Comprehensive risk management cannot be limited to assessing the potential successes and failures of your everyday business. How your bank considers a change in business is just as important.
Relatively poor earnings growth, nonbank competition and intense regulation are but a few of the realities threatening the core business model of banking these days. Some of these realities have warranted bank management to weigh transformational changes to compensate: a new product, an M&A deal or new pricing, to name just a few examples.
But a discussion about any strategic change, even if a new strategy is never implemented, must include an assessment of the risks involved. A mindset that only recognizes the utility of risk management in micro-risk assessment rather than making it an equal partner to finance and business in strategic decision making greatly lessens the chance at finding pathways to long-term financial viability.
A methodical strategic planning framework must clearly weigh risks and returns in a macro and balanced fashion. It must take into account risk appetite, short- and long-range objectives, market climate, and the real-world strengths and weakness of the firm.
The perils of poorly executed strategic plans are not just confined to banking. Spectacular M&A missteps and product innovation lapses at some large tech companies, and poor product development by some pharmaceutical companies, in recent years have not only hurt firm valuations but also sapped competitive advantages that may have been built up over years in otherwise well-run organizations.
The complexity in effective strategic planning comes in understanding the myriad of potential risks and opportunities presented by M&A, technology, new entrants and products, competitive position, profitability, pricing tactics and franchise value, among a host of others.
The OCC's latest semiannual risk perspective report puts banks – large and small – on notice that a core ingredient to effective strategic planning is grounding the process in risk assessment.
Banks at various levels have come to grips with the essential features of risk management in a micro context: identifying, measuring and mitigating credit, market or operational risks. The next step in the evolution of enterprise risk management for the industry is to infuse the strategic planning process with a macro-risk perspective.
To borrow a phrase from former Secretary of Defense Donald Rumsfeld, this means vetting risks according not only to "known knowns" and "known unknowns," but also to "unknown unknowns," and to do it for several types of strategic decisions.
In risk management parlance, "known knowns" are those we can reasonably quantify. A "known unknowns" might be the unforeseen outcome of a conceivable stress event. An "unknown unknown" is even harder to identify, but such risks must be included in the assessment. This is the risk of a potentially catastrophic event, the likelihood of which just cannot be detected by our methods and processes today.
We did not get to the moon and back safely by engaging solely in micro risk management. Certainly NASA had to conceive of every possible circumstance from launch, moon landing and reentry. Television viewers of the moon launches could sense the tension as the mission controller asked the specialist of each critical system whether it was "go" or "no-go."
Certainly each risk of failure to the crew and the propulsion technology had to be accounted for in any number of possible outcomes. There had to be an attempt at assigning probabilities to each outcome and risk. Indeed, NASA does this in advance of missions. For the first moon launch, NASA set a probability threshold of 1 in 1,000 for the likelihood of the crew being lost, and 1 in 100 for mission failure to land on the moon. The space agency's risk appetite set an understandably high bar for acceptable levels of risk.
Assessment of various alternative launch vehicles, lunar landers and crew capsules – and their associated components – turned into one of the biggest strategic planning exercises ever undertaken. Prominently featured in that successful planning was the dominant role of risk management. Less than 15 years after the last moon landing, NASA's vaunted strategic planning process broke down with the Challenger space shuttle accident. A special board convened afterward laid much of the blame on poor risk management.
Fortunately for bankers, lives aren't on the line in making critical strategic decisions. Yet the decisions they make will have important implications for the survivability of the firm. Strategic planning is about making calculated tradeoffs in business activities that lead to long-term growth opportunities, stable and healthy returns, and manageable risks.
The key to successful strategic planning exercises comes in first assessing the macro risks at the center of the effort. Boards and executive committees must agree on the risk appetite overall for the firm at the outset of the strategic exercise. Decisions must be methodical. They can change over time to adapt to changing conditions, but the fortunes of companies that engage in frequent and dramatic shifts in strategic direction can be destabilizing with if they are poorly executed.
One danger in strategic planning is the very human trait (perhaps accentuated by boards and CEOs) of leaning toward familiar or favored outcomes from some underlying bias.
Let's say a potential M&A target has been in sight for some time, with favorable financials. Yet the potential transaction may still pose any number of risks to the buyer that must be assessed, even if it is imperfectly. A strategic planning process that views risk management as a secondary consideration poses grave danger.
Macro risk management in strategic planning means granting the chief risk officer an independent voice in identifying and quantifying all risks embodied in a potential strategy, lining those up against an established risk tolerance and then incorporating a long-term, risk-adjusted view of all the potential outcomes.
Clifford Rossi is Professor-of-the-Practice and Executive-in-Residence at the Robert H. Smith School of Business at the University of Maryland.