Risk Management Reports

Why am I so cautious this year? In the past, beginning in 1988, when I first started these forecasts of risk issues for the coming year, I felt a sense of optimism, the thought that we would make progress in the following twelve months. Re-reading my January issues over the past six years, I find the entry of a nagging caution and pessimism. Perhaps it’s the natural result of growing older, but I sense that many of the potential opportunities in today’s world are over-weighted by a fear of downside consequences. So caution becomes the watchword for 2004.

Back in the utopian days of early 2000, having seen the millennium arrive (one year early, to the mathematically inclined) without the feared Y2K disaster, but with a financial bubble still hanging overhead, I suggested a hard look at the condition of our financial institutions and forecast that trust would be a major issue. In 2001, I warned for the fourth successive year about that bubble (it finally erupted with a bang in April). I also suggested that governance and the role of risk management were the year’s major issues, specifically focused on structure, leadership and communication. After April’s financial collapse and the events of September 11, 2001, my 2002 issues were the restoration of credibility, resilience and a long-term perspective in organizations. Last year, I ran a summary of critical global, market, operational and public policy risks, decrying the growth of the “precautionary principle,” an approach that cripples innovation and progress and creates excessive risk aversion.

This January, I slip back toward caution. The global political situation is poised on edge. With luck, we could make progress in the current hot spots in the Middle East, Africa, and Asia: a constitution in Afghanistan; a constitution, new government and the start of the trial of Saddam Hussein in Iraq; the beginning of an Israeli-Palestinian rapprochement; a quiescent North Korea; and the departure of Robert Mugabe in Zimbabwe. The cards could as easily fall in the opposite direction, with greater chaos in the Middle East, requiring a hasty U.S. pullout, renewed India-Pakistan warfare, a full Israeli re-occupation of the West Bank and Gaza, and a North Korea taking advantage of US preoccupation elsewhere. Add to that the U.S. presidential election in November of 2004 and we have a truly unpredictable situation.

 But have things really changed? Do we now face “. . . a political force committed fanatically to the belief that with the U.S. there can be no permanent modus vivendi, that it is desirable and necessary that the internal harmony of our society be disrupted, our traditional way of life be destroyed, the international authority of our state be broken?” George F. Kennan wrote those words in 1946 describing the Soviet regime (as quoted in Princeton Alumni Weekly, December 17, 2003). They apply equally to the threat of Islamic fanatic terrorism today. Perhaps matters have not changed as much as we think.

 The economic scene is even more disturbing. In the Europe, Japan, and the US we face the explosion of entitlements in aging societies. In the U.S., our problems are a bloated national budget deficit, negligible national savings and an escalating trade deficit. All three threaten the position of the U.S. dollar. Peter Bernstein calls it “an accident waiting to happen,” one in which “all hopes hang on an orderly decline in the dollar.” (Economics and Portfolio Strategy, Nov. 1, 2003 and Dec. 1, 2003). Given the slow recovery in the US and the faster economic growth in Europe, Asia and South America, it is inevitable that investors will turn from financing the US deficits to more attractive returns elsewhere.

 At the same time, we continue to hear disquieting news about our financial markets. A real estate bubble, supported by low interest rates and the loss of faith in stock investments, seems poised for puncture. Mutual funds are tarred with allegations of market timing and late trading frauds. And the foreign exchange market is tainted by claims of kickbacks and bogus trades.

 This makes the U.S. dollar the most critical risk management issue for 2004. It calls for the creation of a variety of economic and political scenarios for which every organization must be prepared financially and emotionally. A lower dollar means that U.S. goods and services will be more affordable outside this country. It also means that others who sell to the U.S. will face higher costs as well as more U.S. protectionism. Interest rates in the U.S. will creep up to attract foreign investment to finance the U.S. debt, but this in turn will hamper the nascent U.S. economic recovery, something the politicians want to avoid.

 Last year the biggest issue was re-establishing organizational credibility after the recent public disasters of such organizations as Enron, Tyco, WorldCom, Adelphia, the New York Stock Exchange, Hollinger, HIH, News Corp, Parmalat, Royal Ahold and Elan, where uncontrolled greed crippled stakeholder confidence. The Harvard Business Review quoted Judith Martin in its December 2003 issue: “When I look in my mail, it’s clear that the number one problem facing American society today is greed.” She really should not have been that surprised about the persistence of greed: it’s a human instinct that has been and will always be with us. The issue is to stifle it through the right combination of internal culture, controls, penalties, and resulting publicity. New laws, rules of governance, and leadership have started this process and organizations worldwide are on the path to correcting the imbalance.

 Today, besides the U.S. dollar, the related issue is flexibility, the capability of any organization to rebound from whatever contingencies may occur in the next twelve to twenty-four months. Can a nonprofit sustain a 20% reduction in donations and continue its beneficial work? Can a local, state, or provincial government survive a 20% drop in tax revenues? Can a profit-making corporation take advantage of a 20% drop in the value of the dollar and expand its sales outside the U.S.? Will outsourcing bite back with substantially higher costs from non-U.S. operations?

 It is in enhanced organizational flexibility that risk management can make its greatest contribution. First, it can use the technique of scenario analysis to undertake broad and integrated risk assessments, particularly for organizational strategic planners. These scenarios will incorporate both quantitative and qualitative estimates. Second, risk management can encourage senior management to be prepared for all contingencies, however remote. Think about those events that fall outside the 95.5% estimate of probability. These “outliers” and their consequences must be incorporated into planning. And third, it can stimulate the creation and use of enhanced financial reserves, using a combination of savings, credit, derivatives and insurance to assure adequate financing whatever occurs. That financing should be directed not only to recovering what might be lost but also to taking advantage of the new opportunities that present themselves in a rapidly-changing environment.

Building and maintaining maximum flexibility in uncertain times means that organizations will have the natural resilience to overcome negative events and build on positive ones. After all, that is the real goal of solid risk management: to build and maintain the confidence of all stakeholders in the organization.