, or has happened in recent history there’s a good chance it will feature prominently in your risk profile. If it’s been a while since something has happened, corporate memory should hopefully also pick things up.

Where risk processes and participants tend to fall down is in identifying situations that haven’t been experienced before. And while staff retention and drawing on experience can help us reflect back over multiple economic cycles to give us greater hindsight over a longer period, if events are unprecedented, or manifest themselves in new ways, they’re unlikely to be flagged or considered seriously.

Life evolves. Conditions change. The risks we face today are different from those in the past. Similarly, the risks we face in the future will be different and will manifest themselves in different ways from those faced in the past. If your risk processes are not informed by a range of sources including futurists, whole-systems thinkers and emerging conditions to give you true foresight, at worst you’ve driving forwards through the rear view mirror, and at best you’ve probably got material blind spots.

3. Understanding disruptive change

Strategic risk is a specific class of risk which ultimately results in not being able to continue the current business or operating model.

Human nature is to operate within a business as usual mindset. In mature organisations, budgets and targets are usually set up to deliver single digit performance growth year on year. Success is predicated on narrow ranges of variability and people don’t dare think about disruptions which could change the fundamental assumptions in their business models. True strategic risk is thinking about exactly that.

While many are quick to add the word “strategic” in front of “risk management” to make their work sound more interesting, the reality is that strategic risk as a class is not well addressed. While there are notable exceptions, most risk assessments I see are well and truly grounded in business as usual, even when disruptive change is very foreseeable.

Look out for organisations who anticipate, understand and seek out disruptive change. Watch out for organisations who are consistently on the back foot and claiming the “reasonably foreseeable” defence. No one actually believes that one anyway.

4. Beware of projections using historical data

The great thing about historical data is that if all things remaining equal, it’s a great predictor of the future. The downside of course is that few things actually do remain equal.

Think about the major changes you’ve experienced in recent years. Were these predictable based on past trends? Perhaps, but the reality is that change often happens in an exponential rather than linear fashion. The GFC, climate change, resource and technology changes mean that a 1 in 100 year event yesterday might be a 1 in 5 year event today. Of course this poses real challenges for actuarial and financial models which draw on historical data to project forward with some sense of certainty.

Data models are incredibly useful, but we need to be careful about relying on projections without testing if the underlying assumptions have changed or understanding the environment which these assumptions actually operate in.

5. CEO driven and learning from risk events and near misses

My personal view is that accountability for risk management has to lie with the Chief Executive, and there is no realistic alternative to this.

While the notion of a Chief Risk Officer is gaining prominence particularly in Europe and in financial services, ultimately the CEO has to drive risk in the organisation. If the CEO isn’t driving it personally, get out of the stock.

Risk events and near misses provide real test of the risk framework and to ask some fundamental questions.

Were these risks previously identified and considered at the right level in the organisation? And if not, why not?

A steely gaze from the CEO asking “Is this because you were attempting to keep things from me, or because you don’t understand your business?” is not easily brushed away, and is a great way to sharpen the minds of executives.

Similarly in testing why response plans didn’t stand up, was it because the executive didn’t take risk management seriously, or were the plans half-baked?An annual signoff from the CEO to the board that the risk management system is effective and that the status of all material risks have been reported certainly sharpens the mind.

6. Beware of a good news culture

Any risk system and process is only as good as the information which flows.

In a large proportion of cases where the board was blindsided by risks to the point of organisation failure or a “near death experience”, there was a “good news culture” whereby good news flowed up the line and bad news was spun into good news or didn’t flow at all.

While a dominant CEO or board can drive results, a culture where people are afraid to communicate bad news is a dangerous place to be.

Reward people for telling it as it is, and taking actions to respond. And again, look out if you see a CEO who’s dominant to the point of creating a good news (yes men) culture. Again, a signoff that all material risks have been considered at an appropriate level in the organisation is a great way to drive focus, and face up to reality.

7. Independent review / assurance

If you’re on the board or in the C-suite and not a specialist in risk management, how do you know whether risk management is working well in your organisation?

The ASX Corporate Governance Council suggests that boards should get independent assurance over the risk management framework in a holistic sense, and that one of the best functions to provide this is internal audit. For mine, this is great advice, and a smart move by any board.

Of course, to make sure that internal audit is truly independent and not “in the pocket”, you’d do well to make sure you’re covering all the points in the IIA’s policy agenda (covered elsewhere in this edition).

In summary, it’s possible for organisations to invest heavily in risk management, tick all the boxes and produce all the standard verbiage in the annual report. But risk management has to drive into the organisation’s culture – it needs to just be part of how they do business.

This article first appeared in the inaugural issue of Risk Management Today in May 2010.