Well-managed risks in a quickly evolving economic environment

Wed 15 Dec 2021

The global economy is entering another difficult phase which features a broad range of emerging and evolving risks. The persistence of the pandemic has disrupted the way business is conducted across the globe, in some ways permanently. The economic impact for developed countries has been somewhat mitigated by emergency fiscal stimulus. However, the debt burdens that ensued and price pressures are denting the effectiveness of policymakers, at a time when the end of the pandemic still seems out of reach. Risks don’t come in isolation. The more one risk factor persists and grows, the higher the probability of a domino on other factors, which may seem relatively low risk until that point.  The evolving pandemic now threatens a twelve-year economic and financial paradigm of central bank accommodation. Domestic price pressures intensify as global value chains are near or at breaking points. Central bankers are now more hesitant to underwrite risk for financial markets. 2022 could stress global financial markets and economies beyond any year in the recent decade. 

The picture is further complicated by the advent of Sustainability as a major investment, regulatory and political theme. In the past, the Environmental-Legal-Regulatory-Political risk factors were bundled in organisations’ annual reports. However, the sheer burden of transformation obligations undertaken by nations after COP26 will tend to subdue legal, regulatory and even political concerns under the great umbrella of Sustainability. For the uninitiated, that notion encompasses far more than ‘Environmental’ concerns. At its core lies a complete overhaul of how we think of business, politics, and the human race’s relationship not just with the planet but also with each other. It commits those entities, participating, be it governments, businesses or supra-national organisations, to a total change of course and thought. Investor vigilance is heightened and failure to espouse the core of those values could result in financial oblivion, not to mention social ostracism. It would be no exaggeration to say that humanity has never so voluntarily and entirely undertaken the road to self-improvement.

In other words, the world is in flux. And while that may always be the case, we feel that the next few years may feature a nearly unprecedented transformation of business practices worldwide.

Thriving in a world where everything is up in the air, may come down to chance. However, CEOs and heads of investment organisations often employ a four-step process that would allow them to deliver their objectives and minimise the impact on operational resilience.

Meta-cognition: To begin with, organisations will have to go through a sort of meta-cognition exercise. They will not only have to keep an open mind on what risks the future may bring but also spend an amount of time analysing how they are thinking about risk. Is the thought process encompassing enough? Is the team diverse enough to capture the whole spectrum? How about second-order risks -those that are immaterial until another, prior, risk factor is activated? After identification, is there sufficient discussion and a structured enough process to identify the most potent risks?

Environment: After having established a process in a vacuum, organisations need to open the conversation to the specific factors in the environment. What effects will particular risks have on specific operations? Investment managers and economists often employ various risk dashboards that quantify risks and cover the entire spectrum.

Scenario building: However, one has to accept that the economy is a social science, not a mathematical one. Analysing the environment and capturing the most potent risks still says very little about the probability of a particular risk becoming prevalent. Thus, managers often have to come up with scenarios. “What is the probability of Risk A over Risk B?”. “Let us assume that Risk A becomes prevalent”. What might the first and second-order consequences look like?”. “How do decisions branch out from here”.

Learn-Repeat: Thereafter, the system has to be robust enough to update risks, but also keep coming back to first principles at regular intervals. The principle is called “Kaizen”, Japanese for “continuous improvement”, and has been a staple in the operations management field for decades. This makes Post-mortems valuable learning tools. “We were thinking of Risk A a year ago. Did we play the scenario correctly? Are there other parameters we should have taken in”?

Understanding a world in such a state of flux is difficult enough. The future can only be seen not as an inevitability but rather as a potential scenario. Even if an organisation manages to create enough scenarios, model them appropriately and systemically make right decisions more often than they make wrong, there is still the possibility of a tail-risk, like the 2008 global financial crisis or the 2019 pandemic, the type that upends paradigms.

This creates the need for flexibility, a full review of the system at any possible nexus point. The first and foremost question asked is not “how Risk A would affect our operations”, but rather “is our decision-making system still appropriate for that sort of Risk becoming prevalent?”