“ERM is not enough”:: How to prepare for a Black Swan [Booz & Co]

Great to know that there are still major Consultancy firms ready and willing to wade-in to help firms understand the type of risks that could “kill” an enterprise but about which too little is widely known, less is understood and next to nothing is done to extend the current “risk horizon” or to build RESILIENCE into the Commercial/Corporate defences.

Of course the following perspective is certainly not the only one available…”Black Swans”, Systemic Risk, Complexity, Uncertainty are topics that I have covered in this blog on MANY occasions…but it is worth a read. It may answer some questions or prompt new one’s, either way, you will have given the matter further thought and, if it leads you to a more resilient enterprise, the benefits will be communicated to others…and you can thank me later!

These events can threaten a com­pany’s survival, and boards and senior leaders are responsible for protecting shareholders and other stakeholders. They must ask, What else can go wrong?

A Disrupter Analysis Stress Test

The solution to this conundrum is disrupter analysis. Disrupter analysis does not seek to predict black swans; that cannot be done. And it is not meant to replace ERM, but rather to complement it. Disrupter analysis — which is typically conducted by a separate team working in collaboration with the ERM staff, functional and business unit leaders, and senior management — is designed to periodically administer a stress test to a large company in order to assess its ability to withstand black swans.

The analysis consists of a four-step process that will be familiar to professional ERM managers. It quickly and efficiently maps the shape of the enterprise, determines the breadth of potential disrupters, asks the “what ifs” to determine how severely certain events could stress the enterprise, and then implements the contingency plans.

1. Mapping the enterprise. The shape of a company is determined by a number of factors, starting with its geographic footprint, its operations, the composition and construction of its supply chain, and its channel partners and customers. In mapping these elements, it is important to look beyond first-order relationships. Recently, for example, Apple’s supply of lithium-ion batteries, used in iPods, suddenly dried up. Unfortunately, as Apple quickly discovered, almost all its suppliers purchased a critical polymer used to make the batteries from the Kureha Corporation, a Japanese company whose operations were disrupted by the March 11 earthquake. In fact, Kureha’s share of the global market for polyvinylidene fluoride, which is used as a binder in lithium-ion batteries, is 70 percent. This is why analysts must also map second-order relationships (the suppliers of the company’s suppliers). In some critical cases, even third-order relationships should be mapped.

After the shape of the enterprise has been mapped with the help of the ERM staff, finance and other group functions participate in team sessions to map sources and concentrations of revenue, profit, and capital. Then the often-hidden concentrations that exist in go-to-market activities — including the business’s products, services, channels, and customers — are considered.

A determination of the com­pany’s shape must also include a mapping of industry structure and competitive dynamics, as well as the firm’s position in both. To determine how a black swan event could stress a company, the team needs to understand the foundation on which the status quo rests.

2. Creating the disrupter list. The key to creating a list of potential black swan events is to cast a wide net by cataloguing possible catastrophic environmental, economic, political, societal, and technological events. The team should add much more to the list than ERM typically does, and continue until the net is wide enough to include representatives of as many different black swan categories as possible.

After the long list is compiled, the events are categorized by the type of impact they might have on the business. The result is a shorter, more workable synthesis that encapsulates the black swan events that could threaten the company.

3. Asking “what if.” Armed with the enterprise map and a concise list of disruptive events, the analysis team can begin to ask what would happen to the company if the events, or even combinations of events, occurred. The likelihood of occurrence is not a major concern here; these are, after all, black swans. Rather, the team needs to determine the relative impact and consequences of a given catastrophe.

This stage of the analysis often produces surprising results. Revelations can include greater concentrations of risk than were previously recognized, more severe and unexpected consequences, and, sometimes, seemingly obvious mistakes in how an enterprise has been shaped. The widespread adoption of offshoring strategies has spawned one example. At first, offshoring spread out the exposures and risks of operational disruptions because large companies were expanding their ranks of partners and their geographic footprints. But more recently, new exposures have arisen: Offshoring has created greater concentrations of risk in far-flung locations, where high-magnitude, low-frequency risks are often more varied and where the likelihood of rapid recovery can be much lower. Consider what might happen to the world’s consumer electronics and apparel industries, for example, if the recent labour unrest in southern Chinese factories develops into a disruptive labour movement similar to what the West experienced during the early 20th century.

4. Implementing contingency plans. Typically, the analysis team systematically generates mitigation options for each major “what if” insight. It looks for options that address multiple risks, and prioritizes them by the magnitude of risk exposure as well as the expense and ease of implementation.

Sometimes companies complete this final step on their own, using their ERM departments. The ERM staff usually participates throughout the analysis and is the most logical and effective group to shore up any major exposures. However, sometimes internal complexities warrant third-party involvement. Also, most boards prefer to involve an external, objective set of eyes, especially when recommendations include critical strategic and operational issues.

No company can be completely prepared for every possible black swan event. But the board, the executive team, and the ERM staff can complement the day-to-day work of the ERM function with periodic disrupter analyses. These analyses can ensure that the com­pany has adequately focused its attention on high-magnitude, low-frequency events, performed stress tests on its fitness in the face of such events, and prepared itself for unexpected catastrophes.

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2 Responses to “ERM is not enough”:: How to prepare for a Black Swan [Booz & Co]

  1. Autumn says:

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    • Many thanks for the kind words!

      I do try to keep subjects, that many people find pretty boring, a bit more interesting and amusing. Sometimes that is easier than others but it is ALWAYS good to know that the message is appreciated!


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