Friday, 13 July 2012
Risk management must adapt to build resiliency in current financial climate
In today’s climate of financial uncertainty, business and risk managers must focus on building resilience in order to bounce back from setbacks rather than employing older risk management techniques that simply attempt to predict and reduce threats.
According to a new PwC paper, entitled Prospering in an era of uncertainty—the case for resilience, business could face an investor backlash if they do not build in resilience to counter the ‘looming storms brewing in the current financial climate’.
The paper, published in association with the UK’s University of Oxford, warned that those sectors with longer and potentially more damaging supply chain disruption, including financial services and manufacturers, are most at risk if they do not start adapting risk management plans.
Given today’s financial and operating environment, it advises organisations to accept that they must take a ‘radical new stance’ to managing risk and adapt early rather than ‘scrambling to action stations once the alarm bells have sounded’.
“Traditional risk management focuses on removing uncertainty, which is almost impossible in the current treacherous financial climate. Resilience accepts that shocks will occur and gives as much prominence to an organisation’s power of response as to its power of control,” says the paper.
Martin Caddick, PwC Business Continuity Leader, said: “In this environment of heightened turbulence, faster change and greater connectivity, new forms of risk—global, systemic, and emergent—are contagious rather than containable.
“Embracing the concept of resilience allows boards and executives to bring the benefits of risk thinking to exploit opportunities and also manage risks. More than ever, acknowledging uncertainties is an essential part of creating sustainable value in any business,” he added.
This has a knock-on effect for risk management, according to the report’s authors. “What’s clear is that, faced with today’s pervasive change and uncertainty, it’s no longer enough for organisations to rely purely on a risk management approach that uses historical corporate data to predict future events and impacts,” they argue.
Enterprise Risk Management (ERM) is now expected to widen its scope.
“Enterprise Risk Management (ERM) grew up in the years of cheap credit. Today, boards and executives are looking to extend its foundations and build on its many strengths, in order to strike the right balance between risk management and value creation, and create a new framework that links strategy, risk and resilience in a way that’s more appropriate to the new uncertain environment,” says the report.
Resilience accepts shocks will occur and the organisation’s power of response is as important as its power of control.
This enables boards and executives to bring the benefits of risk thinking to the exploitation of opportunity as well as to the management of downside risk, says the report.
It argues that resilience brings three key benefits:
First, short-term survival: responding quickly and robustly to shocks;
Second, adaptation: enhanced awareness of change in the external environment and the need for intelligent response;
Third, transformation: moving into new markets and creating entirely new experiences for customers.
The paper, published following a series of workshops with FTSE 100 companies around the world, discusses two elements of resilience. It calls these ‘buffers’ and ‘adaptive capacity’. As predictability wanes, the need for buffers and adaptive capacity increases, it says.
Buffers provide the breathing space needed to absorb shocks and mount a considered response. Examples are operational assets that can be realised in a crisis, cash and other liquid assets on the balance sheet, and diversification of suppliers, customers and sources of funds to avoid over-concentration of risk.
Buffers tend to be tangible assets, although they are boosted significantly by the organisation’s reputation externally. In the immediate aftermath of a major shock, buffers are a pre-requisite for survival, says the paper.
Adaptive capacity combines strategic flexibility and organisational agility with a culture that supports learning and renewal. According to the paper’s authors, an increasingly important element of adaptive capacity lies in the relationship an organisation has with its customers and supply chain partners.
Whereas buffers are prerequisites for survival, adaptive capacity becomes more important as an indicator of longer-term resilience, the experts argue.
Mark Dawson, PwC Governance, Risk and Compliance Partner, said: “Highly leveraged balance sheets and the ruthless exploitation of supply chains may increase short-term profits but this kind of behaviour reduces buffers to a point where they cannot withstand a shock,”
“Boards need to regularly review their operational performance and short-term efficiency goals to understand the trade-off between resilience and efficiency. In the boom years where most growth constraints were absent, some balance sheets became so over-leveraged that resilience buffers were completely absent, but the cost was deferred until a subsequent shock destroyed all shareholder value,” he added.
According to the paper’s authors there is no one-size-fits-all approach to resilience, and no right answers to the dilemmas it raises.
To help achieve resilience, organisations must closely interlink their key internal processes—risk management, strategy, performance, management, and reward—while also connecting top management’s agenda with experiences and perspectives from the fringes of the organisation, they add.
“Organisations that understand these linkages are starting to change what they measure as key performance and key risk indicators. They are measuring behavioural indicators and process measures as well as financial ones, and focusing more on predictive indicators than the lagging indicators that have previously provided false confidence. And they are using the required quantification of risk appetite and tolerance to clarify and cascade measures to the front line about freedom, barriers and limits alongside traditional financial delegations,” concludes the paper.