Prof. Patrick O. Connelly: Black Swans

– the Next Generation Risk Management Strategy Must Include the Consideration of These “birds”

Part 1

In the series of articles published over that past few years, the author has discussed many of the enterprise risks and proposed solutions to enable any enterprise of any size to address the exposure introduced by each risk. Admittedly, most of the risks discussed were internal, therefore known and readily identifiable, and subject to protection or hedge.

These risks might include:

  • Default risk for nonpayment of undisputed debt
  • Default risk from insolvency or bankruptcy
  • Failure to provide trained support or proper succession
  • Provider failure to perform/supply
  • Credit insurer failure to cover…to name only a few.
  • Foreign exchange volatility
  • Government policy change risk
  • Foreign market volatility

Among the solutions to exposures that impact enterprise value and business continuity discussed in previous articles was the need to assess risk beyond the internal environment, particularly including awareness of risk in the extended value and supply chains. Understanding the challenges and opportunities associated with risk in supplier networks, provider networks and third-party intermediary networks adds an important dimension to the risk management, and corporate governance strategy for success of the enterprise.

Given the current level of economic stress in most markets, it will be generally unpopular to recommend yet another layer of risk assessment. However, introducing this extended due diligence may very well:

  • extend the life of the enterprise
  • prevent an exogenous “surprise”
  • hedge against loss of reputational capital
  • sustain a more acceptable access to and cost of funding

The unfortunate rise in previously unforeseen external risks has resulted in a new risk management term:  the Black Swan2.  It has been generally described as an:

  • economic event,
  • not generally predictable or even identifiable using traditional ERM processes, but
  • introducing serious consequences into the enterprise business risk model.

The condition has been exacerbated by:

  • growing globalization
  • rapidly changing:
    • geopolitics trends
    • economics trends
    • regulatory trends
    • trade volatility
    • technologies changes
    • environmental conditions
    • events of terrorism
  • historical focus on internal risks and solutions, “known risks”
  • lack of expertise and experience in assessing external risks

Market disruptions in 2012 as described by interests in their individual regions were driven by:

  • Eurozone crisis
  • Libor crisis
  • US Debt crisis and the Fiscal Cliff issue

Supplementing this list following the review of some of the more easily identifiable Black Swans we find:

  • Arab Spring
  • Chinese “hard landing” from the high level growth rates
  • Possible oil price shocks
  • Venezuela succession questions
  • Japanese tsunami/Fukushima nuclear disaster

At the global level, the World Economic Forum has been working to address the uncertainties of these major risks for the last eight years.3   Note that much of the methodology described applies to enterprises and the markets in which they reside, and the risk characteristics of the WEF report could easily, and should  complement the risk characteristics traditionally considered by enterprises.

In this age of increasing focus on risk management, stakeholders rely upon        and are confident in enterprise management and expect a high level of attention to corporate governance. It seems important to introduce discussion regarding the need and methodology for identifying, discussing and charting possible solutions to Black Swan events, in order to maintain this high confidence from stakeholders.

The sense of urgency in response to a particular risk depends upon the probability of occurrence of the event. In order to properly deal with Black Swans, enterprises should make a clear distinction between those risks generally identifiable and whose probability can be estimated (and hedged), and those unknown or unexpected risk events wherein the probabilities remain equally unknown and planning must take the form of scenario analysis.

As a simple example, fundamental risk management practices include a consideration of the sources of critical product supplies to the enterprise. Understanding that customer loyalty and competitive advantage rely first upon the provision by the enterprise of:

  • Product or service of excellent quality
  • Provided at a price acceptable to the customer
  • Available for delivery or provision when ordered
  • Supplied in a timely fashion

The series of events across time, wherein orders are placed and product is delivered (and the debt extinguished) is the substance of the relationship and the source of customer loyalty and enterprise differentiation in the market.

Any change to the expected performance gives rise to risk in the relationship model. To the extent that the failure extends beyond a specific customer to a broader segment of the portfolio of customers, it may impact the entire business model.

Consider the following diagram.

Under a standard risk protocol, the Enterprise managed the stock of its most important product through a network of purchase from diverse sources, thus reducing the impact of a failure to supply from either Supplier 1,2 or 3, or any two of the suppliers. Purchasing organizations regularly monitor the “fill rates” or provisioning of orders placed in order to maintain a suitable mix of suppliers in order to assure product availability as required. In most organizations, this represents sufficient action and has historically been deemed sufficient to represent a business control over the process.

However, there remains a key risk that, though of low probability, might represent a catastrophic scenario for customer if not business continuity.

An example might include an enterprise whose strong diversification strategy requires it to divide its sourcing among several suppliers in order to assure access and delivery of critical components. Performance history of each of the three suppliers indicates that each is a strong performer, thus minimizing the risk of supply interruption. This tier 1 transaction hedges risk of non-availability from one, or even two sources, by extending buying opportunities to three separate sources. What if the diversification schedule through which product purchases are executed holds a critical but unknown flaw?

However, unless the risk review extends to Tier 3, including the supplier sourcing strategy, it may easily be missed that each and all of the three secure critical components of the enterprise regular bill of materials from a single manufacturer. This lack of knowledge and risk is clearly a black swan, introducing a significant potential risk with tremendous consequences to the enterprise.

What if ALL suppliers upon whom the Enterprise relies for the supply of Critical Product 6.211, purchase that product from a single manufacturer. This would not normally be a feature of the transaction discussed in the supplier agreement with Enterprise. This would not be omitted due to malice, perhaps not even considered an oversight, because it represents non-traditional thinking that extends beyond the standard representations and certifications contained in the agreement.
Enterprise agrees to order and supplier agrees to ship, given conditions agreed to by the parties. Neither party intends that the product ordered will not be available for shipment, and by no direct fault of the supplier. But the resulting failure to ship would be catastrophic to the Enterprise!

The mere discussion of this scenario by Enterprise executives could release a chain of research, analysis and events that could save the Enterprise from failure. This is especially true where Black Swan events, such as the concentration of purchasing from all of Enterprise suppliers regarding this critical product, focused in one manufacturer. Without evaluation of the business and in this case supplier model beyond the traditional inquiry, there would be an unknown exposure of potentially catastrophic proportion.

The conclusion of this article will be in the July edition of ACCEElerator

See The Black Swan by Nassim Nicholas Taleb, 2007, Second Edition, Amazon.com
3 For  research methodologies and current insight into the subject of global complex risk, see here
Professor Connelly is the author of numerous articles on the subject of foreign trade, China trade and risk management. Questions may be directed to patrick@creditcee.eu. All rights reserved by the author.
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