Ten years on from the financial crash of 2008 and the corporate world pays much more attention to risk and governance than it did a decade ago. Regulators around the world now require more thorough reporting of risk, as warning of potential future disruption. Nevertheless we still see catastrophic collapses like Carillion earlier this year, so have we got it right when it comes to risk?
Risk management has become a discipline of control with the design of checks and balances, systems of contingency planning to ensure business continuity. This is all part of what we now call good governance, anticipation of the future to predict and avert unwelcome outcomes. However this is a narrow view of risk that excludes risk as enterprise, innovation and reward for investors. Within the investor community risk is welcome as an invitation for gain, not a warning of danger.
Speaking at an Investor Relations seminar recently, I was surprised at how the subject of risk repeatedly assumed threat and rarely addressed reward: this seemed strange for an investor audience. Regulators want to encourage good corporate behaviour to reduce the number of catastrophic failures, they demand risk be portrayed a disruptive threat. Regulators design the risk reporting rules that become law through the FRC, SEC and others, so they get noticed.
Unlike regulators, who exist to preserve market stability, investors trade in the currency of risk. They know that the word comes from the Italian risciare meaning to dare. Investors of all types have a highly attuned sense of the correlation between risk and reward, they must appraise that the balance is in their favour and have the information for this, but they don’t need a ‘nanny-state’ intermediary to protect them from the marketplace. Investors know instinctively the consequences of high risk decisions, but political expediency demands a third party regulator.
For the past 25 years regulators on both sides of the Atlantic have been chasing the game, responding to crises by updating codes based on the assumption that each successive corporate collapse was caused by inadequate or misleading information provided to investors. This is a flawed assumption: institutional investors bailed out of Carillion long before the first profit warning, they could read the signs that the company’s own board could not. Investors are not stupid, especially those with a keen sense of their own fiduciary responsibility, they look for warning signs and act swiftly to protect their own reputation for guessing it right.
That risk is seen almost universally as threat rather than opportunity, is not down to excessive regulation alone. The insurance industry over the past 500 years is partly culpable for commercial exploitation of fear, but also more recently the acceptance of Prospect Theory from the work of Daniel Kahneman and Amos Tversky. Nobel prize-winning work proved that it is embedded within human nature that we fear loss more that we value gain. Consequently it is no surprise that ‘risk aversion’ is hard-wired into the decision making process of even the most enlightened boardrooms.
The challenge remains within corporate reporting of how best to talk of risk to two very different audiences: one seeking a message of risk as threat control, the other a message of opportunity exploitation. They cannot be the same, so it comes down to copy and context. The latter is of course about how risk as part of an known and unknowable future is explained. It is not quite as simple as optimistically versus pessimistically, but it does depend on the way the future is envisioned and this is where regulators are uncomfortable, they deal with facts ….and there are no facts in the future!
Forecasting a future is something that boards must do with competence: strategy is a statement of future direction and risk is a statement of future uncertainty. However when it comes to prediction, there are only two types of forecast – lucky and wrong. Boards feel obliged to deliver certainty, this reassures employees, suppliers, customers and investors, but there is danger in promising certainty in the future, in fact doing so can be rightly termed ‘high risk’. Strange that incorrect forecasts for strategy attract little criticism, yet incorrect forecasts for risk get a lot more attention.
What is the solution? The simple one is to distinguish between risk and uncertainty using a distinction first identified over century ago by an American economist called Frank Knight. Put simply risk is anything that can be calculated with a probability of outcome, whereas uncertainty is everything else. Take a look at your risk register and strip out the uncertainties. Spend some time discussing around the board table the resources needed to reduce these. This exercise in itself could be used to reassure or possibly inspire investors.
Why then does risk need to be rehabilitated? it has become by default a story of threat control, when it should be about exploiting uncertainty. Eradication of risk might be what the regulator desires – or the Treasury in the case of public services – but investors will not be interested if there is no risk. The presence of risk is part of the appeal of the risk-reward equation, if there is no risk then there is no attraction. Investors expect an inspirational risk story, so please provide one.