CHAPTER 2

Strategic Risk: Bringing the Discussion into the Boardroom

Craig Cohon

The Next Practice

Financial institutions and their leaders are very comfortable discussing market risks in terms of equity and fixed income risk, derivatives, treasury, asset and liability risks, and hedge-fund risks. In addition, a large ­proportion of time is spent on developing models, processes and systems to look at credit risk. With Basel II and Sarbanes-Oxley, ­operational risk management and the importance and quality of internal processes and controls are self-evident. This is a comfortable way to look at strategic risk.

A more holistic approach, is the well thought-through strategic risk models put together by Adrian J. Slywotzky and John Drzik of Mercer Management that look at industry, technology, brand, customer, competitor, project, and stagnation risks.

Strategic risk, however, should challenge and explore the very basis of the firm and the business model. These two approaches miss a key component.

Strategic risk is not only about reputation. It is about the long-term survival of business as we know it. It is about building additional sustainable value into your business. Many leaders tend to think about this in terms of more active and strategic government, communications, or external relations. It is not.

This chapter will provide answers to two important topic areas and articulate an initial plan to better understand and evaluate this strategic risk:

• How can you bring strategic risk into the boardroom and make it a robust and relevant discussion?
• Is strategic risk the same in developed and emerging markets? What are the key components of this strategic risk?

Strategic Risk as a Boardroom Responsibility

Often, integrated strategic risk never makes it into a boardroom discussion. This is looking at multiple risks and ensuring that leadership evaluates risks that viewed together could have a very different profile for the firm. Boards are often left to make decisions based on what might be only gut instinct and high-level summary. Why?

Different components of overall risk usually get buried in operating units within the firm. For instance, industry risk, which includes risks such as margin squeeze, rising R&D/capital expenditure costs, over­capacity, commoditization of products, deregulation, and extreme business-­cycle volatility, is often vetted by the CFO.

Technology risk and shifts in technology, patent expiry, outsourcing, and process improvements often stop at a lower level in the IT department.

Brand risks, social legitimacy and CSR (Corporate Social Responsibility) risks rest with corporate affairs or a committee of the board.

Strategy departments often look at competitive risk and analyze emerging global rivals, consumer trends, gradual market-share gainers, and one-off competitors in local markets.

Shifting customer priorities, increasing customer power, “me-too product” development and over-reliance on chasing the same few corporate or high net-worth customers fall on the shoulders of the product development teams.

Summarizing and synthesizing all these risks can lead to a very ­different conclusion and forward strategy. Bringing it together allows the board to look at new and innovative ways to manage the risk and take advantage of trends in the industry. Two examples outlined as follows highlight the issue.

The first concerns not seeing the industry convergence between the banking and telecom sector. If the retail banking sector had synthesized risk categories and looked beyond the traditional industry players might have pre-empted this rapidly growing competitive threat.

• For instance, cell-phone technology coupled with remittances of more than US$12bn in the Philippines led to the creation of an innovative telecom banking solution. SMART phone continues to threaten established banks in the region. SMART money is the ultimate in cashless convenience. A consumer simply transfers cash through the cell phone to pay bills, shop and reload “pay as you go” time.

The second example concerns not spotting consumer trends and calculating forward risk in a large merger in the media/Internet arena. Furthermore, if boards had integrated consumer trends thinking and long-term value creation, they might have spotted the high-level risk in the AOL/Time Warner merger in 2000.

• A merger gone wrong—the AOL/Time Warner merger was driven by the convergence of media and the rapid rise of the Internet. Fuelled by emotion and senior management egos and the desire to be bigger and bolder, this merger missed the key consumer insight. Consumers were becoming unwilling to pay for e-mail and content access. Customers converted to free services in the thousands and have fled the AOL brand. The write-down of the AOL assets continues to be significant.

These examples demonstrate the need for a simple and highly efficient integrated strategic risk process. There is a simple four-step plan to bring the discussion into the boardroom and ensure value is created for the firm.

Step One—Change the Language Throughout the Organization

It is the responsibility of senior management to reframe the language associated with strategic risk. The language should focus on three elements:

• Continue to ask for risk analysis that highlights important issues;
• Request leadership not only to develop risk mitigation plans but create the necessary innovation to reduce the risk; and
• Once the innovation is highlighted, articulate the strategy to implement the innovation.

This simple reframing will help move the organization from a negative and often defensive frame to a positive solution-driven mode.

Step Two—Develop Systems for the Siloed Risk Analysis to Be Shared Across the Group

The individual risks are seldom shared across divisions or business units. Therefore, when the risks become aggregated the overall impact on the organization is only seen too late in the process. Leaders should develop a risk, innovation and strategy quarterly review with the most senior managers in the firm. The rigorous implementation of this process is critical. This step allows the top leadership team to understand deeply the different risks and begin to have a common view on a total, strategic risk profile for the firm.

Step Three—Synthesize the Risks, Articulate the Necessary Innovation and Develop a Strategic Way Forward

This is the most difficult step. It is often left to the CEO to integrate all the thinking and determine the best way forward. Organizations are great at analysis and often poor at synthesis. It should be the responsibility of the senior leadership team to take the time and develop the capability to scan across and innovate. They will have to think very strategically about the firm. Together, they should create the capacity to understand deeply the entire risk and opportunity space.

Step Four—Engage the Board in a Yearly Strategic Workshop

Engaging the board is the final, critical step. We often “dumb down” board meetings and make them highly orchestrated review sessions. Boards should be thought of as strategic support as well as external oversight. Most board members only use a small amount of their total skills and intellect during board meetings. Develop a yearly workshop that allows the board to really understand all risks across the firm and help develop the strategic way forward.

This four-step process has the following benefits.

• It enables mitigation of the total risks and makes sense to protect company stability.
• It develops tools and systems for thinking systematically about the future and identifying opportunities.
• It turns strategic threats into growth opportunities.
• Capital can be better utilized and its costs reduced.
• Organizing systems and processes will increase the Risk-­Adjusted Return on Capital (RAROC) of the firm.
• Corporate reputation is protected.
• It helps companies to fend off additional regulatory and ­legislative assaults on how they run their businesses.
• It helps corporate executives to defend themselves against lawsuits of the sort that have been filed against former Enron, Tyco, and WorldCom executives.

Strategic risk as a board responsibility will allow better thinking and strategic development for the firm. The other key strategic risk is outlined in the next part of this chapter.

• Is strategic risk the same in developed and emerging markets? What are the key components of this strategic risk?

The Developing World and Strategic Risk

Financial services organizations have felt the renewed strategic risk of a significantly increased regulatory environment and highly aware public. There has been the failure of the unregulated Enron and many of the financial titans of Wall Street have been put on notice a number of times through heavy financial fines. From Japan to London, the industry is under the lens of not just a watchdog but also of an aggressive pack of regulatory and civil society wolves.

Some companies and highly experienced CEOs see the risks coming and understand them. They then plan for this change and create the right systems, culture, processes, and measurement to reduce the risk. Others miss out.

Furthermore, leaders and their companies that do not deeply understand the risks of operating in emerging markets may take short cuts and get into trouble. Get it wrong here and disaster can strike.

The Western public’s understanding that the highest global standards should be imposed on corporations has further accelerated the risk of losing social legitimacy. Most leaders in the financial services industry have understood this risk and have actively put policies and procedures in place to deal with the developing world.

PR and policy implementation, however, is different from a fundamental change to one’s business model. The board-level discussions that occur when financial institutions are faced with a new form of risk in a developed market must occur for developing markets, just as would be the case for any other risk.

The Emerging Consumer—Not What You Think

These new potential consumers in emerging markets are very diverse in habits, attitudes and behavior. They may be very local but have immense aspirations. Income may come from a variety of sources including traditional work, highly entrepreneurial local activity, and even remittances from family within and across national borders.

Despite this, most financial institutions are not innovating to identify new types of customers. Not actively investing in this option has a significant strategic risk that could reduce shareholder value over time and destroy future brand value. Why does this happen?

Types of Missed Opportunity

There are three types of strategic opportunity risk that will be explored:

• Opting out of new growth opportunities;
• Not recognizing possibilities for innovation; and
• Missing the new competitive threat.

Opting out of new growth opportunities. The largest national and multinational corporate clients will also be on every financial institution’s target list. Just providing the same services as the competition is unlikely to be a successful strategy. In the developed markets and emerging markets with this segmentation frame, the battle continues to be fought with ever-increasing competition for a growing but limited pie. While the total available capital pool is increasing, the cost of customer acquisition and retention is also increasing and the pace of that growth is often dependent on international and national macroeconomic factors.

The risk here is of opting out of increasing the revenue pie and building deeper and more profound lasting relationships with a whole new consumer segment.

Not recognizing possibilities for innovation. If you do not think a market exists, then it is difficult to create a business to service that market. Even if a market has been identified, often credit procedures, distribution models, product and service solutions, marketing and HR practices are within a similar corporate framework. Indeed, the regulations driven by the BIS require this to be the case. The conclusion that this cost structure cannot support this market is often therefore right; little innovation takes place, the business does not get leadership attention and does not expand. Actually, it is often killed. Even so, the opportunity to innovate with these consumers will be throughout every part of the business model.

There is a basic need for innovation in product and service solutions for credit, savings, equity and insurance. New credit and deposit systems and procedures need to be put in place. Interesting and innovative, low-cost distribution models are required to increase access that can be leveraged with the help of technology, especially cell-phone banking.

There is the risk that new entrants will figure out how to develop financial products and services for an emerging consumer segment, develop a profitable business model, create grassroots social legitimacy and build a compelling long-term business proposition.

Missing the new competitive threat. If you believe that a market does not exist, then you will not enter it. If you do not innovate, then you will not be in a position to see the emerging consumer as an opportunity, but someone else will. They will develop a new business model. They will get the cost structure down to a point where the business is run on a primarily variable cost basis. They will take the license to operate in this consumer space away from the established players. They will be entrepreneurial and agile. They will experiment relentlessly and they will create value.

Commercial and investment banks, insurance companies and certain private equity and financial advisory firms are all vulnerable. These new financial service companies will potentially become experts on innovation with emerging consumers and use their capability to build relevant ­business models to disrupt traditional banking sectors.

These new market entrants are potentially able to give similar value and service at lower costs with greater product and service innovation. It is happening today and is a trend that will accelerate.

Financial institutions should undertake a fundamental risk-­reduction assessment. Furthermore, a structure and plan should be developed to ­capture the opportunity and challenge the very basis of the firm and its business model. The final section of this chapter lays out the initial roadmap.

To reduce the risk, one must start by asking different questions. The strategic risk assessment should include some of the following questions.

• The opportunity—do I see an opportunity with the emerging consumer? What is the opportunity? Is it part of my strategic plan? If not, why not? What is preventing my organization from capturing this market opportunity?
• Organizational readiness—how do I think about the market? What are the best areas for us to commit resources? Can I pilot a new business model without the system killing it? Will it take energy and focus away from our core operations? What am I missing?
• Outside support—do I have the skills and knowledge, mental attitudes and beliefs on the inside of the firm to capture this opportunity? Will the politics and technocrats get in the way? Do I need an outside catalyst?

Once these questions have been answered, then you can move to ­testing this market space.

Here are the four key guidelines to follow:

• Set up an independent team;
• Deeply understand the emerging consumer;
• Create constrained innovation and develop the business model from the ground up; and
• Learn before investing.

Set up an independent team. Find a highly entrepreneurial team of young professionals and give them the space to innovate in one market. Watch out for the five traps.

• The team recruitment trap. The wrong people are recruited for the team. This type of work calls for an entrepreneurial skill and knowledge base. This is often hard to find in large companies. Setting up a typical corporate team on this will not get you the breakthrough concept development. The teams are often too risk-averse and think of success in corporate terms versus entrepreneurial terms. The killer instinct and passion is often lacking.
• Company inertia kills the innovation before it can develop. The company, not the individuals, often acts as the devil’s advocate. This means that the internal inertia, company policies, politics and overall skepticism of the organization kills the innovation and does not listen to the insights before they have the chance to be developed into a new business concept.
• Leadership control—typical governance. Corporate leaders like to be in control. “Updates, review sessions, pre-reads . . . leadership must be in the details or they don’t get the job done.” This space is about the art of letting go as a leader. The team creates upward dependency on the leadership to have the answer and never fully develops its own unique thinking and business idea.
• Death by PowerPoint. The business never actually gets built. You get a PowerPoint presentation at the end of six months (a business concept on paper). This often happens because the default setting is to push away any model that does not fit with the existing proven successful structure. Taking on the existing business model and creating something that bumps up against this is threatening to the organization. The PowerPoint deck dies and never turns into a pilot business model.
• You don’t know what you don’t know. This is the highest risk. Companies and most individuals in them do not know how to work in this new area. The data are not easily available. Therefore, the team does not ask the right questions or put the process in place to discover the deep insights that can create the breakthrough. Once the team is in place, however, it is critical to understand the new consumer.

Deeply understand the new consumer. The traditional approach in this space is to look at income as the surrogate for defining the market opportunity. However, this only scratches the surface.

Creating a scalable business in an entirely new market demands the development of consumer insights, value propositions, product design criteria and market analytics (including data sources) from the bottom up. Methodologies and frameworks, databases and algorithms, and embedded assumptions and conclusions that are applied by companies in mature market settings generally do not apply in these new markets—and often impede the definition of a realizable growth opportunity.

• New consumers may not operate according to mature market consumer expectations and patterns.
• Existing consumer practices and product uses are very heterogeneous, even within local and micro-markets.
• Reliable, statistically valid data are scarce—or simply does not exist in the private sector.
• Companies only superficially understand user requirements and values, and the untested assumptions of managers have not been challenged in the market.

To understand the new consumer, begin to take the following three steps.

• Get close: develop an immersion program where you can have direct, intensive exposure to the lives of the new consumers and their user/market environment.
• Do the analysis: implement a research phase in which the company develops the data, methodological and analytical foundation in the following areas: (i) deep, qualitative consumer insights and ethnographic research; (ii) market sizing and segmentation; (iii) existing product price-performance analysis; (iv) product solution evaluation; (v) local route to market benchmarking; and (vi) environmental analysis.
• Validate and integrate: use the previous analysis to develop and statistically validate consumer hypotheses and value propositions, design criteria and the conditions for the new ­business model.

Create constrained innovation and develop the business model from the ground up. There should be four conditions imposed:

• The innovation must result in a product or service of world-class quality.
• The innovation must achieve a significant price reduction—at least 90 percent off the cost of a comparable produce or ­service.
• The innovation must be scalable: it must be able to be produced, marketed and used in many locales and circumstances.
• The innovation must be affordable.

Learn before investing. Think big, start small and scale fast—before a global business case is developed, learn how to create a business with new consumers in three phases.

Prototype—get the business model right. Work with consumers to develop product and service offering, test new route-to-market opportunities with existing infrastructure. Get the right team in place to lead this business.

Pilot—begin to put some capital into the business idea and see if the model can pay out. Start to understand the global standards necessary (IT infrastructure, brand, governance, etc.) from the local nuanced and relevant consumer opportunities (product and route-to-market innovation).

Scale—slowly develop the ability to scale and conservatively put ­additional capital to go deeper within a market or begin operations across markets.