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Modeling Risk
Friday, September 6, 2024
By Cristian deRitis
Should a company's CEO publicly take a stand on political issues? It might be wise for the executive management team to stick to topics related to their business and avoid political statements altogether.
However, staying silent can also disappoint customers and employees who might expect the company to take a stand on social values like civil rights or environmental protection.
Chief risk officers, of course, must consider all political risk scenarios. While executive leadership can debate the role of their public voice, risk managers cannot ignore politics, because policies on taxes, regulations and the economy could substantially impact a company’s financial health and risk profile.
Cristian deRitis
Let’s now consider how risk professionals should carefully and effectively incorporate political risk into their forecasts and assessments.
To begin, it's crucial to define what constitutes political risk. At its core, political risk refers to the probability that political decisions, events or conditions will affect the business environment in ways that can harm the operations, profitability or strategic goals of an organization. This can range from government instability and changes in policy or regulation to more severe scenarios like nationalization or the expropriation of assets.
Political risk stands out as a particularly intricate challenge for risk managers to both measure and forecast. This type of risk can significantly impact the stability and profitability of investments, both within and across borders.
The handling of political risk requires a nuanced approach, blending the analytical rigor of hard data with a deep understanding of political dynamics.
Risk managers can adopt a multi-pronged strategy to navigate the complexities of political risk. The first step involves the identification and assessment of potential political proposals or threats.
This entails a thorough analysis of the political landscape in which a business operates – including an examination of factors such as the legal and regulatory framework, the stability and direction of the current government, and the likelihood of significant political events (e.g., elections, referendums). Tools like Political, Economic, Social, Technological, Legal and Environmental (PESTLE) analysis can provide a structured approach to this evaluation.
Following the identification of risks, the next step is to quantify their potential impact. Given the inherently qualitative nature of political factors, this can be challenging.
However, risk managers can employ scenario planning and modeling techniques to estimate the financial implications of different political outcomes. For instance, they can create "what-if" scenarios that simulate the effects of a change in trade policy or foreign investment regulations on a company's operations and bottom line.
The current U.S. presidential election cycle provides a leading example of how risk managers can leverage scenarios for political risk management.
Based on their stated platforms, Vice President Kamala Harris and former President Donald Trump will pursue very different economic policies if elected president. Each has put forward a wide range of proposals for changes in taxes and government spending, and for new trade, immigration and regulatory policies, that could have significant effects on the economy’s performance.
A recent Moody’s Analytics report assessed the macroeconomic consequences of the policies proposed by the presidential candidates. The authors of the report produced four unique scenarios (dependent on both the winning presidential candidate and the composition of the Congressional legislature), estimating the probabilities of each and operationalizing them into business forecasts, as follows:
Broadly, the tariff and immigration policies adopted under the Republican Sweep scenario are projected to result in higher inflation and interest rates and weaker economic growth. At the opposite end of the spectrum, a Democratic Sweep scenario that broadly maintains the status quo on economic policy is projected to produce lower levels of inflation and unemployment.
Sources: BLS, Moody’s Analytics
Sources: BLS, Moody’s Analytics
The benefit of this scenario approach is that it provides a framework that risk managers can integrate into their existing forecasting processes. Utilizing a large-scale structural econometric model, the Moody’s Analytics team translated the campaign rhetoric put forward by both parties into forecasts of employment, wages, debt burdens and house prices (etc.) that portfolio risk managers can plug directly into their own forecasting models of company revenues and losses.
The transparent framework offers an opportunity for risk managers to overlay other forecast assumptions should they want to test the sensitivity of their own forecasts of portfolio performance to a different probability distribution across the scenarios. The framework also permits risk managers to consider other variations of these what-if scenarios, such as increasing the proposed tariff rate under the Republican Sweep scenario to 20% or increasing spending on an expanded child tax credit under the Democratic Sweep scenario.
After assessing the risks, the implementation of mitigation strategies is paramount. As usual, diversification is a key tactic. By spreading investments and operations across multiple countries, industries or other segments, companies can reduce their exposure to any single political event or decision.
Furthermore, risk managers could consider the use of political risk insurance or options contracts, which can provide financial protection against losses arising from specific political events.
Engagement and advocacy represent another potentially crucial aspect of managing political risk. Establishing strong relationships with key stakeholders, including government officials and local communities, may help in navigating the political landscape. Moreover, actively participating in policy discussions with industry associations can give companies a voice in shaping the regulatory environment in which they operate.
It is also essential to maintain resilience and flexibility in operations and strategy. The political landscape can change rapidly, and businesses must be prepared to adapt. This might involve contingency planning for various political scenarios or developing exit strategies for high-risk markets.
Managing political risk in today's global business environment demands a dynamic and informed approach. By systematically identifying, assessing and mitigating political risks, and by remaining agile in the face of political change, risk managers can protect their organizations from potential threats and capitalize on emerging opportunities. The key lies in understanding the political landscape, engaging with stakeholders and preparing for the multitude of ways in which politics can impact business operations.
Risk managers also need to be mindful not to let personal opinions or political preferences cloud their analysis. Careful consideration of a wide range of potential outcomes can help weed out any subjectivity.
Through these strategies, businesses can navigate the uncertainties of political risk and thrive in the global market.
Cristian deRitis is the Deputy Chief Economist at Moody's Analytics. As the head of model research and development, he specializes in the analysis of current and future economic conditions, consumer credit markets and housing. Before joining Moody's Analytics, he worked for Fannie Mae. In addition to his published research, Cristian is named on two U.S. patents for credit modeling techniques. Cristian is also a co-host on the popular Inside Economics Podcast. He can be reached at cristian.deritis@moodys.com.
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