Emerging risks Vs Innovation

        “You only find out who is swimming naked when the tide goes out.”

                                                                                                            -  Warren Buffet

Much has happened in the past few years to shake the historical assumptions underpinning business and business models. The global economic meltdown is first and foremost of these changes, which has combined with issues surrounding global climate change, the price of oil and supply chains, even talent. The consequence has been a sea-change in the way businesses are run. In effect, they are transforming the very nature of many companies’ business models. Companies need to prepare for a new reality in which emerging risks increasingly impact their earnings and long-term strategy. Those that develop the ability to manage emerging risks will gain a significant competitive advantage over rivals who lack this level of sophistication. The unfamiliarity of emerging risks is the fundamental reason companies still struggle to identify and assess them. Companies need to develop the ability to integrate emerging risks into their decision making.

Given the crossroads that emerging risks are creating for companies, they cannot be ignored in the path of growth. In addition to spending time identifying what highly improbable event could impair them, companies should pay increased attention to assessing the quantum of a financial shock that could destabilize their business. Designing a framework to achieve this is not easy. Companies that operate in the same industry and even geography can have very different exposures to emerging risks, depending on their financial structure, etc. After determining the companies’ capacity to withstand such shocks, , they should examine the potential impact of emerging risks from another angle: risk-adjusted scenario planning. By doing so, they not only gain insight into specific situations or a series of events that can result in a loss, but also understand how the range of potential outcomes will impact their company’s portfolio of businesses. Such planning exercises can reveal not only how potential risks can impair a business, but also how risks can enable a company to gain a competitive advantage. By designing such frameworks, companies can anticipate outcomes and quickly respond when an event strikes. They will be able to pinpoint areas of vulnerability under different market conditions, and the net impact on the overall organization. These insights allow companies to focus on initiatives to mitigate emerging risks and to capitalize on the resultant market conditions.

  “Crack-brained meddling by the authorities (can) aggravate an existing crisis.”

                                                                                                                  - Karl Marx

Regulation is becoming increasingly stringent and multi-layered. As governments recognise that they cannot afford to provide for the populations in these important areas from health to retirement, there will be increasing need for the people to take more responsibility for their own welfare. The result will be more government imposed regulation on the industry. IFRS 4(phase II), Solvency 2 and other regulatory initiatives have implementation dates in 2012. Most in the industry believe that the burden of the regulatory compliance will only increase in this coming decade. Many industries—banking, telecom, transport, and energy, to name a few—face an increasing level of regulation. While there is a legitimate case for more consistent regulation and oversight, such as to reduce regulatory arbitrage, it is less obvious that we really need more or tighter regulation. Financial regulation imposes significant costs on the economy. For instance, excessive regulation can stifle financial innovation, reduce the flow of credit to worthy firms and consumers, and impede economic growth. Thus, what we need to prevent future crises is a more dynamic approach to regulation and oversight -one that is strong precisely when market forces become weak.

                                 “Innovation is the central issue of economic prosperity.”

-          Michael Porter

The severe decline in trade, FDIs and access to international financing pose a risk to the global business that underpins innovation. In the current scenario managing risks means correction. Most of the companies that are successful today are so because they took great innovative steps during recessions when others went into red. As Jack Trout said differentiate or die! It’s not an mp3 it’s the IPod. It’s not a TV it’s a Sony. It’s not style it’s Zara. Just look at Apple Inc. - the name itself has become synonymous to innovation. It may be among the very few companies unaffected by the economic downturn. All thanks to its innovation-driven culture. It has, within a decade, revolutionised five industries – music, retail, computers, animation and movie. Similarly, the story of Nokia, a company which has reinvented itself four times, first as a manufacturer of boots, then televisions, then computers, and finally mobile phones. As a result of this, the Company is very serious about innovation, simply because it knows that its survival depends upon that next killer product line. As a result of this, innovation has been written into the DNA of the organization.

Growing aversion to risk combined with other factors (such as difficulties for investors to exit) is already drying up many sources of seed and venture capital. Everyone talks about corporate antibodies that resist innovation, but what about corporate white blood cells. Finnish experience in the deep recession in the 1990s is an example of how knowledge can become the driving force in economic transformation and growth. Korea turned its major 1997 financial crisis into an opportunity to undertake a major reform of its economic incentive and institutional regimes. However, the primary ingredient in innovation isn't brains, but guts. Clearly, innovation will be one of the keys to manage the emerging risks from the downturn. 

Identifying Risks

In the face of an uncertain and volatile future, companies must constantly assess whether their capacity to identify and analyze risks is aligned with their goals. In the wake of the financial crisis, most companies and economies are making efforts to improve their ability to identify and assess emerging risks. Nevertheless, this is a handicap that they can no longer afford in a business environment increasingly defined by global recession, major government policy shifts, volatile commodity prices, and unstable financial markets. In 2012, countries around the world are facing major political change – at a time when the world is already in the throes of great instability. Approximately 53% percent of the global population will witness the change in political leadership. More than anything else, 2012 will be a year of political events and change. Around 26 countries such as the US, China, France and Russia are facing changes in leadership and are headed to the polls. Adding to this, many nations are experiencing political instability, often triggered by a shaky economy and immense dissatisfaction among the population. Just look at Greece, Ireland, Spain, Portugal, Italy or Tunisia to name only a few.  

Emerging risks must be treated as trends or events that may create volatility in an organization’s business environment as well as in its strategic and operational performance. The characteristics of emerging risks will often demand significant strategic or operational changes to hedge or minimize their potential impact. Companies must explicitly identify their key value drivers in order to identify emerging risks and analyze their potential impact on the company as well as its extended enterprise of customers. Risk also offers opportunities to foster innovation for sustainable growth.

“Two little mice fell into a bucket of cream. The first mouse quickly gave up and drowned, but the second mouse, he struggled so hard that he eventually churned that cream into butter and he walked out.”

                                                  — Frank Abagnale Jr. in the movie “Catch Me If You Can”

Today’s fast changing world creates more uncertainty for organisations and makes it harder for them to understand where new risks are going to come from. Whatever words we use to define risks, it’s clear that the risk landscape facing companies is dynamic. Organisations responsible for managing risk can see that a new risk landscape is emerging. But it’s often difficult for them to define what’s behind the changes, or how they should respond to them. The first step towards making the right responses is to map out what’s different in today’s risk landscape and to determine how to adapt to these differences. The risks germinated by the crisis should be used as a springboard to accelerate structural shifts towards a stronger, fairer and cleaner economic future. Failing to do so might lead only to a temporary recovery as the macro-economic and structural roots of the current downturn would remain untouched. Conclusively, averting risks may keep one in comfort-zone for a while but does not guarantee the same for a longer duration. The best way is to face them – manage by controlling them and turning them into productive forces.

Risk Averseness

It was 2pm, September 15, 2008. From the 40^th floor of my office, I looked at 745, Seventh Avenue, New York. People were coming out of this building, much earlier than in any other usual weekday, with small cartons, with files and folders and their last memorabilia of what was a rising career at Lehman Brothers. Walking out in their high-street Italian suits, they looked unmistakeably gloomy with their future in uncertainty. Lehman Brothers had filed for bankruptcy under Chapter 11 bankruptcy protection. The filing marked the largest bankruptcy in U.S. history with $613 billion dollars of debt. A few months back, it posted its first loss since being spun off by American Express which was in 1994. This event, formally kick-started the financial crisis that swept through global financial markets in 2008. Actually the roots of this risk emanated from the subprime mortgage and had begun spreading over a year ago.

Three days later on September 18, 2008. I was working at global headquarters of my then client, Morgan Stanley. Just after bankruptcy of Lehman Brothers, the focus of almost all the employees was on the Morgan Stanley’s plummeting share prices. The stock price, normally floating in $40s, reached a nadir - below $1. Everyone was keeping his fingers crossed and expecting the announcement of the fall of another investment-behemoth. At this crucial juncture, John Mack, the then CEO of Morgan Stanley, announced a strategic alliance with Japan’s largest financial group, Mitsubishi UFJ which bolstered former’s capital and equity positions. Morgan Stanley survived the financial storm.

History bears countless evidences that big companies have followed the path of oblivion when unable to manage their risks. For instance in this case, many financial companies failed to manage the risks created by the housing market downturn and subsequent sub-prime mortgage crisis which took heavy toll. Poor risk management led to fall of Lehman Brothers, Wachovia, WorldCom, Enron, Bear Stearns, Daewoo and the list goes on. On the contrary, many companies have successfully erected the mammoth corporates and turned it into successful firms during crisis by managing the risks efficiently. Corporate giants like FedEx, P&G, Hewlett Packard, TESCO, GE, General Motors and IBM came into existence during economic turbulence. Thus, risks may pinch the business severely but when managed well can prove to be a gold-mine of opportunity. In other words, the risks can be turned into opportunities if dealt proficiently.

    “Progress always involves risks. You can’t steal second base and keep your foot on first.”

                                                                                                                                                    – Frederick Wilcox

The concept of the risk is inherent to our human condition since the dawn of recorded history. Not only are there more risk situations today, but modern technological development has brought a heightened awareness of risk - both of those risks that we knew about in the past, and the emerging, new risks that are associated with the march of progress. A key element in this heightened awareness is the fact that we now know a great deal more about the physical world than we did in the 19th and much of the 20th century. The world has always been faced with “risk” – but unlike earlier, risks can now reach magnitudes of damage that hadn’t been imagined in earlier times. These and other harmful events may have put policy makers and the public "on the alert", but being aware is not the same thing as being equipped to prevent those risks or mitigate the damage they cause. Addressing risks in a changing environment requires a much broader perspective than those adopted in the past, and that requirement applies even to our very understanding of risk. These days, risk assessment needs to combine knowledge from a wider variety of disciplines and areas of expertise and pay increased attention to changing conditions within the driving forces mentioned above. Never the less the current business climate remains marred by a sense of fragility and vulnerability. Emerging risks are increasingly introducing volatility into companies’ earnings.