A Secret for Success: Understanding Risk Management

A Secret for Success: Understanding Risk Management

If the state of risk analysis could stand some improvement, what does that say about risk management?  The point is, flawed risk analysis leads to poor risk management: garbage in, garbage out.

In a previous article, I made the point that “risk analysis is a fundamental, often underestimated, strategic function of business management.”  I also argued that current standards and practices in the field aren’t what they should be, and this has implications for strategy.

This is an enduring problem which all corporate and organizational strategic thinkers need to address constantly.  As FedEx Chairman and CEO Frederick W. Smith has said, “Risk management is not a checklist; it is a mentality that needs to be top-of-mind.”  The risk management mentality cannot come and go.

Risk management, after all, relies on accurate information and sound analysis to guard a company against the threats it faces and the weaknesses it possesses.  If the underlying analysis isn’t sound, risk management will very likely prove ineffective.  In many instances, strategic failures in this area originate with poor risk analysis.  Often, the costs are high.

The classic example of this corporate disaster genre is Long Term Capital Management.  Leveraged 250-to-1, and driven by unexpected sovereign debt crises in East Asia and Russia, the hedge fund lost 83% of its equity in September 1998 (falling from $2.3 billion to $400 million in about three weeks), prompting a near meltdown of the global financial system.  Today, JP Morgan is facing a $920 million fine for its “London whale” fiasco (which already cost the bank $6.2 billion in trading losses).

Chart:  Value of $1000 Invested in Long-Term Capital Management, the Dow Jones Index, and in US Treasury bonds between 1994 and 1998.  (Source:  Wikipedia)

Financial risks always make for great blog copy but the principle is a serious one that applies to all risks across the board.  The failure to implement enterprise-wide measures is of fundamental importance not simply because risk management helps insulate operations from losses and management from embarrassment.  Much more importantly, effective enterprise risk management is a keystone of strategy, and plays a critical role in defining and developing competitive advantage.

Without it, corporations and other organizations are undefended against the threats they face and whatever competitive advantage they possess is vulnerable to exogenous shocks from their competitors, their industry, and the world at large.  The failure to develop a robust, enterprise-wide risk management system constitutes a powerful competitive disadvantage.

The fact that competitive disadvantages exist, and are as important to an organization as its competitive advantages, has generally been overlooked in the strategic literature for managers and chief executives.  Even the best research tends to emphasize the offensive characteristics of building competitive advantage.  To be fair, risks (Weaknesses and Threats in the SWOT lingo) are referred to, often indirectly, and are assumed to exist, but they are rarely analyzed to the extent Strengths and Opportunities are.  Pursue your competitive advantages, the experts seem to say, and the disadvantages that plague your operations will almost take care of themselves.

Keep in mind, the defining characteristic of competitive advantage is the position a company occupies or strives to create in the competitive structure of the industry.  Company A’s strategies to define, pursue, and command competitive advantage are expressed in its response to combinations of strengths and opportunities the company encounters daily.  Within that competitive structure, Company A’s weaknesses constitute opportunities for its competitors to exploit, just as the strengths of its competitors constitute threats to Company A.  Just as its competitors are developing strategies to exploit Company A’s weaknesses, Company A must develop counter-strategies (risk management) to stave off the threats.

There is plenty of evidence published daily in The Wall Street Journal and The Financial Times that defensive strategies – such as risk management – directed at countering weaknesses and threats are too often de-emphasized, or at best poorly understood, if they are given any consideration at all.

The inevitable negative consequences are very much avoidable; a well-executed SWOT can be an effective tool for generating quality insights and description of risks any company faces.  A rigorous risk analysis process can turn these insights into understanding.  Armed with this understanding, Company A will be well-positioned for the creation and implementation of effective strategies for managing the full spectrum of risks they might encounter.

Categories: Finance, International

About Author

Steven Slezak

Steven is on the faculty at Cal Poly in San Luis Obispo, California, where he teaches finance and strategy. He taught financial management and financial mathematics at the Johns Hopkins University MBA program. He holds a degree in Foreign Service from Georgetown University and an MBA in Finance from JHU.