Black Swans

The Next Generation Risk Management Strategy Must Include a Consideration of these “birds”

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TAO INSTITUTE OF CREDIT & RISK MANAGEMENT


Patrick Connelly

PATRICK CONNELLY

FOUNDER & CEO at TAO INSTITUTE OF CREDIT & RISK MANAGEMENT

In the series of articles published over that past few years, the author has discussed many enterprise risks and proposed solutions to enable any enterprise of any size to address the exposure introduced by each risk. Admittedly, most of the exposures identified and 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
• Convertibility risk

 

Among the solutions to exposures that impact enterprise value and business continuity discussed in previous articles1 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:
   a) geopolitics trends
   b) economics trends
   c) regulatory trends
   d) trade volatility
   e) technologies changes
   f) environmental conditions
   g) 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. 

 

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