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Thursday, January 14, 2016

Surviving the Deviant Risks that KILL Businesses – Don’t do ‘a Volkswagen’

A happenstance that occurs for the first time and causes serious, usually fatal losses for a particular business, an industry or a whole system – the financial system for example – has become known as a Black Swan Event but is also termed an Unquantifiable Uncertainty.

Unquantifiable because there is no data relating to the past on which to base a probability model, so no way to estimate the loss that may be incurred when the event happens.

Uncertainty is an alternative word used to describe a risk or uncertain outcome; in this case a detailed description of the risk event cannot be imagined therefore specific avoidance, corrective or remedial actions cannot be organised.

The Board and Senior Executives of Volkswagen AG should have realised that an extreme risk event could strike the business at any time. That is assuming that they had read or heard of The Black Swan by Nassim Nicholas Taleb. If in fact they were aware of the chameleon in the room that could destroy the business – in the form of an unimaginable risk with devastating potential – they did not prepare to deal with such an event.

Perhaps they thought that since they could not imagine what may happen to overwhelm VW Group they should simply wait for a crisis to break and then thrash around, blame each other, fire people, apologise, ‘re-arrange the deckchairs on the Titanic’ and put aside a hopelessly inadequate €6.5 billion.

Unimaginable Risk Drivers must not be overlooked simply because they cannot be imagined, described or counted. They will occur in the future and they are the risks most likely to destroy real businesses.

The Financial Times article of September 30, 2015 titled Seven Reasons Volkswagen is worse than Enron states: “The stock collapse is only the beginning. Potentially irreparable reputational damage, a crisis of confidence and massive legal liabilities could do the company in.” Volkswagen AG’s (stock) price dropped from 213.45 on July 2nd to 96.50 on October 1, 2015.

Most physical business Board Risk Committees, Chief Risk Officers, CEOs and business Owners only pay attention to assessing and managing those risks for which data is available. They follow the banking fraternity’s love affair with risk and probability models, which naturally cannot be produced in the absence of data. Of course that means that when unimaginable risks occur they are totally unprepared to manage the fallout, so they miss opportunities to limit the damage and/or opportunities to capitalise on the resulting market turmoil.

The consequences that ensued in the wake of Lehman’s collapse in September 2008 negatively affected the lives and livelihoods of millions of people in every corner of the Globe, and will continue to do so for at least a decade. However the purchase of Bear Stearns (including its valuable New York office building) in the midst of this Extreme Risk crisis is an example of a survivor (J P Morgan Chase) taking over a failing competitor based on ‘fire sale’ asset values; asset values were falling rapidly as inter-bank credit evaporated and banks frantically chased cash to meet margin calls and other obligations falling due.

Despite all the previously unimaginable disasters that have occurred there is a widespread naïve belief that mathematical models can foretell future risk. However models cannot because they use historical data, ignore data projections that fall beyond 99.7% probability, include too few variables and use simplified assumptions.

In the face of rapid change and globalisation, data driven risk management methods alone are no longer adequate. Unquantifiable Uncertainty Risk cannot be modelled because there is no data, so cannot be covered by traditional risk management practices or insurance; moreover extreme risk events (Black Swans) occur relatively frequently and result in business failures.

Business leaders are ‘risk managers’ entrusted with safeguarding the jobs of their employees and the assets of their investors therefore they must take seriously the possibility that those jobs and assets could be destroyed by an unimaginable extreme event.

Operating in the real world of business, as opposed to the purely financial world that only makes money, means facing future risks; hence Risk Management is about Managing the Future.

The challenge is that the Future does not exist; the past existed but only the present exists – one moment at a time. Therefore we cannot know the Future; in order to fulfil our responsibility to manage the Future we must imagine it and anticipate it. Three factors work in our favour as we attempt to anticipate the Future:

The Future is constrained by the existing environment both physical and social – it comes from today carrying the baggage of the past,

One major set of variables that shapes the Future is the collective decisions made by the world’s seven billion citizens, some of whom have more influence than others, and

As William Gibson said in 1993; “The Future is already here - it’s just not very evenly distributed.”

Searching the web and reading books such as An Optimist's Tour of the Future: One Curious Man Sets Out to Answer "What's Next?" by Mark Stevenson and watching TED.com talks like Nadya Zhexembayeva’s To Hold On, Let Go; also available on YouTube, can provide a lot of material to help create planning scenarios.

Of course the other set of variables that shape the Future is provided by Nature and Major Impact Events that result in one or a combination of the following categories of risk; Black Swan Event Risk, Liquidity Risk, Operational Risk, Concentration and Correlation Risk, and Lack of Flexibility and Agility Risk.

All of these risk variants could strike a real business as a result of a catalyst that was previously unimaginable.

In all cases except the first mentioned (Black Swan Event Risk) it is possible to take pre-emptive practical steps to protect a business; for example reinventing the business model every three and half years, as Ms Zhexembayeva recommends, could avoid the negative impact of the Lack of Flexibility and Agility inherent in most businesses today.

On the other hand the most challenging variables that shape the Future are those caused by Nature and Major Impact Events, collectively often called Black Swan Events. When such events have arisen in the past they have caused many real businesses to fail – thus destroying jobs and investors’ assets.

Therefore Executives and Owners in real businesses wishing to prepare to deal with and possibly profit from a Black Swan Event, require an entirely new approach in order to be adequately prepared to manage the fallout. Otherwise they risk missing opportunities to limit the damage and/or to capitalise on any bargain arising in the resulting market turmoil.

Black Swan events that were unimaginable before they happened have occurred frequently in the recent past, some examples of those that had global impact are listed here:

1990 US High Yield (HY) bond market collapses
1991 Oil price surge
1992 Swedish banking crisis
1994 Mexican crisis
1997 Asian crisis
1998 Russia default, Rouble crash, Long-Term Capital Management LP (LTCM) collapse
2000 TMT (Technology Media & Telecoms) collapse (a.k.a. Dot-com Bubble)
2001 9/11 payment system disruption
2002 Argentina crisis
2004 Russian banking crisis, Indian Ocean tsunami
2008 Global credit crisis
2010 Greece
2011 Japan triple tragedy - force 9 quake, massive tsunami and Fukushima nuclear melt-down
2014 Rouble in free-fall
2015 Euro – Swiss Franc (EUR-CHF) exchange rate CAP removed

Black Swan events are generally comprehended in respect of Financial Institutions and systemic catastrophes, as illustrated by the above listed examples. Nevertheless lesser and often more local events with the same devastating consequences and bearing the same characteristics often occur. These mini- or industry specific or geographically localised or single supply chain related incidents may only directly touch a single business, a group of connected businesses or the businesses within a region however they almost inevitably prove fatal in respect of those businesses directly or indirectly affected.

This is due to the fact that leaders in the vast majority of businesses do not prepare to deal with the fallout that follows unimaginable events; the associated risks are ignored simply because they cannot be imagined, described or counted.

Therefore, should an Unquantifiable Uncertainty strike, the corporate entities' equity capital becomes the last line of defence against bankruptcy.

Although bankruptcy of failed businesses is considered part of the capitalism notion of creative destruction it is not a satisfactory outcome as it destroys jobs, destroys investments and often devastates communities. Hence it is preferable that business leaders prepare to ensure the survival of their business regardless of what may happen to threaten its future.

Having recognised the Unquantifiable Uncertainty risk category the first sensible step to take is to anticipate the potential maximum future loss that could result from such an occurrence. Armed with this information the leadership team should think through and discuss possible defensive measures that could be taken in order to protect the entity's capital and ongoing concern status.

The aim of such preparation would be to arm executives with an array of possible action steps that could be tailored to any situation that may arise, thus enabling them (a) to react immediately and effectively in any extreme situation and thereby (b) to be in a position to capitalise on the opportunities that are bound to arise in the wake of such situations.

As a first planning step the size of the challenge can be estimated by aggregating the ‘forced sale’ net disposable value of the entity’s assets; which could be referred to as the ‘Maximum Covered Liabilities’ (MCL) if no management action is initiated. In other words the MCL is the amount of the liabilities that can be paid using asset sale proceeds, the balance of the liabilities plus equity and reserves can be termed the 'Maximum Uncovered Liabilities' (MUL).

The MUL minus the Equity Capital could be referred to as the ‘Owner Protection Gap’ (OPG). Preparation for dealing with a Black Swan event should focus on identifying actions that could be taken to reduce the OPG in the face of an Extreme Risk situation.

Black Swans can be positive as well as negative, depending on the circumstances; Black Swans are also ‘scalable’, meaning the consequences positive or negative, have unknown limits.

In The Black Swan, Nassim Nicholas Taleb wrote; “Knowing you cannot predict does not mean that you cannot benefit from unpredictability. The bottom line: be prepared! Narrow-minded prediction (based on mathematical models) has an analgesic or therapeutic effect. Be aware of the numbing effect of magic numbers. Be prepared for all relevant eventualities.”

In short, Mr Taleb suggests that one should; “learn to distinguish between those human undertakings in which the lack of predictability can be (or has been) extremely beneficial and those where failure to understand the future caused harm, invest in preparedness, not in prediction. Chance favours the prepared but do not prepare for something precise, Black Swans cannot be predicted; and seize any opportunity, or anything that looks like an opportunity because opportunities are rare, very rare.”

Nadya Zhexembayeva, in her TED.com talk titled To Hold On, Let Go – Forget ‘Built to Last’ Build to Reinvent, suggested that those operating real businesses “must remake who we are, what we offer, and how we deliver our offerings to the world. Take the essence of what you are, and let go of everything else; because the business you are in today (will) not be the business you’ll be in three and a half years from now.”

Invest in Preparedness, not in Prediction

Business leaders are more likely to succeed in their most important responsibility, which is to protect the jobs of their employees and their investors’ assets, by being prepared to act effectively when a previously unimaginable risk driven event occurs and by reinventing their business model often enough to avoid becoming obsolete in the face of rapid change.


Ron Wells is the author of The Chameleon in the Room: Embrace Business Risk – Assure Survival & Growth, refer to www.t3plimited.com for more information.

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