Pascal vander Straeten6 November 2012; South Yara (VIC)

Belgian-Luxembourg Chamber of Commerce

Risk Management and the Role of the Corporate Board in Risk Management

Chaos Theory and Its Application to Risk Management

Characteristics of a Corporate Board Applying Chaos Theory to Risk Management

Internal sources of risk include:• Overestimating demand for a product

• Poor quality control leading to manufacture of a flawed product

External sources of risk include:• A crisis in the Middle East that disrupts oil supplies

• Unexpected competition from an entrepreneurial rival

Assumption that objective measurement of risk is possible

Quantitative methodology; no qualitative differences between types of risks

Risk = probability of negative outcome X the severity of the outcome

The assessment of risk is “grounded in specific conventions, and forms of life” [sic] (Garland, 2003, p. 56)

Impossibility of comparing risks on a common scale; preference for a “multi-attribute approach” (Peterson, 2007)—e.g., auto safety focuses on attributes of accidents and fatalities rather than on monetary considerations alone

But there is no value-free way to choose which attributes on which to focus

The U.K. Turnbill Report “requires embedded risks management to be a critical and integral part of managing the business”

The Combined Code of the London Stock Exchange Requires Directors to:• Review the effectiveness of all controls, financial and non-financial

• Include a corporate governance compliance report in their annual report and accounts

• Ensure that performance-related remuneration formed a significant portion of the executive’s compensation package

Combined Code of the London Stock Exchange, continued—Directors should:• Incorporate challenging criteria in incentive schemes

• Name non-executive directors in their annual report

• Ensure that the remuneration committee and the majority of the audit committee were independent non-executive directors

An emphasis on an “enterprise-wide” system of risk management, in which every employee plays a role (Shimell, 2002, p. 103)

Less hierarchical leadership role for corporate boards—board members should communicate with the CEO, other executives, and “ordinary” employees as part of a corporate-wide risk management approach

But can risk management at any level be possible in light of chaos theory?

Deterministic behavior that appears to be random

Chaotic systems unpredictable due to “sensitive dependence on initial conditions”—”The Butterfly Effect”

Examples of chaotic systems in nature:•The weather•Waves•Heartbeats

But chaos is not “pure” randomness; it only seems random

The apparent randomness is due to our finitude—our inability to measure initial conditions in chaotic systems with enough accuracy to predict long-term results

But there is order in chaos: “chaos describes a complex, unpredictable, and orderly disorder in which patterns of behavior unfold in irregular but similar forms” (Tetenbaum, 1998, p. 24) Example: snowflakes

Order out of chaos, continued•Both novelty and order arise through

“bifurcations”•There may be periods of seemingly random behavior followed by periods of relative stability or equilibrium. Example: the stock market

•Bifurcations can lead to emergent properties and emergent forms of order not found earlier in the system: “self-organizing systems”

Order out of chaos, continued. Examples of systems that produce novelty:•Biological evolution•Business

The “world economy” Silicon Valley

Short-term predictions are possible in chaotic systems

•Such short-term prediction is not possible on a global basis, but on “an incremental or local basis” (Cartwright, 1991, p. 54)

•Although we cannot predict the long-term future, we can anticipate it and have a general idea of the paths it might take. Similar to long-term weather forecasts

Business is a chaotic system•Dynamic but not completely disorderly•Variables in the dynamics of a large corporation Financial health of the company Relations between employees

Relations between lower-level employees and management

Relations between upper management and the board of directors

•Variables, continued Supply of and demand for the company’s goods and/or services

External risks With this many variables, the old paradigm of predictability is unrealistic—but there are still ways the company can manage risks better in a chaotic world

Flexibility/adaptability•A company should adapt “to the changing environment and evolving rules” (Chorafas, 1994, p. 66)

•Failure to adapt quickly enough can cause serious problems. Example: Sears adapted slowly to (first) K-Mart and then Wal-Mart, leading to major profit losses in the 1980s

Gain adequate information•Open environment of knowledge-sharing in the company—no hoarding knowledge

•Emphasis on continuous learning. Example: Hewlett-Packard’s “Not Invented Here Award,” which “is an honor bestowed on a division that implements the most ideas from other divisions in the company” (Tetenbaum, 1998, p. 27)

Emphasis on innovation and creativity• “an environment that supports experimentation, risk-taking, and failure, and views trial-and-error as a viable process” (Tetenbaum, 1998, p. 27)

•Openness to suggestions from diverse employees, both management and ordinary workers, as well as other stakeholders such as “customers and suppliers” (Ibid, p. 28)

“High tolerance for conflict” (Ibid., 28). Tetenbaum gives the example of 3M, which “has new recruits take a course with their supervisors on risk-taking in which they are explicitly taught to be willing to defy their supervisors” (Ibid.)

Less hierarchical approach to management

Make accurate short-term predictions and anticipate possible long-term pathways

Understand qualitative relationships between systems, subsystems—and people—Example: Staff members at a nursing home misunderstood patients’ crying and failure to eat as temper tantrums—they were actually signs of depression (Anderson, et al., 2007, p. 673)

Cause intentional turbulence in a company to stimulate innovation•Deliberately “over-” or “undershoot” the goal (Cartwright, 1991, p. 54)

To facilitate risk management, members of the board of directors can:•Set an example

Good ethics Commitment to do the work necessary to help with risk management

Courage to take responsibility when things go wrong

•Gain knowledge Be knowledgeable about company operations Visit the company’s various units Talk not only to upper managers, but to employees at all levels

Be familiar with key internal relationships between people and units in the company and with relationships that fan outside the company, such as those with customers, suppliers, and regulatory agencies

•Gain knowledge (continued) Be aware of current market conditions, safety concerns about company products, and reactions, both positive and negative, to product quality

Information should be as current as possible

If risks are found, monitor management’s reaction to those risks

•Set a climate of flexibility Allow for conflict at board meetings Encourage managers to express disagreements with the board—”team player” does not mean “yes man”

•Anticipate risks; manage contingencies•Hire innovators

Hire managers with a history of innovation and creative thinking, managers willing to tolerate conflicting ideas and come up with new solutions

Hire managers who have differing ideas for product development

But these managers must realize that conflict is part of working together to solve company problems

•Make risk management company-wide Each employee holds some responsibility for risk management

Even low-level employees should have adequate knowledge to manage risks

Management should listen to employee concerns at all levels

The more aware all employees are regarding risk management and the more they are practically involved, the better prepared the company is to anticipate and deal with risks