Copyright © President & Fellows of Harvard College

Managing Risks: A New Framework

Anette Mikes

Harvard Business School

IRM, Manchester, 25 April 2012

A Case Study in Risk Management

Risk Management is Non-Intuitive

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“JPL engineers graduate from top schools at the

top of their class. They are used to being right

in their design and engineering decisions. I have

to get them comfortable thinking about all the

things that can go wrong.” - Gentry Lee, Chief Systems Engineer, NASA JPL

Risk Management and the Financial Crisis

Conflicting pressures?

• “Faster, better, cheaper”

• “Growth, profit, control”

The cultural position of the risk function

Companies that failed had relegated risk management to a compliance function, with no access to top management.

HBOS had "a cultural indisposition to challenge" and that the task of "being a risk and compliance manager … felt a bit like being a man in a rowing boat trying to slow down an oil tanker.” – UK Treasury Committee (7th report); Paul Moore

Do complex organizations fail – inevitably?

BP Deepwater Horizon: Post Mortem

“The disaster … can be attributed to an organizational culture and incentives that encourage cost cutting and cutting of corners – that reward workers for doing it faster and cheaper, but not better.”

“Management failure crippled “the ability of individuals involved to identify the risks they faced, and to properly evaluate, communicate, and address them.” -The National Commission’s Report to the President

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Individual and Organizational Biases

“Risk mitigation is painful; not a

natural event for humans to

perform.” Gentry Lee – Chief Systems Engineer, NASA, JPL

• Individual biases:

• Overconfidence

• Tendency to anchor our estimates

• Confirmation bias

• Escalation of commitment

• Organizational biases:

• Groupthink

• Rather than mitigating risk, firms incubate risk through the normalization of

deviance

• Effective risk-management processes must counteract those biases

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Individual and Organizational Biases

“Risk mitigation is painful; not a

natural event for humans to

perform.” Gentry Lee – Chief Systems Engineer, NASA, JPL

What’s distinctive about risk management?

• A practice-based definition

(Kaplan & Mikes, HBR forthcoming):

• Active and intrusive processes

that…

• … are capable of challenging

existing assumptions about the

world within and outside the

organization

• ... communicate risk information with

the use of distinct tools (risk maps,

value-at-risk models, stress tests

etc.)

• …complement, but do not displace,

existing management control

practices

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• Risk management is too often treated as a compliance issue

• New categorization of risk

• Some risks can be managed through a traditional rules-based model and some

require alternative approaches

• Companies need to anchor risk discussions in their strategy formulation and

implementation processes.

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Different Types of Risk Management

Different Types of Risk

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• Risks arising from within the company that generate no strategic benefits

• Eg: risks from employees’ and managers’ unauthorized, illegal, unethical, incorrect,

or inappropriate actions; risks from breakdowns in routine operational processes

• Companies should seek to eliminate these risks

• Active prevention: monitoring operational processes and guiding people’s

behaviors and decisions toward desired norms

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Category I: Preventable Risks

• Risks voluntarily accepted by the company in order to generate superior

returns from its strategy

• Eg: credit risk assumed by a bank when it lends money; risks taken on by

companies through their R&D activities

• Not inherently undesirable

• Reduce the probability that the assumed risks materialize and improve the

company’s ability to contain the risk events should they occur

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Category II: Strategy Risks

• Risks arising from events outside the company and beyond its influence or

control.

• Eg: natural and political disasters; major macroeconomic shifts

• Companies cannot prevent such events from occurring

• Management must focus on identification (obvious only in hindsight) and

mitigation of their impact

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Category III: External Risks

Managing Preventable Risks

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Failures in Controlling Preventable risks

Siemens Bribery and Corruption Scandal

o Pay $1.6 billion in fines and $850 million for internal investigations by

outside lawyers and accountants.

o Nine former members of Managing Board sued for $28.3 million for

breaching fiduciary duties

o Two former CEOs agree to pay more than $10 million to settle cases

brought against them.

Société Générale: The Jérôme Kerviel Affair

o Losses of about €7 billion (2007).

o Société Générale has to raise €5.5 billion in new capital.

Situational forces: The fraud triangle

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Situational forces - How good people turn bad

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•Organizational pressure

•Group pressure and the Lure of the Inner Circle

•Blind obedience to authority

•Not recognizing red flags and an exit opportunity

What individuals can do - Step up to situational

forces

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Stand firm on principle despite intense pressures

“I am responsible”

Whistle blowers: individuals who are aware of illegal or unethical

activities who report the activities without expectation of reward

Heroes’ risks:

• Career risk

• Professional ostracism

• Loss of status

• Financial loss

• Loss of credibility

• Companies cannot anticipate every circumstance or conflict of interest that an

employee might encounter, but should clearly articulate their

• Mission

• Values

• Boundaries

• Top managers must serve as role models

• Importance of strong internal control systems and independent internal audit

department

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What corporate leaders can do

“Medicine is for people, not for

profits. The profits follow, and

if we have remembered that,

they have never failed to

appear.”

- George Merck, CEO and founder‘s son (1950).

The Mission

Beliefs System

Domain for Search

and Empowerment

Boundary System

Boundary Systems

Opportunity Space

Managing Strategy Risks

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“Building great things means taking risks.

This can be scary and prevents most companies from

doing the bold things they should.

However, in a world that’s changing so quickly, you’re

guaranteed to fail if you don’t take any risks. We have

another saying:

The riskiest thing is to take no risks.” - Facebook IPO prospectus

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• 3 distinct approaches to managing strategy risks

• “One size does not fit all” In terms of the structures and roles for the risk

management function

• However, all encourage employees to challenge existing assumptions and

debate risk information

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• High intrinsic risk, but risk changes slowly over time

• Risk management handled at the project level

• Case: Risk management at JPL

• CRO

• Risk review board made up of independent technical experts

• Role is to challenge project engineers’ design, risk-assessment, and risk-mitigation

decisions (“culture of intellectual confrontation” )

• Authority over budgets: establishes cost and time reserves according to its degree

of risk

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I. Independent Experts

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• Risk stems largely from seemingly unrelated operational choices across a complex organization that accumulate gradually and can remain hidden for a long time

• Risk management by a small central risk-management group that collects information from operating managers

• Hydro One

• CRO runs workshops with employees from all levels and functions

• Employees identify and rank the principal risks to the strategic objectives

• Capital allocation and budgeting decisions linked to identified risks

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II. Facilitators

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• Risk profile can change dramatically with a single deal or major market

movement

• Risk management by embedded experts within the organization to

continuously monitor and influence the business’s risk profile, working with

line managers

• Danger for the embedded risk managers to “go native”

• JP Morgan Private Bank

• Report to both line executives and a centralized risk-management function

• Continually ask “what if” questions

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III. Embedded Experts

• Companies tend to label and compartmentalize risk, especially along

business function lines

• Companies can achieve an integrated risk perspective by anchoring their

discussions in strategic planning

• Companies also need a risk oversight structure

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Avoiding the Function Trap

• Risk discussions generated from the Balanced Scorecard

• Eg: “growing client relationships” identified as a key objective,

• Management realized that strategy had introduced a new risk factor: client default.

• Implication: monitor CDS rates of large clients etc....

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Infosys

“As we asked ourselves about what risks we

should be looking at, we gradually zeroed in

on risks to business objectives specified in

our corporate scorecard.” MD Raganath, CRO, Infosys

• Risk discussions generated from the company’s strategy map

• Risk events identified for each objective

• Risk Event Card prepared for each risk

• High-level summary of results presented to senior management

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Volkswagen do Brasil

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Volkswagen do Brasil: Risk Event Card

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Volkswagen do Brasil: Risk Report Card

• Hydro One:

• Large company, but small risk group

• JPL / JP Morgan Private Bank:

• Small companies/units, but multiple project-level review boards or teams of

embedded risk managers

• Infosys:

• Dual structure: central risk team; specialized functional teams

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Organizing the risk function

Managing External Risks

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• Some external risk events sufficiently imminent for managers to manage them

like their strategy risks

• Eg: risk of increased protectionism at Infosys

• Most external risk events require a different analytic approach

• Probability of occurrence very low

• Difficult to envision them during the normal strategy processes

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• Natural and economic disasters with immediate impact

• Eg: 2010 Icelandic volcano eruption; bursting of a major asset price bubble; 2011

Japanese earthquake and tsunami

• Geopolitical and environmental changes with long-term impact

• Eg: political shifts; long-term environmental changes; depletion of critical natural

resources

• Competitive risks with medium-term impact

• Eg: emergence of disruptive technologies; radical strategic moves by industry

players

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Sources of External Risk

• Tail-risk stress tests

• Assess major changes in one or two specific variables whose effects would be

major and immediate, although the exact timing is not forecastable

• Depends critically on the assumptions (may themselves be biased)

• Scenario planning

• Systematic process for defining the plausible boundaries of future states of the

world

• Long-range analysis (typically 5-10 year)

• War-gaming

• Assesses a firm’s vulnerability to disruptive technologies or changes in

competitors’ strategies

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Dealing With External Risks

Wrap-up

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• Risk management focuses on uncertainties that could impair mission and

strategic objectives

• Mitigating risk involves dispersing resources and diversifying investments

• Most companies need a separate function to handle strategy- and external-

risk management

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Risk Management is Not Strategy Management

Smart questions or dumb questions?

“Do you have an embedded risk management system?”

“Do you have a strong risk culture?”

“Do you have a risk appetite policy that is well understood by every member of

the organization?”

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Dumb questions

•Lack traction, and is relatively easy for a CEO or CRO to answer and deflect

without revealing much of substance

•Invite busy executives to rehearse risk management clichés

•The answers to banks of dumb questions are more likely to be self- reinforcing

and reveal little about the real risk management.

•They will tend to produce an illusion of control.

Power, M., Smart and Dumb Questions to Ask About Risk Management.

Risk Watch, May 2011

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Smart questions to the CEO

•What are the processes by which you satisfy yourself that risk appetite is a real

constraint on action?

•Is the organization good at stopping bad projects that have gained

momentum?

•When was the last time something was stopped in the organization because it

was considered too risky?

•How do you feel about meetings with the chief risk officer? Do you feel you talk

to your chief risk officer enough?

•What are the three most important bits of management information that you

use each day? What do they tell you, if anything, about risk?

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Power, M., Smart and Dumb Questions to Ask About Risk Management.

Risk Watch, May 2011

Smart questions to the CRO

•Have you ever been excluded from meetings that you felt you ought to attend?

What did you do about it?

•Do you feel you have enough contact with the CEO?

•Can you envisage being able to veto developments? Did you ever try, and why?

•Are you involved in product development from the beginning? If not, why not?

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Power, M., Smart and Dumb Questions to Ask About Risk Management.

Risk Watch, May 2011

It’s an evolution: Risk managers shape their

own fate too!

•Taking responsibility or shifting blame

•Competing with other staff groups

•Expanding or limiting boundaries

•Working on the relationship with the business

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Copyright © President & Fellows of Harvard College

Thank you!