Business

Friday July 24, 2009

Board’s role in managing systemic risk

Whose Business is it Anyway - By John Zinkin


It must recognise that systemic risk may be created by the externalities of the company

IN previous articles I covered the board’s role in setting, implementing and evaluating strategy. However, for strategy to be really effective, it must cope with risk properly.

From the board’s perspective there are four types of risk that must be managed if the agreed strategy is to deliver the intended outcomes. They are systemic, strategic, business and operational risk.

Each brings its own portfolio of problems and their impact on the viability of the company differs. Systemic risk – the rarest form of risk – can totally destroy the firm by destroying the industry in which the firm operates. Strategic risk puts the firm’s business model in question, and can also destroy the firm, but not the industry.

Business risk can make the company incapable of meeting its objectives, while operational risk affects part of the firm’s business model. Systemic, strategic and business risk tend to be external to the firm, while operational risk can be both external and internal.

Today, I will only cover systemic risk. This is typically the risk with which boards concern themselves least, often not even recognising that such a thing as systemic exists, or if it does, how it will manifest itself and affect their company.

Traffic jams cost companies and economies millions of dollars every day, and yet they are not shown on company income statements even though they had a hand in creating such costs

What is systemic risk?

It often manifests itself in a deterioration of both the economic and financial outlook because it affects both.

As a result it also amplifies financial risks, as the current economic and financial crisis is showing only too clearly. It often happens as a result of a combination of trends in the socio-cultural, technical and competitive environments coming together in unexpected ways that drastically undermine the received wisdom and assumptions on which “business as usual” are premised – the so-called “Black Swans”.

Systemic risk is created by a phenomenon known as the “Tragedy of the Commons” which deals with the costs of individual actions, which, when added up together, overwhelm the system. The Tragedy of the Commons was first recognised in 1968 and can best be captured in the quote by Garrett Hardin: “The owner of a factory on the bank of a stream – whose property extends to the middle of the stream – often has difficulty seeing why it is not his natural right to muddy the waters flowing past his door.”

The point is that the cost of one individual behaving badly is borne by the whole community that depends on the waters flowing past their door, while the entire saving is credited to the polluter. This means that nobody really notices what is happening because they do not have to bear the full cost. Then others start to copy the bad behaviour, until the river can no longer cope with all the rubbish that is being dumped into it and it dies, destroying the river on which everybody depended on. Originally, the focus was on environmental risk, now including climate change – the planet’s systemic risk.

Boards must recognise that systemic risk may be created by the externalities of the company. At the individual firm level, they do not appear to cost anything, and so boards encourage the activities. However, this ceases to be true once a large number of companies adopt the same course of action.

Traffic congestion, pollution and now global warming are all cases in point of this. The combined actions of groups of individuals create a situation where all end up suffering inconvenience at best, and serious economic consequences at worst.

Traffic jams cost companies and economies millions of dollars every day, and yet they are not shown on company income statements even though they had a hand in creating such costs.

The financial crisis

The financial crisis created by subprime mortgages and structured products nobody really understood is a systemic crisis. The disaster in this case was that it paid individuals so handsomely to be totally irresponsible. People in Wall Street, and the mortgage brokers who originated the toxic assets were richly rewarded for putting the system at risk.

As long as only a few firms were operating on the “originate-package-distribute” model the collective impact of their actions was too small to pose a systemic risk. However, as soon as it became apparent at the individual and individual firm level that it paid so well to be irresponsible, the growing number of participants and the size and number of their transactions collectively, nearly brought down the system for everybody.

Boards of financial institutions did not understand the systemic risk their companies were creating. Remuneration committees had no idea of the damage done to society as a whole by the bonus packages they agreed for CEOs and top management.

Their ignorance cost the global economy dearly, throwing a hundred million people into poverty, as well as destroying some of finance’s most highly respected institutions.

● The writer is CEO of Securities Industry Development Corp, the training and development arm of the Securities Commission. Readers’ feedback is welcome. Please e-mail
starbiz@thestar.com.my.

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