Riding the Waves of the Cycle
By Alice Underwood and Dave Ingram
In our last article, “We’re Going to Need a Bigger Boat” (AR, August 2010), we introduced four different perspectives on risk and argued that enterprise risk management must make room for each of the four. In part that’s because a restrictive definition of ERM—limited to only one of the four perspectives—would alienate the other three types of firms.
But there’s another reason to consider as well: the waves of economic cycles refuse to stand still.
Changing Risk Environments
Those holding the pragmatist risk perspective see the waves of the risk environment as choppy and chaotic, while the risk reward managers believe that patterns can be discerned. Both groups are able to observe the same data—why do they form such different interpretations?
One reason is that, over time, the risk environment changes. A simplistic model of changes in the risk environment might posit that either things are “normal” or they are “broken.” But an observer who holds the conservation perspective on risk might say that extreme hazard and danger are the “normal” state of affairs, while a profit maximizer would be more likely to argue that profitability is “normal” and hazardous conditions prevail only when the market is “broken.” The pragmatist considers chaos the normal state, interrupted by brief periods of apparent order; the risk reward manager expects results to be reasonably predictable most of the time.
Expanding the model to allow more than two states allows for the possibility that all four views can make sense. Consider a model with four risk regimes:
Boom Times. Risk is low and profits are going up.
Recession. Risk is high and profits are going down.
Uncertain. Risk is very unpredictable; profits might go up or down.
Moderate. Both risk and profit fall within a predictable range.
As the cycle moves through these four different states, external conditions match the worldview of each of the four different risk perspectives. Each perspective has been right part of the time and will be again at some point in the future. But none of the risk perspectives are perfectly adapted to external conditions all of the time.
Risk reward manager purists may object that their view takes into account the full range of the cycle. But economic cycles are not sine curves; the period and amplitude are irregular, unexpected “black swan” events do occur, and there are always “unknown unknowns.” Model risk can never be eliminated, and narrowly restricting ERM obscures this important fact.
Risk reward management-based ERM works especially well in the moderate risk environment when risks are fairly predictable. But in boom times, firms following such an ERM program will unduly restrict their business—not as much as conservation firms, but certainly more than profit maximization firms—and more aggressive competitors will be much more successful. In the recession environment, risk reward management ERM again advocates a middle path; this may mean the firm sustains too much damage to take full advantage of the market when it turns. When times are uncertain, a firm following ERM based solely on risk reward management will be frustrated by frequent surprises and a world that does not quite fit the model. Competitors not tied to a particular view of risk will fare better, making decisions in the moment with maximum flexibility.
In any given risk environment, companies holding a risk perspective and following an ERM program aligned with external circumstances will fare best.
Some companies following strategies that are poorly aligned with the environment muddle along with indifferent results and survive until their preferred environment returns. Others sustain enough damage that they do not survive. A few change their risk perspective and ERM program to suit the new environment. Meanwhile, new firms enter the market with risk perspectives and ERM programs that are aligned with the current environment.
Since many of the poorly aligned firms shrink, die out, or change perspective—and since new firms tend to be well-aligned with the current risk regime—the market as a whole adjusts to greater alignment with the risk environment via a process of “natural selection.”
To thrive under all risk regimes, a firm ideally would follow a strategy of rational adaptability and be able and willing to do the following:
The difference between rational adaptability and the process of “natural selection” described above is conscious recognition of the validity of differing risk perspectives and proactive implementation of changes in strategy.
- Identify changes in the risk regime
- Shift its risk perspective
- Modify its ERM program
A company practicing rational adaptability recognizes that during boom times, risk really does present significant opportunities, and it is appropriate to empower the profit maximizers, focusing ERM efforts on risk trading to ensure that risks are correctly priced using a consistent firm-wide metric. When the environment is moderate, the firm gives additional authority to its risk reward managers, using modeling results to reevaluate long-term strategies. In times of recession, the focus shifts to conservation: tightening underwriting standards and placing special emphasis on firm-wide risk identification and risk control. And in uncertain times, there is particular emphasis on diversification, keeping various options open.
Crewing the Ship
Although rational adaptability may be an ideal solution, it requires the accomplishment of difficult tasks with precise timing, like a champion surfer judging the exact moment to catch the wave.
An alternative strategy is to build harmony from the discordant risk voices within the firm—and all four voices do exist within most firms. This means risk committees must include not just the risk reward managers, who believe in the risk models and the risk-steering programs that are based upon those models, but also those who distrust such models. All four perspectives should be represented and encouraged to speak out.
Every harmonious firm will create its own unique compromises among the four views. Different firms will choose different times and ways to honor the inherent caution of the conservators, to heed the pragmatists’ call for diversification, to follow the models of the risk reward managers, or to give the profit maximizers greater scope to grow. The resulting strategy will never seem perfectly “right” to any of the four groups. But as the waves of the cycle rise and fall, a harmonious crew—incorporating the strengths and insights of each of the four perspectives—will be able to prevent their boat from capsizing and keep it on course to continued success.