Global Risks corporate responses

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Global Risks corporate responses

• Sean Cleary
• IRM SA Conference 2007
• Johannesburg, October 16, 2007

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Origins and meaning

• Risk - early Italian risicare (to dare), from
  late Latin risigus. Skeat relates it to Spanish
  risco a steep, abrupt rock, from whence the
  sense of danger may easily have arisen among
  sailors. Skeat cites the Spanish arriesgar to
  venture into danger, literally to go against a
  rock.
• The OED dates the words origin in English to
  1661 and defines it as hazard, danger exposure
  to mischance or peril. Hazard has its origins in
  the Arabic al zahr, meaning dice.
• Modern concept arose about 300 years ago. By
  1719, denoted the chance or hazard of commercial
  loss, specifically in the case of insured
  property or goods.
• In Against the Gods, Peter Bernstein calls
  mastery of risk
• the revolutionary idea that defines the
  boundary between modern times and the past the
  notion that the future is more than a whim of the
  gods and that men and women are not passive
  before nature. Until human beings discovered a
  way across that boundary, the future was a mirror
  of the past, or the murky domain of oracles and
  soothsayers who held a monopoly over knowledge of
  anticipated events.
• Risk is measurable uncertainty, characterised by
  a measure of randomness, with knowable and
  thus calculable probabilities. Uncertainty is
  unmeasurable randomness with unknowable
  probabilities.

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Risk is the business of business

• Risk is the business of business anticipate
  change and manage it on the basis of an opinion
  about the future
• Risk intimately linked to innovation. Nobel
  prize-winning economist William Baumol
  innovation most important feature of market
  economy. Competition forces us to innovate most
  innovation comes from companies, not universities
  
• Identifying, assessing, assuming, mitigating and
  managing risk is core of business behaviour.
  Innovation poses risks, but only sustainable way
  of managing business risk in a fast-changing,
  competitive marketplace
• If company is a living system, building capacity
  to resist shocks through organic adaptation is
  key. Change now continuous, not episodic, and
  language of life sciences more suited to the risk
  management than industrial prescripts 99 per
  cent of all species are extinct 1 per cent that
  survived not strongest or smartest, but most
  adaptive to changes experienced
• Jared Diamond Guns, Germs and Steel new work
  exploring why diverse communities choose to fail
  or survive. Four reasons for failure, all
  relevant for modern businesses
• Failure to anticipate a problem
• Failure to perceive it once it has arisen
• Failure to try to resolve it once it has been
  recognised and
• Failure in ones attempts to solve it

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Risk management principles
Communicate management intentions Clarify
corporate expectations Strengthen risk awareness
Risk Control Verify results
Determination of Risk Profile
Risk Identification and Analysis
Information and Communication
Risk Assessment
Monitoring for early warning

• COUNTER-MEASURES RESIDUAL RISK
• Define risk management strategies
• Identify institutional collaborators
• Allocate tasks based on comparative advantage

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Comparison of Market Risks
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Competitive challenges

• Critical factors for competitive advantage
• Brace for turbulence
• Manage risk skillfully
• What does this mean?
• Build first-rate and relevant information,
  knowledge, understanding and skills
• Build in capacity to anticipate, absorb and
  manage rapid and discontinuous change
• DEVELOP ORGANIC RESILIENCE

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Top 10 Risks comparedBrainstorming in IC and GS
- November 2005

• Intelligence community
• Persistent and challenged differences between
  high low opportunity geographical areas,
  resulting in uncontrollable migratory flows and
  humanitarian crises
• Intelligence communitys inability to overcome
  cognitive straightjackets/adopt new approaches
• Competition for resources (primarily oil and
  water)
• Synergies between terror, crime and drug networks
• Pandemics, including avian flu and HIV/AIDS
• Ability of extremist factions to shape Islams
  face
• WMD in the hands of terrorist organizations/
  rogue states
• Inability of societies to deal with cultural
  diversity/minorities
• Inability to come to grips with the roots of
  radicalization and extremism
• Irreversible disruption of global environmental
  equilibriums (incl. global warming)

• Goldman Sachs
• Hedge funds and derivatives
• World oil supply
• Wealth disparities in emerging economies
• Opportunities and challenges for growth in China
• Trade liberalization
• The dollar and the twin deficits
• Environmental accords
• Geopolitical conflicts
• Global terrorism
• World health conditions

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WEF Global risks
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Global Risks correlated
- Affect business but are not operational,
project or financial risks - Are highly
interdependent and often systemic (i.e. do not
manifest in isolation and can result in extensive
conflation) - Characterised by uncertainty,
sharp discontinuities, non-linearity and
disproportional impacts
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Two senses of systemic risk

• As used in financial markets
• the risk that an event will trigger a loss of
  economic value or confidence in, and attendant
  increases in uncertainty about, a substantial
  portion of the financial system, that is serious
  enough to quite probably have significant adverse
  effects on the real economy.   Group of 10,
  Summary Report on Consolidation in the Financial
  Sector, January 2001, www.bis.org
• But more broadly
• Systemic risks are risks that originate in an
  identifiable event that threatens predictable
  harm to one element of the system and which, due
  to links between different systemic components is
  (or has the potential to be) amplified in either
  magnitude or direction, leading to substantial
  damage to the system as a whole. OECD, WEF 

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Key Global Risk Themes at Davos 2007

• Dangers of complacency in the face of benign
  conditions
• The new year will begin with the greatest
  divergence for a generation between the general
  view of global risks and risks as priced in
  financial markets, Lawrence Summers, Harvard
  University.
• are compounded by increasing interdependency
  ...
• Interdependence is the defining issue of
  the 21st Century,
  Tony Blair, Prime Minister of the United Kingdom.
• Risk conflation and interconnectedness make
  the world increasingly
  vulnerable to the cascading nature of risk
  events.
• and a fundamental disconnect between risk and
  mitigation
• even though some tactical gains have been made
  in specific areas of risk - such as co-operation
  on dealing with terrorism, and improved
  preparedness for a major pandemic outbreak.

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Key challenges

• Inherent elements
• Complexity
• Inter-connectivity
• Causality
• Challenges in mitigation
• Divergent perceptions
• Policy agendas, time-frames and trade-offs
• Institutional fragility and incapacity

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Neo-classical economicshomo economicus

• Neo-classical economic theory suggests that
  people
• systematically apply rational calculations to
  economic decisions to enable optimisation of the
  utility of choice in the context of constraints
• Assumes we make decisions in a state of
  deliberative equilibrium, where preferences,
  information and constraints would shape the
  decision if time and computational ability were
  unlimited

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The sub-prime credit crisis

• Global glut in savings in most of Asia and Middle
  East
• Largely offset by excess of investment over
  savings in West, especially US. US current
  account deficit absorbed almost two-thirds of
  gross savings surplus in recent years
• After stock market collapse in 2000, US
  government and US households became net consumers
  of capital financial surplus in business sector
  Private Equity boom
• Excessive household spending sustained by U.S.
  monetary policy. Rising spending led to rise in
  household debt, financed by borrowing against
  homes. Debts transmitted through securitised
  lending.
• Led to sub-prime crisis several months until
  related trades unwound. Funds and banks around
  world purchased bonds, or risk related to bonds,
  backed by sub-prime home loans, bundled into
  collateralized debt obligations
• J.P. Morgan estimates about 1.5 trillion in
  collateralized debt obligations, and about 500
  billion to 600 billion in structured finance
  collateralized debt obligations, bonds backed by
  sub-prime and other mortgages, and commercial
  mortgage-backed securities. Much of the risk thus
  amplified by collateralized debt obligations.
• Emergence of these complex products coincided
  with growth of credit derivatives allowing banks
  and funds to hedge exposure. Further difficulties
  with bank-owned, off-balance sheet conduits and
  other specialised vehicles with investments in
  asset-backed securities Some have struggled to
  raise finance after withdrawal of pension funds
  and insurance companies that normally buy their
  short-term paper
• U.S. Federal Reserve interest rate cut was needed
  to stabilise markets

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Recovery from the crisis

• Core uncertainty in assessing recovery
  trajectory, is extent to which central bankers
  can definitively influence the creation of money
  and credit. Trade in derivative instruments in
  2006 is estimated at U.S. 300 trillion, over six
  times global GDP of U.S. 48 trillion. Effects of
  efforts by the Fed or the ECB to prime pump by
  reducing rates, are uncertain.
• After the crisis, buyers of derivative and
  securitised assets will not simply accept the
  agencies ratings. Less paper will be issued by
  sub-prime brokers and fewer packaged products by
  investment houses. Prices will rise and global
  credit will be reduced. Carry trades will be
  viewed more sceptically, further reducing
  volumes. Probably also seen peak of profit cycle
  of excess money in equity markets. 
• What happens if sustained contraction in U.S.
  household spending? What other group of consumers
  will underpin growth in exports by countries with
  big current account surpluses?
• China's rapid expansion in the past few years was
  also aided by easy global credit. Domestic
  consumption trails savings and investment.
  Tighter credit will lead to slowdown in global
  economic activity, just as low rates fuelled the
  boom. European and Japanese growth are dependent
  on U.S. and Chinese markets and cannot compensate
  for simultaneous slowing in U.S. and Chinese
  growth.
• High levels of uncertainty -- caution indicated!

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Inaccurate appreciation of risk
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Cognitive distortions in risk
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Insights into risk from neuroscience - 1
Colin Camerer, George Loewenstein and Drazen
Prelec, Neuroeconomics Why economics needs
brains, Scandinavian Journal of Economics, vol.
106, no. 3, pp. 555579, September 2004.
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Insights into risk from neuroscience - 2
Colin Camerer, George Loewenstein and Drazen
Prelec, Neuroeconomics Why economics needs
brains, Scandinavian Journal of Economics, vol.
106, no. 3, pp. 555579, September 2004.
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Socio-economic trade-offs
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Considerations on inter-dependency

• Consider a utility that is part of an integrated
  system the power grid and wants to determine
  whether to invest in additional capacity or
  security measures (such as taking care of growing
  vegetation near distribution lines) to reduce the
  chance that it will cause a power outage.
• In any highly interdependent system, such as the
  power grid, there is a systemic tendency to
  under-invest in reliability.
• A consequence of interdependency is that a part
  of the cost of a failure is passed on to
  competitors and their customers.

Kunreuther, Howard, contribution to Global Risks
2007, Global Risk Network, World Economic Forum
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Global mega-trends

• Global systemic trends
• Degradation of the global eco-system
• High and growing dependence on hydro-carbons
  (exacerbating climate change and systemic
  vulnerability)
• Increasing complexity and accelerating
  technological and social change
• Unprecedented personal mobility and systemic
  inter-connectivity
• Exceptional levels of innovation and accelerated
  obsolescence due to global competition
• Eastward shift of global manufacturing and
  service centres
• Challenges to U.S. hegemony and Anglo-Saxon
  cultural dominance
• Disaggregation of real and financial economies
• Demographic trends
• Aging of populations in G8, EU15 and certain
  large emerging markets, producing
• High propensity to consume
• Rising aversion to risk, and
• Structural macro-economic problems due to social
  service costs
• Rapid population growth in lower income countries
• Migration into Europe and cultural clashes
• Trends in social experience
• Uneven experience of the costs and benefits of
  globalisation
• Widespread perception of governments as weak at
  national and international levels

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Geo-strategic data visualization

• Geo-economic trend analysis
• Risk trend analysis
• Defence planning

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Rising Asia EIU 2006 Shift in the economic CoG
Goldman Sachs suggests China may pass USA in real
exchange rate terms by 2027

• Asias share of global GDP (ppp) will rise from
  35.7 percent in 2005, to 39.5 per cent in 2010
  and 43.2 per cent in 2020
• Relatively high growth in the USA will see its
  share fall only slightly from 20.8 per cent to
  20.3 per cent and then 19 percent over the same
  period
• Europes share allowing for expansion of the EU
  from its present 25 members to 28 in 2010, and 33
  in 2020 is forecast at 21 per cent, 20.2 per
  cent and 19.1 percent respectively
• Chinas share of the global economy by the same
  measures may rise from 13.7 per cent to 19.4 per
  cent over the fifteen years
• India advances from 6.2 percent to 8.8 percent
• Most other regions and countries cited within
  them will maintain their present shares.

Share of global GDP (p.p.p)
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Global meta-challenges

• Global economy unmediated by a polity and lacking
  an agreed normative system to underpin it
• Inadequate attention to an management of Global
  Commons
• High systemic interconnectivity, especially in
  financial markets
• Fracturing of the global systemic paradigm
• Faith qua ideology challenging secular
  rationalism
• Big implications for bio-technology from
  pharmaceuticals to genetic engineering
• Failure of NPT bargain and proliferation of WMD
• Globalization of organized crime and extensive
  links with ideological terror groups
• Failing and failed states unresolved boundaries
  territorial disputes
• Humanitarian disasters affecting 1.4bn people
• Exacerbated by global climate change and
  possibility of significant increase in extreme
  weather events
• Inability of those most vulnerable to address

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How will things develop?

• Revival of faith religion
• Growing acceptance of cultural diversity
  constructive relativism
• Uneven attempts to regulate regulation
• Emergence of new syncretistic approaches -
  reductionism

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Vectors of engagement

• Improving insight (and foresight) - quantum
  information and entanglement multi-actor
  strategy/scenario integration
• Enhancing the flow of information
• Refocusing incentives
• Improving investment
• Implementing through institutions

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The Internet as an instrument of risk mitigation

• Robust communication network capable of surviving
  a nuclear war
• Nodal, packet-switching-based not circuit-based
  network
• Characterised by redundancy, distributed
  architecture, fail-safe measures, an autonomous
  character and formal communication and
  negotiation protocols

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Systemic characteristics of effective mitigation
of global risks

• Planned redundancy
• Fail-safe measures
• Distributed architecture enabling operational
  continuity and disaster recovery

• Autonomous systems imbedded intelligence and
  functionality
• Structured communication and negotiation protocols

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Global Risk mitigation system resilience in the
face of uncertainty

• Successful risk management requires both
  foresight and insight need an institutional
  focus on developing integrated, dynamic,
  interactive frameworks
• Redundancy, fail-safe measures, distributed
  architectures, autonomous functionality, and
  structured communication and negotiation
  protocols are key

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Core global opportunities

• One billion new consumers, moving past 5000
  threshold by 2015 annual emerging market
  spending power rises to at least 9000bn, from
  4000bn at present
• Aging populations in USA, Europe and Japan need
  to dispose of assets against retirement pension
  provision will not be sufficient to fund long
  retirement periods
• These assets can only be purchased by populations
  of emerging economies
• Assumptions built into all economic growth models
  for next 40 years postulate increasing aggregate
  global prosperity China, India, SE Asia
• Rising pressures on use of hydrocarbon energy
  sources require development of alternative
  sources if growth and prosperity in oil producing
  countries!
• Scale of challenge requires strategic
  partnerships

• Health and human capital development are the two
  fundamental drivers of economic success
  productivity, personal satisfaction, social
  capital
• Increasing longevity demands and facilitates
  superior health services and life-long education
• Increasing complexity and accelerating change
  demands new educational models, systems and
  opportunities
• Deeper financial integration and sophistication
  demands more sophisticated systems and skills
• Media will increasingly shape individual
  expectations and frame social, political and
  economic issues
• New and converging technologies will increasingly
  define new economic opportunities and shape
  socio-political environments
• These investments health, education, financial
  services, media and new technologies are
  recession proof in this horizon

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Resilience to risk

• Critical factors for competitive advantage
• Brace for turbulence
• Manage risk skillfully
• What does this mean?
• Build first-rate and relevant information,
  knowledge, understanding and skills global
  battle for talent
• Build in capacity to anticipate, absorb and
  manage rapid and discontinuous change
• DEVELOP ORGANIC RESILIENCE

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Humility as key to resilience

• Black swans cannot be predicted, nor prevented,
  but can be managed
• Highly connected, nonlinear, volatile world
  small disturbances can combine to produce large
  discontinuities, resilience only possible
  response. Resilience is ability and capacity of
  the firm to withstand systemic discontinuities.
  Companies that succeed are those which brace for
  the certainty of turbulence, and skillfully
  manage risk
• Cantor Fitzgerald, international fixed-income
  securities firm, lost most of its workforce and
  US headquarters, but resumed trading when markets
  reopened less than a week later. Two features
• Effective preparation planned redundancy
  mirror sites ("Chance favours the prepared mind)
• Heterarchies" (not hierarchies) - interdependent
  relationships, laterally distributed authority,
  empowerment at all levels, knowledge sharing that
  promotes decentralization.
• How to manage risk in conditions of uncertainty?
  Essential organizational elements - making risk
  thinking part of the culture aligning risk
  identification and assessment, strategic
  management and communication, are essential, but
  give no competitive advantage
• Four additional critical elements
• Build and use knowledge networks Networks offer
  the most effective organizational response to
  complexity. Good networks are built on the
  "strength of weak ties" and are most effective
  early-warning system conceivable.
• Be aware of cognitive biases Awareness of one's
  weaknesses is a good first step to overcoming
  them!
• Puncture denial be prepared and act fast
  Mundane but most effective. Airbus 380 "people
  were in denial" said the Chief Salesman of
  Airbus)
• Display humility Comes more easily to
  self-confident leaders - know strengths/weaknesses
  Surround themselves with people who complement
  and challenge them, and seek insights of others
  with expert knowledge

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