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2 Mastering Risk

Welcome to Mastering Risk


Companies have always lacked certainty about the future, Recent years have seen extraordinary progress in the Over the next four weeks, Mastering Risk will explore
but in today’s business environment, the frequency and development of risk management tools and techniques, the most important and topical concepts of strategic,
impact of unexpected events is greater than ever. Strong which are giving companies ever-greater protection against financial and operational risk management. Written by
new competitors and business models can erode market the bewildering variety of threats they face. But as many of academics from the world’s leading business schools and
share, volatility in commodity or currency prices can the contributors to this series are keen to point out, there is international risk experts, the series will provide a
increase costs and reduce profits, and natural disasters can a common tendency when discussing risk to focus only on comprehensive and valuable guide to current thinking
disrupt supply chains or damage premises. In short, the risks the negative aspects of the term. Downside risk is only one around risk, and will be essential reading for anyone
of doing business come in many guises – and companies side of the equation – as well as being something to avoid interested in the dynamic forces that are shaping modern
must identify and manage these risks as effectively as they and minimise, risk is also something that should be business, as well as the ways in which today’s companies are
can using the tools at their disposal. embraced in the form of business opportunity. able to exert some degree of control over them.

EAMONN KELLY AND STEVE WEBER

A delicate balance
between risk and reward
A common perception of risk is that it is something to be The world has always been a com-
plex and uncertain place from the per-
indicate one perspective: that a mod-
ern city is such a complex organism,
spective of anyone trying to create with so many redundant pathways

avoided and minimised. But if they are to succeed in the value over time. But without inappro-
priately flattening out the past and
available to intelligent agents, that it
is incredibly and surprisingly robust.
indulging in the fantasy that the When hit somewhere, it routes around

long term, businesses also need to remind themselves that “good old days” were simple and
straightforward, we should acknowl-
the damage to self-heal in surprising
ways. Then in August, a hurricane
edge the obvious fact that business slams into New Orleans, and that

risk-taking is a powerful source of reward and opportunity today is indeed faster-moving, more
interconnected, increasingly global,
experience seems to signal the oppo-
site: that a modern city is such a
and both bigger and broader than it tightly interconnected organism, with
has ever been. Moreover, competitive all its resources stretched in a relent-
pressures frequently lead to radical less drive for efficiency, that it would
s risk bad for business? In the something to be avoided. One is sim- changes in our business models and not take much to bring the whole

I
uncertain, complex and volatile ply the hard-wired human psychology ultimately generate unanticipated thing crashing down.
environment of 2005, it no of loss aversion – for most people, it problems – think of British Airways’ In fact, we do not know enough
doubt seems to many execu- hurts more to be at risk of losing $10 recent troubles arising from the out- about the behaviour of complex sys-
tives to be so. Risk is some- than it feels good to have a chance to sourcing of its catering. tems to be certain how big a shock it
thing to be managed, reduced, gain an equivalent amount. As the pace of change accelerates, would take to drive them to a new
hedged or sold to others. But it Another is the leftover experience many executives have the very under- state, or towards chaos. The prevailing
is worth recalling that the orig- of the 1990s – in a highly permissive standable feeling that uncertainty and mood today is arguably to default to
inal concept of risk, derived and opportunity-rich business envi- risk are increasing at a faster rate the pessimistic interpretation – that
from early European seafaring ronment, where it was remarkably than is quantifiable and manageable. we occupy systems that are essentially
adventurism, contained a powerful hard to fail, a smart and simple risk That sounds like a scary proposition, fragile and vulnerable. Paradoxically,
sense of opportunity and reward as strategy consisted simply of protecting but does it need to be so? In fact, a big- from the perspective of a generic actor
well as downside and danger. against catastrophic downsides and ger menu of uncertainties provides in any system, that may be the more
We believe that, in the future, win- then letting the engine run. daring innovators with new opportu- reassuring belief – after all, the more
ning businesses will be those that are A third reason is the extraordinary nities to create upside risk. robust and metastable the system is as
best able to balance coping strategies, innovation in risk management tools, To see this more clearly, consider a whole, the less it needs any specific
which are defensive and focused on which allow sophisticated hedging, whether changes in the external busi- company, country or person to flour-
avoiding downside risks, with an repackaging and pricing of risk within ness environment make the business ish or even survive. In a metastable
increasing mix of exploitation and increasingly liquid marketplaces. ecosystem as a whole more fragile – or system, nobody is too big or important
exploration strategies, which embrace These tools are important – but they more robust. Is the larger system to fail. But from the perspective of a
risk and make the most of the oppor- are unlikely to confer much in the within which your business operates strategic actor, both interpretations
tunities it presents. This will require way of sustainable advantage over the brittle and at the edge of chaos? Or is signal opportunity. Knowing more
more than just continuous improve- longer term. A business that gives in it “metastable” – a system that is not than others do about the nature of the
ment in traditional risk management to loss-aversion psychology, sells off in equilibrium but is nonetheless system can be a critical source of
tools – it will also involve a shift in its risk to others and simply lets the enduring over the long term? advantage – and it requires us to think
mindset and focus. engine run, will in the future most In July, a series of terrorist bombs about the larger and more external
There are good reasons why probably be described by one word: hit the London underground train net- context within which we operate.
executives tend to think of risk as unprofitable. work. That experience seems to But how much attention do
Mastering Risk 3

executives pay to the external features knowledge within the organisation is advantage – that will come from seiz- And that means moving to re-
of their business environment? In our undervalued. ing the upsides of risk. embrace risk as a source of advantage.
work with major corporations, Global Companies increasingly cope with There are two simple but impor- In the future, managing the standard
Business Network often draws a dis- downside risk by throwing money at tant claims behind this argument. downside risks will increasingly
tinction between three critical environ- the problem. At a price, it is almost First, we believe that the information become a “hygiene factor” in business
ments for every business. The first is always possible to offload the risks revolution has made “that which is planning – simply part of the cost of
the internal environment – the organi- you know about, through multiple lay- known” more evenly distributed playing. The notion that some compa-
sation itself and its people, systems, ers of hedging and insurance. This is around the world and closer to real nies are too big or important to fail,
assets, processes, culture and so on. good, because it offers reallocation, time. Put differently, facts (including and, thus, can manage risk differently,
The second is the market environment specialisation, economies of scale and fact-based statistical assessments of will become less prevalent. In the
– the world of customers and competi- scope, and all the other benefits that risk) will be available to everyone, all 1960s, it really was true that “as goes
tors, products and substitutes, suppli- come with the disaggregation of busi- the time, at commoditised (and, thus, General Motors, so goes America,” but
ers and partners. The third is the ness functions. But giving away risk nearly equal) pricing. There will be there really is no equivalent of that
external environment – the world of (or, more precisely, paying someone to precious little and diminishing differ- today, and it will become less likely
political dynamics, economic growth, take it away) at some point means giv- entiation available in access to “that over time that any company could
technological development, social and ing up control of significant pieces of which is known”. This, of course, achieve that threshold. Sustained
demographic shifts and changes in the the value chain and allowing others to means that the “unknown” or at least advantage will come from the capacity
physical environment. control it to their advantage. “the uncertain” will become increas- to adapt faster and more effectively
In our experience, most organisa- And finally, companies cope with ingly important as a source of com- than the rest of the pack.
tions pay far more attention to the first risk by acting conservatively. Cau- petitive advantage. This notion is familiar as rhetoric,
two than they do to the third. What tion, discretion and prudence are sen- Our second claim lies at the inter- but still unfulfilled as practice in
beliefs could lie behind this allocation sible ways to view a complex world. section of technology and ideology. In many respects. When advantage lies
of executive bandwidth? One hypothe- But it is remarkably easy, particu- many aspects of economic, social and
sis is that the big, messy external larly for large and successful organi- political life, information technologies
world is so hard to understand that the sations with a lot to protect, to combined with market-friendly ideolo-
returns to investing the next marginal become overly conservative. Conser- gies have led to the increasing appli-
bit of attention there are too small to vatism at some point simply has to cation of markets as a way of “At a price, it is almost always
matter. A second hypothesis is that the yield to growth strategies; the key is allocating resources and solving prob-
external space contains too much irrel-
evant risk. Over time, the risks that
to know when to move. Cost-cutting lems. It is axiomatic within simple possible to offload the risks you
matter to the business will eventually
filter down to be picked up and know about, through multiple
responded to accordingly.
These hypotheses are not entirely
wrong. But they are also not com-
layers of hedging and insurance”
pletely satisfactory because they pro-
vide no real source of sustainable mostly in the unknown and the
advantage. The observation that exter- uncertain, the ability to sense and
nally originated risk is hard to under- learn faster, to correct mistakes and
stand spells opportunity for someone drop losing bets, to tolerate ambigu-
who can separate, even partially, sig- ity and live with, even embrace,
nal from noise. And if you wait until ambivalence, becomes absolutely
upside risk filters down to the transac- essential.
tional space also inhabited by your In the future, the discipline of busi-
customers and competitors, it is ness risk practice will need to help
already too late to seize the most organisations navigate these chal-
attractive opportunities. lenges. This will require paying much
Yet most risk management today is greater attention to the external world
based on coping strategies that man- beyond the immediate business envi-
age downside risk. Such defensive ronment, and the mapping of risks
measures are needed, of course – but within more integrated frameworks
they also have their limitations. Con- that highlight their sensitivity to
sider the most common coping strate- external uncertainty. It will require
gies adopted today. Many companies can only go so far. Loss-aversion is microeconomic theory that externali- the systematic development of new
cope with downside risk by using not a long-term way to win. In ties – situations where the full costs competencies and capabilities that
increasingly sophisticated econometric expanding markets, the smart hope- and benefits of a decision do not fall work from the “outside-in” – such as
and other mathematical models. This ful will always beat the fearful. on the decision maker but on someone early warning and scanning systems, Eamonn Kelly is the CEO of
is good, so far as it goes. But models This can be a deeper problem even else – are a source of inefficiency in scenario planning, systems thinking Global Business Network
have limitations, and it is often the than Clayton Christensen’s “innova- market settings. And so a critical and real options. It will require new (GBN) and a partner in the
case that the more finely tuned the tor’s dilemma”, although it certainly piece of the re-engineering of market- approaches to experimentation and Monitor Group. He is also
model, the more catastrophically it overlaps with and reinforces his places, enabled by information tech- learning, and greater investment in the author of “Powerful
tends to fail when the world moves important insight about the powerful nology, has been the internalisation of the ongoing development of decision- Times: Rising to the
outside the parameters for which it forces that drive good companies fol- many externalities. For example, pol- making executives. It will require Challenge of our Uncertain
was designed (consider Long Term lowing sound business practices to luters increasingly have to pay the more emphasis on the nurturing and World” (Wharton School
Capital Management, the hedge fund wait too long before developing and costs of their pollution. sustenance of internal and external Publishing, 2005).
built around complex mathematical deploying disruptive technologies. This is good for the system as a human networks, and a strategic con- ekelly@gbn.com
models that came close to collapse in Combine the organisational conser- whole of course. But it is not good versation that places risk as a source
1998). Furthermore, those parameters vatism of so many incumbents with for actors that have previously been of discovery and opportunity.
are often much less transparent than the loss aversion hard-wired into indi- able to capture the benefits of a prod- Most importantly, however, it will
they need to be because they become vidual human brains, and you have a uct or an action and externalise the require treating uncertainty as a
deeply buried within the assumptions recipe for disruptive market change. costs on to others. And there lies the powerful starting point for innova-
of the model. That is just fine for the disruptive second emerging challenge for corpo- tion and renewal, rather than simply
Companies also cope with downside entrants and for the business ecosys- rate risk thinking. When companies as a threat to be minimised. The new
risk by elevating the risk function tem as a whole; indeed it is a big part could hold the return piece of the discipline of risk will eradicate from
within the corporate hierarchy – for of what makes some ecosystems risk-return combination and impose our mental lexicon, once and for all,
example, by establishing risk manage- metastable overall. But it is not so the risk part on someone else, it was the mistaken 19th-century notion of
ment committees at the board level. good for the companies that are eaten wonderful for the company that “survival of the fittest”. In a con-
This is also good, because it ensures up along the way. They need a more could get away with it, but socially stantly changing environment, the
that risk receives greater resources aggressive and advantage-seeking inefficient. Nowadays, with technol- organism that is optimally tuned for Steve Weber is a professor
and attention and that risk manage- way to think about risk and they ogy enabling greater transparency today’s world is a dead organism in of political science at the
ment and mitigation enjoy greater need it now more than ever. and measurement of external costs, tomorrow’s very different world. For- University of California at
clout. But too much attention to risk at We believe that coping strategies, and ideology moving towards ensur- get survival of the fittest, and replace Berkeley and a senior
the board level can yield an overly while remaining a necessary part of ing that they are internalised by it with survival of the most adapt- consultant with GBN. He is
defensive posture, because quantifiable any corporate strategy, will in the those generating them, companies able. After all, as Darwin himself also the author of “The
(and often disaggregated) data future increasingly be seen, used and have less of this “risk externality observed: “It is not the strongest of Success of Open Source”
becomes a fixation for decision-making priced as utilities that everyone sim- inefficiency” to capitalise on. There- the species that survive, nor the most (Harvard University Press,
and the tacit, tactile understanding ply must have. But they will not be a fore, they need to find something intelligent. Rather, it is those most 2004).
that is present in other forms of source of significant and sustained else to replace it. responsive to change.” steve_weber@berkeley.edu