Opponents of quantitative risk management models believe these models are counterproductive: they inhibit companies from taking calculated chances without preventing major mistakes (see the 2008 economic crisis). A new study of seven successful companies shows that when complemented by rigorous qualitative risk management practices and expanded roles for risk managers, quantitative models enhance rather than inhibit a company’s innovation and initiative.
Sceptics of enterprise risk management believe that the 2008 financial crisis proves their point: risk management practices do little to prevent risks. Instead, according to these sceptics, focusing on potential risks only leads to a fear of innovation and initiative. Companies stay in their safe zones, becoming sitting ducks for competitors who are not afraid to take chances.
Robert Kaplan of Harvard Business School and Anette Mikes of HEC Lausanne reject the idea of risk management as a ‘hiding hand’ that inhibits companies. On the contrary, by clearly identifying the risks that a company can manage, they argue, effective risk management is a ‘revealing hand’ that highlights the best opportunities for change and growth.
A core problem is that the traditional approach of risk management focuses exclusively on quantitative measurements and compliance objectives. The core role of traditional risk management functions is independent overseer, with a mandate to prevent risks.
Based on their in-depth case studies of seven companies (including four financial companies) with highly effective risk management practices, Kaplan and Mikes reveal additional roles for risk management beyond the traditional compliance role.
Fulfilling these various roles requires a set of fundamental risk components, including effective processes (e.g. face-to-face meetings with key managers or on-going workshops with broad participation), and tools (e.g. value-at-risk models, scenarios, risk radar charts), for identifying, assessing and prioritizing risk.
For example, risk radar charts map a company’s risk appetite based on key dimensions, such as employee relations, shareholder returns, environment, safety, corporate image, and so forth. The map might show risk appetite stretching to 4.5 for the corporate image dimension, but staying at less than 2 for employee relations, indicating that companies might be ready to risk their corporate image but are concerned about maintaining their employee relations.
Effective risk management also requires an organization-wide consensus on values and beliefs — that is, which risks are most important to the company. Leaders must reach an agreement on the usually unavoidable trade-offs in risk situations (e.g. the risk related to a price increase involves a trade-off between revenue growth and dissatisfied customers) in order to make the best decisions for the long-term success of the company.
Guided by values, empowered through expanded roles and armed with quantitative and qualitative processes and tools, risk managers don’t impede a company’s progress but on the contrary help light the way.
To ensure active and effective risk management, companies should take the following steps:
Failures in quantitative risk management should not be used to reject all quantitative risk management models and tools. The problem is not with the models, but the fact that they are mistakenly used as the sole factor in making risk-management decisions that involve complex and sometimes subtle trade-offs. Risk management is more art than science; it requires both quantitative and qualitative approaches to be successful.
Risk Management — The Revealing Hand. Robert S. Kaplan & Anette Mikes. Journal of Applied Corporate Finance (Winter 2016).
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