Global economic stability is currently being threatened by geopolitical risk, climate change and the cyber revolution. What steps can risk mangers take to build a strategic risk framework that can effectively assess the likelihood and potential impact of these dangerous macro risks?
Friday, January 18, 2019
By Clifford Rossi
Blame it on indigestion from all the holiday feasting recently that's left me more pessimistic heading into the new year, but 2019 appears to be one of the most perilous in decades in terms of strategic risk planning. On a global scale, a wide range of macro risks - including geopolitical risk, climate risk and cyber risk - are simmering.
In the immortal words of former US Secretary of Defense Donald Rumsfeld, a host of unknown unknowns and unknown knowns could either trip up firms for many years to come or, under the right circumstances, present opportunities for stable growth and prosperity. The effectiveness of your strategic risk planning process will determine how well your firm can ride out any storms or chart a course to new opportunities in a world of greater volatility.
To be successful, boards need to get their arms around strategic risk more than ever before and inject a heavy dose of critical thinking and challenge into the discussion. Risk officers, meanwhile, must take a more active role, providing both effective counsel and analysis to this process.
In other words, 2019 will be the year of strategic risk.
What Makes 2019 Different?
The macro risks we face in 2019 for the most part are not new. What's changed is the likelihood for economic, social and political strife has increased, as have the tail risks that may result from such outcomes. To some extent, these macro risks have been accentuated by a combination of a decade of digging ourselves out from a devastating financial crisis and deferred responses over many years to emerging natural and manmade threats to society.
On the economic front, the great unwinding of quantitative easing is underway - and its effect on markets and sentiment will be telling. Most unsettling is that valuations in major sectors that have enjoyed substantial windfalls under favorable interest rate conditions (e.g., equities, real estate, fixed income and commodities) have become volatile and unsettled of late.
Likewise, as rates rise, a hangover in corporate debt looms large. Moreover, ongoing struggles to rein in large sovereign debt levels could potentially trigger events that lead to a significant market slide at some point in the near future.
Seismic geopolitical changes are among the other forces that pose similar risks to economic stability. Traditional economic and strategic alliances are in a state of flux, as exemplified by the slow-moving train wreck called Brexit.
What's more, social unrest is on the rise in Europe and in other corners of the world, as is protectionism and nationalism. (Global relationships among adversaries, while far from perfect, at least reduce the potential for major conflict by strengthening multilateral trade and economic ties.) Hitting closer to home, the rise of political polarization, brinksmanship and a “win at all costs mentality” poses serious challenges to the US for at least the next two years.
Climatological events, regardless of their source, are also increasingly affecting economic activity. Whether we're in a climatological era of our own making or one that is simply cyclical, the scale and scope of natural disasters of all kinds has been notable, with real economic consequences.
Technology has been an amplifying force in raising awareness to these macro risks, enhancing value but also raising risk levels. Social media, AI and large-scale computing applications have transformed our ability to exchange ideas and access information at a speed and scale of unimaginable levels just a decade ago.
At the same time, an explosion of technological innovations in social and financial applications presents a range of opportunities and risks. Algorithmic trading platforms, relatively unregulated fintech companies and increasingly sophisticated cyber threats require constant attention.
How can you make sense of all of these disparate factors with respect to your company's strategic risk profile?
Building a Strategic Risk Framework
The easy part of developing a strategic risk planning process is putting a list together of what macro risks keep you up at night. Assessing their likelihood and impact on your business is an entirely different matter.
An effective strategic risk assessment process requires some mapping of macro risk potential market impacts to business strategies and their associated risks and financial outcomes. Breaking down each business strategy by risk-type impact can help isolate important vulnerabilities.
For example, in 2003, if a bank's major growth strategy had been to double the share of nontraditional mortgages, an objective assessment of such a strategy's impact - not only on credit risk but also on reputational, regulatory and legal risks - might have led the bank to question whether it had the ability to take on such risks. Moreover, if that same bank had evaluated a macro-risk scenario in which a systemic crisis occurred in the next five years, it could have carefully assessed potential losses under such a severe scenario, potentially leading to a different decision and strategy on lending.
Translating global and macro-level risks to individual business strategy outcomes requires a great deal of thought and objectivity. Indeed, this must go well beyond merely forwarding the latest article on a particular macro risk to management.
Personal biases must not influence strategic risk planning. One such bias, unfortunately, is the tendency of board and senior management to overweight near-term outcomes. This bias can wind up being short-sighted, and strategic risk planning therefore needs to consider not only coming-year effects but also what could happen five or more years down the road.
While much of the strategic risk planning process relies on soft analysis and business judgment, selection of a set of forward-looking metrics can be instrumental in assessing potential outcomes of macro risks. Depending on the nature of your business, examples of such metrics could include market-forward interest rates, consumer and social media sentiment, and shipping and inventory trends.
Another important part of the strategic risk planning exercise is assessing your company's ability to execute strategies under each macro risk scenario. For example, do you have the right number of people with the right skills? Are your processes and infrastructure adequate and sufficient for the strategy? What is the company's technology readiness with respect to strategy? Lastly, and most importantly, if lightning strikes and a macro risk triggers a tail risk event, what is the company's risk contingency plan?
A host of macro risks in 2019 elevate the importance of effective strategic risk planning. To understand what strategies ultimately give your firm the best chance at enhancing long-term franchise value, management must implement a comprehensive strategic risk approach that assesses the impact of various macro risks on each strategy and each risk type.
Clifford Rossi (PhD) is Professor-of-the-Practice and Executive-in-Residence at the Robert H. Smith School of Business, University of Maryland, and a Principal of Chesapeake Risk Advisors, LLC. He has nearly 25 years of experience in financial risk management, having held a number of C-level positions at major banking institutions. Prior to his current posts he was the chief risk officer for Citigroup's North America Consumer Lending Division.