PwC report identifies a ‘fundamental shift in risk management’

Economic turmoil, political upheavals and natural disasters, all combined with advancing globalization and rapid technology progress, are creating a new era of risk for businesses and causing a fundamental shift in risk management practices, according to a new PwC US 2012 annual report.

Entitled ‘Risk in Review’ the report is based on a survey of more than 1,000 executives and risk management leaders.

"2011 marked a year of reckoning, and many companies are still struggling to create an effective approach to managing the ever-widening risk landscape. Businesses are scrambling to fix weak links in their systems stemming from non-traditional risks such as social media and digital technology, to dealing with the realities of operating in today's global marketplace," said Dean Simone, leader of PwC's US Risk Assurance practice.

"In this new risk era, corporate boards and senior management have a crucial role to play to ensure they set the right culture and align their strategy to risk imperatives."

According to the report, forward-looking companies are responding by shifting their risk management focus in several fundamental ways: from internal to external, from operational to strategic and from bottom-up to top-down.

To better prepare themselves to deal with unexpected events for the upcoming year and beyond, companies installed new risk management organizational structures, have put in place a new breed of risk management leadership and have adopted innovative techniques such as scenario analysis and predictive indicators.

To address changing risk landscape, PwC recommends the following risk management approaches for 2012:

Increasing cross-communication: Place greater emphasis on communications and data sharing in 2012 and take steps to improve cross-functional and departmental communication.

Improving data quality and reporting: Enhance global economic teams to help improve data quality and put in place improved processes for reporting data. Different business units should meet periodically with different business units to review and exchange information and data as a form of early alert to possible upcoming risks to the business.

Better forecasting and scenario analysis: Leverage more sophisticated tools such as early-warning systems and contingency plans to reconfigure approaches to manage risk (i.e. set up scenario models or Monte Carlo analysis geared to the nuances of the business, run models as events unfold, etc.)

Elevating the chief risk officer (CRO): Put risk management role on the proactive offensive instead of reactive defense by giving CROs more cross-functional access and ability to effect decision-making.

Integrating risk management: Manage risk holistically by continuing to integrate risk management into decision-making processes relating to ‘traditional’ functions (i.e. strategic planning). Don't exclude new areas of risk (i.e. talent management and outsourcing), but address and integrate them into decision-making processes.

Bolstering IT: Address data privacy and security concerns and take stock of where to build better processes, practices, procedures and technical defenses. Shifting technology and heightened competition for new customers in new markets are also exposed to more risks, so it's imperative to study the setbacks and successes of peers who pioneered the use of these new technologies.

Greater board involvement: Understand the risks facing a company and have in-depth discussions with management to make sure those risks are being handled properly. The discussion should also cover potential risks that are not yet on management's radar and what the implications of those emerging risks might be.

To download a full copy of the report visit: http://www.pwc.com/riskinreview

Parallel Strategic Risk Profile of omnipotent Bankers versus omnipresent Bacteria

WHETHER you call the current financial situation a setback, a crisis or a meltdown, it has had at least one positive effect: financiers are searching for new ways to deal with complex risk.

Let's examine a new suggestion for them. Look to again at nature, where analogous problems have already been solved by engineers and computer scientists.

Bacteria, for example, have a robust, adaptive regulatory system that optimises the growth of the colony under any set of conditions. They adapt to the composition of their growth medium, the acidity, temperature and salinity of their environment, attack by other organisms and many other threats.

Adaptation and survival, depends on regulatory systems built into the system itself, and yet this regulation does not constrain growth or innovation.

What does this have to do with finance?

Clearly, there are formal similarities and parallel comparisons can be made from the architectures of financial systems and biological systems. Financial systems are composed of institutions - banks, pension funds, finance houses, insurance companies and the like.

These create credible packaged products; mortgages, mutual funds, insurance policies and credit default swaps. Consumers, by their nature, have confidence in these institutions and buy and sell these 'products', funds flow throughout the system and, in normal circumstances, growth follows.
In a bacterial colony, the equivalent of institutions are interactive chemical pathways - families of enzymes and metabolic reactions that are linked together to perform necessary functions. These create products in the form of molecules such as DNA, ATP, proteins and lipids.

These products are then used or consumed, by the bacteria and normally growth occurs. The most succesful of these reactions have risen to the top through an evolutionary process that rewards success.

In both financial and bacterial systems, commitment to growth does not come without risks. In financial systems, a party to a contract may not be able to meet its' obligations. In bacterial systems, molecules and organic elements that are necessary for growth may be missing or depleted.

Financial instruments may lose value because of price fluctuations and diverse market trends. A bacterial colony's external media may literally dry up or be excessively consumed. Financial markets may lack liquidity. Micro-organisms may lose their ability to generate their central energy molecule, ATP.

Bacteria have remarkable arrays of response mechanisms that protect them against these and other threats. While some regulatory mechanisms are engaged to counter specific threats, others operate in a more general way to protect against threats that the organism has not yet encountered. Bacteria also optimise growth for any external and internal conditions. That is why they represent an excellent system on which to base a model financial system.

Finance and biology are distant fields, of course, but there is a way to bridge them: engineering. Recently, my research group and others have found that biological systems such as bacterial colonies can be analysed and modelled using tools developed to study "hybrid systems", which are characterised by a combination of both continuous and discrete dynamic behaviour.

The classic example is a bouncing ball; other examples are air traffic control, production plants and wireless networks. This leads me to believe that we can use those same tools to analyse financial systems and make them more resilient.

As another example, consider two cars approaching an intersection. This is a hybrid system because the cars move smoothly forward but also stop, start and change direction. How do you ensure that the cars pass without crashing? How do you get them through in the fastest time possible? Can a system of regulators be designed to optimise both safety and speed? Where will the cars be at some specified time after they pass?

Now multiply the number of cars by 1000 and add many more intersections. The problems become very difficult to solve, but not impossible. I suggest that the corresponding problems in the financial world - to avoid crashes, maximise productivity, design a regulatory system and predict the future - are equally accessible to our analytical tools.

First, though, we need to analyse finance as a hybrid system. I'm confident we can do that because of recent work showing that the tools we use to analyse such systems are applicable to biology.

Two results in particular will resonate with the financial sector. One predicts which bacterial genes are essential and which can be knocked out without killing the organism. This is the bacterial version of asking "is this bank too big to fail; if I get rid of it, will the whole system crash?"

The second models how flocks of birds or schools of fish perform collective tasks without centralised coordination. It is not a big stretch to propose that financial group behaviour, like panic selling, may be analysed using these tools.

More complex questions about the growth of bacterial colonies can be answered if more complete information is known, such as the individual biological properties of each cell. Similarly, more complete information about financial institutions will allow more complex questions about financial systems to be answered.

This proposal raises several practical questions. Will the relevant parties make the information available? Where should the information reside, who will have access to it and how will confidentiality be guaranteed?

In conversations with financiers, there is an appetite for making the information available if confidentiality and anonymity are guaranteed. There is also acceptance that a government agency should be the repository of the information.

All we need now is the political and corporate will to gather the information, engage the right team and apply these tools to help solve a really important problem.