Tag: International Business

Understanding China’s One-Child Policy Shift: Big Demographic and Economic Changes Ahead

Understanding China’s One-Child Policy Shift: Big Demographic and Economic Changes Ahead

Understanding China’s One-Child Policy Shift: Big Demographic and Economic Changes Ahead

Today, China announced that it is abandoning its 35-year policy of limiting families to only one child. This policy has become a demographic experiment unmatched in the history of the world. Owing to this policy on reproduction, China is experiencing many challenges and risks that were not foreseen when the one-child policy was adopted. At its core, is a challenge to the social composition of China and its economic trajectory within the global economy.

Gender Imbalance will Pose Social Risks

The one-child policy and cultural preferences for boys over girls, has created a horrific gender imbalance. Enabled by ultrasound and gender specific infanticide, China now has more men than women. Some estimates have 116 boys being born for each 100 girls. Over many years, this imbalanced is estimated to result in some 80 million men in Asia without wives by 2040. It is an imbalance that the world has simply not seen before. Will these men demand wives from poorer countries? Probably. Will they succumb to deviant and dangerous behavior? Probably, but hopefully not. 80 million is about the population of Germany. It is about a quarter of the US. The void will be felt for years. Owing to wars, society has overcome lower numbers of men, but lower numbers of women is mostly unseen in our recent human history. It will pose social risks unseen before.

The Rise of Little Emperors

Younger people in China live a different life compared to their parents and grandparents. The one-child policy, exercised over 35 years, means that 4 grandparents, produce 2 parents, and one grandchild. It means a child grows up with 6 adults doting on him or her. It also means that child gets more of what he or she wants. This new psyche is called, “the little emperor.” And understandably, the six adults want the best and most for their only heir. In a country where eldercare has historically been handled at home, it also challenges how the Chinese will age and where they will live. We think of cultural challenges with millenials in the US, but China is dealing with the same issue, too.

Rapid Aging is in the Future for China

Below is a population pyramid of China now and in 2050. The gender imbalance is most obvious in the youngest people. The aging of China is soon upon us. It will have major economic implications to the world.

Impact of China on Global Economics

We often lose sight of the impact that China had on global prosperity. In the 1990s, trade and business with China really opened-up and expanded. It allowed US and European firms to move manufacturing to China in a big way. It provided a reduction in the cost of manufacturing to much of the world. That controlled the cost of making many things. Indirectly, it meant that inflation could be more easily controlled in developed markets. As long as some (and a growing part) of the manufacturing base could be shifted to low-paid Chinese workers, the developed markets could see expansion in product offerings and firms could expand without as much of a concern for inflation. In many ways, the success of Walmart has been tied to its ability to source from China. Walmart brought an increase in lifestyle offerings to the US middle class, built on low-cost labor in China. China has also been a boom for some US firms. Even Starbucks sees its future as tied to growth in China. The ability to add millions of new customers to a business is invaluable. China has offered that to the world market since the 1990s. Expansion in nearly every commodity over the past 40 years has been tied to the growth and increase in prosperity in China. That growth is now under examination.

Questions about China’s Growth Going Forward

Questions about the future growth in China are increasing. With economic growth recently coming in below expectations, these concerns are becoming more poignant. Trade is flat with China. Even internal consumption, like electricity use is more or less flat. The concern is that China is not growing as projected. Few people trust the economic numbers published by the Chinese government. Maybe China has reached a plateau in economic growth. The future does have some challenges for China. The one-child policy has left an aging China. Before 2050, China will be a smaller country than it is today. It is hard to believe. It will be an older country, too. Smaller and older counties have less productivity and consume less (unless then make large investments in technology to boost productivity and keep older workers working). The imminent aging of China is bad news for businesses that have grown to rely on China as a labor source or demand source.

It is interesting to think that we have spent the last 40 years in the US and developed markets defeating inflation. In many ways, China helped us control inflation, by providing a low cost labor source. China and our economic partnerships with China now pose new risks to the global market going forward. As China ages, its labor offerings will become less valuable. Might global labor costs increase – stimulating inflation? Might demand from China tail off – driving deflation? It really depends on what happens in other parts of the world For international firms, it will require pivots away from China. Here are some things to consider with the demographic shift at work in China.

China and the World will Age

The one-child policy and demographic experiment is over. China has seen the problem that is looming and is hoping to correct it, but the next 20-35 years are in the books already. China will be an older country. How does your business work with the elderly? There will be great expansion in products and services that help the elderly. Healthcare and housing will require major investments. Technology that serves the elderly will be a prerequisite.

Leverage Automation

If your business is built on low-cost labor in China, look for opportunities to further remove the labor through automation. Any expansion from more young workers in China is decades away, at best. The next few decades suggest that China will not be the workhorse that it was over the last few decades.

Look for Labor and Growth In India and Africa

The population boom is alive and well in India and Africa, however. The state of the economies in these parts of the world still involves pulling people out of abject poverty. In spite of that, fundamental investments in infrastructure, people, and products will occur. Map a path to capture this growth.

Some Thoughts and Observations on Growth

For companies and investors looking for growth in the world, I offer a few major trends. The world will have massive expansion in the warmest climates. Warm climates demand air conditioning, refrigeration, and such comforts go a long way in changing the satisfaction of the population. With rare exception do people ever give up such comfort. Also, the growth of these populations (especially in India) will correspond to higher per capita GDP. As people move out of the depths of poverty and into the so-called “global middle class” they adopt a richer diet that is based more on animal protein. This will require more soybean production for the raising of animals and put new pressures on sustainable animal husbandry as meat consumes not just soy beans, but large amounts of water and energy. These people will need transportation and communications. The development of low cost automobiles and the expansion of mopeds will bring these growing populations access to combustible engines and the continued environmental challenges posed by them. On the flip side, the U.S., Europe, Japan and China will need solutions for an aging population. Obviously healthcare is a focus. But these aging populations will consume services. Some of this can be met by immigration, but automation and even robots will, and already are answering the call.

Build your plan for the future. Take note; China has and does not like what it sees.

About Russell Walker, Ph.D.

Dr. Walker is Clinical Associate Professor of Managerial Economics and Decision Sciences at the Kellogg School of Management of Northwestern University.

Professor Walker has developed and taught executive programs on Enterprise Risk, Operational Risk, Corporate Governance, Analytics and Big Data, and Global Leadership. He founded and teaches the Analytical Consulting Lab, Risk Lab, Global Lab, and Digital Lab – all very popular experiential learning classes at the Kellogg School of Management, which bring Kellogg MBA students together with corporate opportunities focused on data and strategy. He also teaches courses in risk management, analytics, and on strategies in globalization.His most recent book From Big Data to Big Profits: Success with Data and Analytics is published by Oxford University Press (2015), which explores how firms can best monetize Big Data. He is the author of the book Winning with Risk Management (World Scientific Publishing, 2013), which examines the principles and practice of risk management through business case studies. He has also authored many business cases and published multiple Kellogg case studies through Harvard Business School Publishing. His cases have been highlighted by the Harvard Business School Publishing, the Aspen Institute, PRMIA, and the Bank of England for excellence in teaching risk management.

He serves on the Scientific and Technical Council for the Menus of Change, an initiative led by the Harvard School of Public Health and the Culinary Institute of America, to develop healthier and more environmentally friendly food choices. He was formerly on the board of the Education and Technology Committee to the Morton Arboretum. He was a board member of the Virginia Hispanic Chamber of Commerce, where he developed support programs for Hispanic entrepreneurs and worked with US senators on US Latino matters.

He is at @RussWalker1492 and russellwalkerphd.com.

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The World in 2050: Rapid Changes Ahead

The World in 2050: Rapid Changes Ahead

The World in 2050: Rapid Changes Ahead

Last week, I picked up a copy of the Wall Street Journal and was saddened and troubled to see the picture of a baby Syrian boy’s body being recovered from the sea. It was all the more ironic that I was preparing to give a talk on the World in 2050. It made me think that we are on the cusp of many rapid and dramatic changes. By 2050, we will have some 9.6 billion people on the planet, up from our current population of some 7.3 billion.[1] A big change facing the human race is the massive demographic shift that we will see in accordance with this population growth. Not all populations are growing equally. The sad events in Syria and elsewhere are part of this big shift. The world will have a super abundance of people in some places and a rapidly aging population in other places. As far as we can tell, the size, speed, and dramatic nature of the changes to our population are unprecedented in human history and will pose both challenges and opportunities.

India will Surpass China in Population (and Growth?)

We have grown comfortable with China being the population and economic growth engine for the world. Need another factory? China has been able to add manufacturing capacity in a low cost manner and find new workers to operate the factories. Due to the one-child policy and now the movement of many Chinese to urban areas, which typically results in the downsizing of family size, China will have a smaller and older population by 2050 (1.30 billion) than it does today (1.37 billion in 2015). It is somewhat hard to accept that China will soon be shrinking. The challenge here is that economically speaking, much of China’s growth has come from its ability to generate a labor supply and customer demand to fuel global markets. With concerns about China not meeting economic growth targets today and some 45% of the population already urbanized, one is forced to wonder if this slowing growth is a permanent change for the future and an earlier start to the inevitable slowdown than anticipated.

This brings us to India, which will be by 2050 become the most populous nation in the history of the world with over 1.66 billion people, up from its current population of some 1.25 billion. India will add more people to its population in the next 35 years than we have in the U.S. today! India still has a great deal of growth potential with only some 30% of its population living in urban areas. India’s growth will require access to more and new food supplies and a low-cost supply of energy. The opening of Iran and the access of other large energy finds in recent decades are all positive factors to support the economic growth of India. There is a strong intellectual base and educational system in India. Conditions for economic hyper growth are very positive.

Africa will Surprise Us

The largest boom in population growth will come from West Africa. Nigeria, which has a landmass about the size of Texas, will grow from its current population of 180 million to about 400 million in 2050.

It will more than double its population in a landmass that is already feeling crowded. The following population pyramid growth for Nigeria shows that Nigeria will remain a growing population through the next century, too.[2]

Most forecasts suggest that Nigeria will about equal the U.S. in population by 2050. Some project even faster population growth for Nigeria such that Nigeria will top the U.S. by 2040. This growth in Nigeria will be similarly matched by other countries in West Africa, leading many industries to examine Africa as a source for talent, customer demand, and indeed overall growth!

The U.S. will become more Hispanic

The U.S., like most developed countries, is aging. We are all familiar with the Baby Boomer population. However, the delay in marriage, lower rate in the formation of families and the reduction of family sizes are new normals for millennials. The net is that America will see an aging population, but immigration and the higher birthrate of immigrants in the U.S. will have U.S. population grow from today’s level of approximately 325 million to some 395 million by 2050. It is a respectable growth, which will come almost entirely from the Hispanic population. The Pew Research Center estimates that 82% of the U.S. population growth will come from Hispanics and that by 2050, the Hispanic population will grow from a current 17% to nearly 30%.

Foreign-born Americans will make up nearly 20% of the population by 2050, up from today’s 12% (although these number are clearly hard to confirm owing to undocumented residents). The Asian population, which is now about 5%, will double to 10% by 2050; the African-American population will remain at about 13%, and Caucasians are expected to comprise less than 47% of the population by 2050, showing a dramatic decline.[3] As you can see from the above population pyramid for the US, we will have an abundance of older people and fewer young people, suggesting that population growth will slow into the next century in the absence of greater immigration. Of course, immigration pressure will exists for the US, suggesting an even richer ethnic composition after 2050!

The World Will Need More Women

The population explosion that is occurring in India comes with an unfortunate and troubling imbalance. Owing to cultural preferences and gender-specific infanticide, India produces more boys than girls, and this is a growing problem. This cultural preference has been at work for many decades now and the population imbalance of women is irreversible. Consider the population pyramids for India and China, showing this grave imbalance.

The United Nations predicts that in Asia, there will be some 80 million to 100 million men with no prospect of forming a family by 2050. We should expect that the imbalance will be concentrated in the poorest strata of society. As families form, the poorest women will have mobility upward and the poorest men will have the hardest time in having families. This will be a social challenge that will bring changes to the concept of families, communities, marriage, and happiness in many of the poorest parts of Asia. The world has not seen this level of imbalance before and how it will be resolved is a new challenge.

Some Thoughts and Observations on Growth

For companies and investors looking for growth in the world, I offer a few major trends. The world will have massive expansion in the warmest climates. Warm climates demand air conditioning, refrigeration, and such comforts go a long way in changing the satisfaction of the population. With rare exception do people ever give up such comfort. Also, the growth of these populations (especially in India) will correspond to higher per capita GDP. As people move out of the depths of poverty and into the so-called “global middle class” they adopt a richer diet that is based more on animal protein. This will require more soybean production for the raising of animals and put new pressures on sustainable animal husbandry as meat consumes not just soy beans, but large amounts of water and energy. These people will need transportation and communications. The development of low cost automobiles and the expansion of mopeds will bring these growing populations access to combustible engines and the continued environmental challenges posed by them. On the flip side, the U.S., Europe, and Japan will need solutions for an aging population. Obviously healthcare is a focus. But these aging populations will consume services. Some of this can be met by immigration, but automation and even robots will, and already are answering the call.

It is clear from the Syrian crisis that millions people will need to move across borders in pursuit of peace and prosperity. This movement will continue to be amplified in the coming decades. Arguably, we are just seeing the beginning. Businesses and governments will need to change how they connect supply and demand globally. Workers are not just contributors but are also customers. Growth will come from matching supply and demand and bring peace and prosperity to the millions (actually billions) of people who are looking to improve their lives.

About Russell Walker, Ph.D.

Dr. Walker is Clinical Associate Professor of Managerial Economics and Decision Sciences at the Kellogg School of Management of Northwestern University.

Professor Walker has developed and taught executive programs on Enterprise Risk, Operational Risk, Corporate Governance, Analytics and Big Data, and Global Leadership. He founded and teaches the Analytical Consulting Lab, Risk Lab, Global Lab, and Digital Lab – all very popular experiential learning classes at the Kellogg School of Management, which bring Kellogg MBA students together with corporate opportunities focused on data and strategy. He also teaches courses in risk management, analytics, and on strategies in globalization.

His most recent book From Big Data to Big Profits: Success with Data and Analytics is published by Oxford University Press (2015), which explores how firms can best monetize Big Data. He is the author of the book Winning with Risk Management (World Scientific Publishing, 2013), which examines the principles and practice of risk management through business case studies.

books together from amazon

He has also authored many business cases and published multiple Kellogg case studies through Harvard Business School Publishing. His cases have been highlighted by the Harvard Business School Publishing, the Aspen Institute, PRMIA, and the Bank of England for excellence in teaching risk management.

He serves on the Scientific and Technical Council for the Menus of Change, an initiative led by the Harvard School of Public Health and the Culinary Institute of America, to develop healthier and more environmentally friendly food choices. He was formerly on the board of the Education and Technology Committee to the Morton Arboretum. He was a board member of the Virginia Hispanic Chamber of Commerce, where he developed support programs for Hispanic entrepreneurs and worked with US senators on US Latino matters.

He is at @RussWalker1492 and russellwalkerphd.com.

[1] United Nations Population Projections, 2012.

[2] Population pyramid graphics are from the International Data Base, made available by the US Census Bureau.

[3] http://www.pewhispanic.org/2008/02/11/us-population-projections-2005-2050/

How to Win With Risk Management

A Q&A with Russell Walker about risk management

Many people think about risk management as a defensive strategy, a tool for minimizing exposure to economic crises or public-relations blowouts. But Russell Walker, a clinical associate professor of managerial economics and decision sciences at the Kellogg School of Management, argues that businesses should be thinking about risk management very differently. He has just written a book on the topic, Winning with Risk Management, published by World Scientific Press, which he kindly agreed to discuss with Kellogg Insight. Here is our conversation, lightly edited and condensed. (For a longer version of our conversation, listen to the accompanying podcast.)Kellogg Insight: Your book argues that a company’s risk management strategy can actually bring it a competitive advantage. Can you start by explaining just what you mean?

Russell Walker: The world of business has taught us that companies develop competencies and use those to create advantages. Companies might, for instance, be excellent in operations, in marketing, pricing, branding, etc. So in the same way we would ask ourselves, “how do we compare against another firm on pricing?” or “how do we compare against a firm on branding?,” we could ask questions about risk management. How does the organization tie into knowledge networks, how is the organization exposed to global stresses, global shocks, shocks in supply chains, or even risk from regulation?

“What’s really exciting about competing on risk is that you could ‘buy’ your competitor’s assets for free.”

KI: You point out that operational risk in particular is often mismanaged—to a company’s peril. What do you mean by operational risk, and why is it important to manage it well?

Russell Walker: Operational risks are the negative outcomes associated with executing a strategy. It’s often the case that we remember the very catastrophic, image-driven, external events: explosions, hazards, tornados, what have you. But many organizations fail not because of outside stresses, but because of challenges internally. There may be technological challenges. And there may be organizational issues dealing with information that might suggest that risks are different. Operational risk mostly is the implicit risk that an organization has accepted by setting a strategy.

KI: So let’s move to a couple concrete examples. Your book takes us through the way two different cell phone companies, Nokia and Ericsson, both responded to the same crisis, a fire in a supplier’s factory that delayed production of a critical component. But the two companies’ responses to this crisis were night and day. What happened?

Russell Walker: Great question. The case is a famous one because it highlights how two companies were exposed to essentially the same risk. Both companies were using a single supplier—Philips in this case—which made a memory chip that was unique in the cell phone industry. Both Nokia and Ericsson found themselves dependent on this single supplier. When Philips was unable to produce chips because of a fire event at its factory, Nokia and Ericsson took drastically different approaches.

Ericsson was laissez-faire: “we’ll wait for more information on our supplier.” Nokia more proactively sought out information. And as you might guess, that more proactive approach by Nokia allowed them to secure the international supply of this memory chip, preventing Ericsson from acquiring any supply. Nokia was able to provide its competitor Ericsson a deathblow, and in doing so gained market share. They picked up 3% of the world’s market share and paid Ericsson nothing for that. The case has changed how technology companies in particular view their global supply chain and assess the risk of their suppliers.

KI: How so?

Russell Walker: We have found that many of the components used in technological devices like iPhones or iPads now accept one of many different components in the marketplace. Whereas in the case of Nokia and Ericsson, the phones were designed around one particular memory chip—only one, made by one supplier—now many of the devices have built in an engineering flexibility that allows them to receive one of many different components. We’ve also seen that Apple has changed its relationship with suppliers. It has a nearly exclusive relationship with Foxconn and develops very deep relationships with its partners. This case shows that both Ericsson and Nokia lacked that kind of deep relationship with a supplier.

KI: Would you say that there are any other ways that technology has shaped the risk landscape?

Russell Walker: Many ways. T.J. Maxx is a large retailer here in the U.S., and they’re not a company that you would expect to necessarily be competitive in the world of data security. But because they elected not to take particular actions to upgrade the security on their credit card transaction systems, they became the victim of a very sophisticated and targeted fraud scheme in which individuals stole credit card information from the satellite transfers from T.J. Maxx stores to their headquarters.

T.J. Maxx is a retailer. They compete on selling brands and clothes and all the things that we wish to wear, not on credit card security and in the technology necessary for that. But now even companies that run small e-commerce webpages are exposed. The case highlights—and it was the largest example of credit card fraud to date in the U.S.—the need for companies to stay abreast of technological risk.

KI: Time and again your book frames risk as this opportunity. I know you’ve touched on it briefly before. But why do you think that the more positive aspects of risk are ignored?

Russell Walker: They’re largely ignored because risk has been presented as a downside, not necessarily as an upside. What is fascinating about risk and understanding your competitive position against risk is that if your competitor is to falter—if you could assist your competitor in some demise—their assets (be they market share, factories, brands, etc.) get transferred.  And in the context of risk, if we look at the examples of Nokia and Ericsson, and even Toyota and British Patroleum, we see that assets get transferred for nothing. What’s really exciting about competing on risk is that you could “buy” your competitor’s assets for free. That largely will define the winners and the losers in a marketplace.

KI: You said something really interesting in your book about CEO tenure, and how that might actually influence how companies think about risk. Do you mind sharing?

Russell Walker: Exact numbers are in the book, but I believe a typical CEO tenure is 4–7 years. But it’s not uncommon for it to even be less. This suggests that a CEO, given his or her reward package, may take risks or make investments that maximize short-term results, and potentially expose the firm to larger risks later down the road. We could look at family businesses as a comparison, where a family business has the goal of preserving the company over a very long period of time, in fact even transferring it to the next generation. And we find that they take different risks, risks more in the direction of, “how do I preserve this and grow this in a sustainable way?” versus “how do I grow revenue rapidly, quickly?”

KI: So it might not be a bad thing for us all to start thinking about public corporations more as family corporations.

Russell Walker: Well, in the sense that you own it and it’s yours, you think about it very differently. In fact it has been suggested that CEOs should be compensated entirely by stock, entirely by ownership.

Winning with Risk Management

Winning with Risk Management

Traditionally, organizations have viewed risk management as a corporate requirement, and have often positioned it along with audit and regulatory functions. Some have even empowered and titled corporate groups to “manage risk” along these lines. This charge has often revolved around managing insurance policies and reviewing reports from rating agencies, which suggests that risk management was viewed more as the hedging of certain risks and the overall outsourcing of critical risk analysis, especially as related to credit risk. The recent economic downturn has shown a new face and place for risk management. The strongest firms in this economic downturn are those who integrated risk management as a more comprehensive part of corporate strategy. The weaker firms almost entirely shared the traditional risk management school of thought mentioned above. This is true in financial services and extends to nearly all industries reliant on credit, market, and operational risk management.

In the recent economic downturn, a few key behaviors of risk management as a driver of corporate strategy have emerged. First and foremost, sound risk management requires executive involvement and ownership. Next, there must exist a culture and climate for openly communicating risk in the organization. Additionally, communication of risk must have an emphasis on data-driven decisions. Lastly, but perhaps most critically, is that the organization must have a “ready response” to a known risk.

Let’s look at how executive involvement and ownership have a role in risk management in driving corporate strategy. A nice example is JP Morgan-Chase. Of the major banks in the US, JP Morgan Chase has carefully skirted the largest issues afflicting its competitors and brilliantly executed a strategy that is rooted in understanding its risk and adapting as needed. We can’t forget their buying of Bear Stearns at $10 a share and their buying of Washington Mutual (formerly the largest savings and loans operator in the US). It is worth looking at Jamie Dimon, Chairman and CEO of JP Morgan Chase. Unlike many a CEO, he took an active role in regular risk briefings. Not only did he ask for detailed risk reports as the CEO, he also recognized the need to set a direction for the organization in reaction to these risk outlooks versus delegating the risk decisions. When the investment banking industry was moving towards greater real-estate investments and larger CDO purchases, he looked to data from the JP Morgan retail banks that showed that mortgage defaults were on the rise, and he provided his team the direction (driven off of data) to move against the herd by selling real-estate backed securities. It is hard to fathom that an organization in the world that would make take such a drastic decision about risk without the direct involvement of its senior leadership. Therefore, just as executive involvement is important in setting corporate strategy, it is equally important in risk decisions.

To be effective as an organization, there must be honesty and openness in communicating risks. It is clear that the international real-estate bubble was in part fueled by a field of mortgages that were, in various forms, deceitful, incomplete, or otherwise untraditional. Indeed, the classically-trained credit risk managers signaled these mortgages as high risks. For many organizations that were focused on short-term earnings and felt a need to outpace the industry in bookings, this communication of risk was dismissed, or worse, even silenced. In the JP Morgan Chase example, it was the retail banking division that shared data with the investment bank on the escalations in mortgage delinquencies. This sharing of data across business lines allowed Mr. Dimon and his corporate team to change strategy on the investment side. For many organizations, sharing unexpected information is unwelcomed. Presumably, other banks could have done the same as JP Morgan Chase, but the focus on communicating risks and data across business lines was not there in other banks. The lesson, of course, is that an enterprise must be willing to communicate about risk, especially when things are going well and the risk has yet to be realized. Businesses lines should take time to learn what other lines are doing given the interconnectedness of risk within an organization.

The importance of information in risk management should not be missed. In recent months, many risk managers have pondered how the traditional risk management models failed to predict the crisis, as a great body of thought has gone into the development of the risk models and techniques that have been used to conventionally manage risk. In that convention resides the problem. Such conventional risk management techniques use historical data to make projections about “worse cases” or statistical anomalies that might happen with some likelihood. However, future negative outcomes are unknown to the models and future “failure paths” are unincorporated in the models. Most of the employed risk models are poor at incorporating new information and even worse at new types or sources of information, such as changes observed in a tangential business line, observations from front-line staff or traders, or alternations in market behavior due to phenomena such as reduced availability of capital.

In the case of JP Morgan Chase seeing signals in their mortgage accounts, they incorporated information on mortgage payments that was unconventional for the evaluation of portfolios of mortgages by the investment bank. Their success came from identifying such novel information and realizing that it challenged conventional thought. In such conditions, relaying on conventional risk models is highly questionable and some would even say harmful. So, the focus of a risk manager should not be strictly quantification (as in the execution of conventional risk models), but the identification and incorporation of information, especially from of new types and of new sources, in order to determine direction and changes that drive risk. Risk management is inherently a process of investigation and learning, rooted in unraveling the complexity of the unknown.

The risks facing organizations are legitimately more complex and tightly connected than ever before. The complexity of risk is largely driven by the continual globalization of business and the increased speed of virtually every business activity, as enabled by technological advances. Using data to make decisions is key; it enables verification, and provides a means of breaking down the complexity of business. For many organizations, there was a reliance on securitization or swaps to transfer risk in ways that were not possible a few years previously. This was heralded, and in fact, there are benefits to these instruments. In many ways, these swaps served as insurance, yet the buyers of such swaps were not necessarily qualified or even financially guaranteed (as is required by many a insurers worldwide). It is clear that very few of the buyers or sellers of such novel financial instruments understood the inherent interconnectivity of risks in these instruments. For instance, the US government is still unwinding the trades and obligations of AIG, which relied heavily on swaps and risk transfers. The case of AIG shows how even a large and diversified firm can struggle to fully understand its obligations and risks. Many firms like AIG, relied heavily on hedging or transferring of risk as a means of risk management. The assumption that risk is perfectly transferred means that one’s counterparty is perfectly resilient, too. This is of course a naïve view and one proven wrong recently, but one that fundamentally demonstrates how a few assumptions about risk can drastically impede a corporate strategy.

Still, in each corporate strategy, particular risks are accepted, namely and ideally those risks which management believes hold some attractive opportunity. Focusing on the data or factors that foretell of the risk accepted is key; it is how one begins to understand a risk and reduce uncertainty. Risk management is a process of investigation and study. Interestingly, many companies worldwide have accepted data at face value, such as credit ratings from the agencies, the financial stability of a counterparty that was buying a swap or credit risk transfer, or the direction of commodity or real estate prices. For example, it is clear that the US automobile industry was not prepared for the recent volatility in oil prices. The “Big Three” manufacturers were largely working on a view that oil would remain inexpensive to the US consumer. Instead, the likes of Toyota and Honda were making calculated investments in hybrid vehicles and other high efficiency vehicles to position themselves for an upswing in oil prices. In many ways, Toyota and Honda, had already “readied their response” to the risk posed by higher oil prices and the subsequent impact on their customers. This reflects a treatment of risk on the part of Toyota and Honda as part of their corporate strategies.

This forward thinking about risk is key in organizations. Toyota and Honda were not immune to the recent economic downturn nor did they completely depart the previously lucrative SUV market in the US, but clearly each was better positioned than the major US manufacturers, because they were better prepared. They identified a risk, took action in a way that would allow their corporate strategy to adapt to an environment with lower consumer interest in large vehicles. The emphasis is on “readying the response,” much in the same way that militaries conduct simulations to prepare for a yet unseen conflict. Companies that ready a response for various situations are not necessarily better at predicting the future; they are just more prepared for what comes to pass. This continuous preparation often makes them better at understanding factors predictive of a risk. So, being ready is not preparing for doomsday, but rather being able and prepared to adapt.

It is interesting we have heard the phrase “liquidity risk” come to describe the woes of many a firm recently. In fact, it is a more polite way of saying that an organization ran out of money. The seeds of today’s liquidity risks were set a few years ago, during more prosperous times, when companies dispersed excess cash through dividends, share buybacks, and undertook a wave of high-priced mergers. Indeed, shareholders and the investment community clamored for this sharing of wealth and punished those firms that held “excessive cash reserves.” Yet, today those organizations that hoarded a bit of cash can protect themselves against “liquidity risk” and can purchase competitor assets at significant discounts. Warren Buffett’s Berkshire Hathaway serves as a wonderful example in this case. Its history and policy of not paying a dividend has drawn naysayers in the past. Yet, this has provided a strategy that positioned the firm to have cash when it is most needed. It has allowed Warren Buffett to follow a strategy of long-term value to investors. The implicit risk decision was tied to strategy. The risk decision and strategy decision go hand in hand.

It is fair to admit that the current economic situation has altered many assumptions about business and markets, and we have seen a massive encroachment (oops, I meant investment) by governments in corporations. This will surely bring new risks to corporations and governments alike. Governments and corporations have different strategies and goals. Although we can more or less agree that corporations are driven to return profits to investors, the role of governments as major shareholders in banks, mortgage-holding firms, automobile manufacturers, and insurance firms is less clear. In part, the governments of the world have provided a rescue plan to stabilize (hopefully) our markets. But such investments by the government come with a price tag. We have already seen the US Congress and UK Parliament adjust and limit banks’ pricing on credit cards. Banks in both countries are furthermore restricted in taking action on defaulting mortgages, as part of accepting the government funds. So, the risks accepted change as the corporate strategy changes. Governments and politicians seem much more sensitive to reputations and public outcries than corporations, suggesting that firms accepting government assistance will likely be addressing a new list of risks and responding to a growing group of constituents. The risk of regulation is high for many industries, and firms should adjust their corporate strategies accordingly.

In driving corporate strategy, we see that risk management is much more than a set of best practices and transferring of risk. Instead, it involves clear identification of those risk accepted. Factors that are believed to drive risk and the data that is predictive of risk should be openly communicated, but this is not limited to risks internal to the firm. Let’s not forget, “Profit is reward for taking risk,” as so wisely put by the famous economist Frank Knight in 1921. Therefore, firms should not only be selective in which risks to take, but willing to pounce when the opportunity presents itself. This involves tracking the risk position of competitors, in order to understand competitive advantages. So, risk management is not an exercise in paranoia, but rather a thoughtful approach to understanding uncertainty, exposures, opportunities, and limits in order to make educated investments. It requires executive involvement, an emphasis on making data-driven decisions, open communication about risks, and a discipline to think through scenarios and ready responses. Indeed, a great many of the winners coming out of our current economic environment will be those that not only held a bit more cash, but had a bit more information than their competitors and were able to seize a window of opportunity.

These lessons show that risk management is really about the identification of key information and its use in the decision-making process. It is not about guidelines or the execution of conventional mathematical models. It is more important than ever as preparing for the unknown requires having the best information not the industry accepted “best practice.” This all signals that the risk management team belongs on the corporate strategy team, not on the phone with insurance brokers.

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