What is effective risk management?

April 12, 2014 9 comments

Some say that risk management is effective when it has all the components described in their favorite standard (ISO 31000:2009) or framework (COSO ERM). (COSO ERM specifically states this as the requirement).

Some say that risk management is effective when all the principles in their favorite guidance are present and functioning. (ISO talks about its “set of principles that organisations must follow to achieve effective risk management.”) The principles are (from a consultant’s site that provides a high-level view of the standard):

  • Creates and protects value;
  • Is an integral part of all of the organisation’s processes;
  • Forms part of decision making;
  • Explicitly expresses uncertainty;
  • Is systematic, structured and timely;
  • Is based on the best available information;
  • Is tailored to the organisation;
  • Takes human and cultural factors into account;
  • Is transparent and inclusive;
  • Is dynamic, iterative and responsive to change; and
  • Facilitates continual improvement of the organisation.

Some say that risk management is effective when activities are compliant with the organization’s related policies and standards. But are those policies and standards adequate?

Some will say that risk management is effective when the board, operating and executive management believe it adds value and are satisfied that it provides the information they require. I believe that has merit but they may be satisfied with less than mature risk management (that seems to be the case with many current organizations who are satisfied with enterprise list management, until they are caught short).

Some will say that risk management is effective when an independent assessment/audit/examination is performed and the report says so. The trouble is that the people who do such audits generally rely on one of the above criteria (components present, principles in operation, etc.)

I would like to suggest a different approach.

Let’s start by considering why organizations should have risk management. It’s NOT because laws and regulations mandate it in many cases. It’s NOT because people say you need it. It’s because effective risk management provides a level of assurance that an organization will not only achieve its objectives (or exceed them) but will set the best objectives.

Quoting from COSO ERM:

“Enterprise risk management helps an entity get to where it wants to go and avoid pitfalls and surprises along the way.”

COSO explains that effective risk management enables:

  • “A greater likelihood of achieving business objectives”
  • “More informed risk-taking and decision-making”

Irish guidance on the ISO 31000:2009 risk management standard says:

“The purpose of managing risk is to increase the likelihood of an organization achieving its objectives by being in a position to manage threats and adverse situations and being ready to take advantage of opportunities that may arise.”

The Australian mining company, BHP Billiton, has a risk management policy signed by its CEO. It includes:

“Risk is inherent in our business. The identification and management of risk is central to delivering on the Corporate Objective.

  • By understanding and managing risk we provide greater certainty and confidence for our shareholders, employees, customers and suppliers, and for the communities in which we operate.
  • Successful risk management can be a source of competitive advantage.
  • Risk Management will be embedded into our critical business activities, functions and processes. Risk understanding and our tolerance for risk will be key considerations in our decision making.

“The effective management of risk is vital to the continued growth and success of our Group.”

I like what E&Y has to say:

“An effective [ERM] capability provides value by giving organizations the confidence to take on risk, rather than avoid it.

“By effectively managing the right risks, management has more timely, comprehensive and a deeper understanding of risk which, in turn, facilitates better decision-making and confidence to take on new ventures or even to accept higher levels of risk.”

So we can see that, as the BHP CEO said, effective risk management is not only essential to the success of an organization but “can be a source of competitive advantage”.

For the last year or two, I have been saying that you assess the effectiveness of risk management by asking decision-makers at all levels whether the risk information is enabling them to make better decisions and be more successful.

In other words, assess risk management not by its structure but by its effect.

I still think that is a key test, but I am going to add a new dimension to my thinking.

Let’s consider a company that has significant foreign currency exposure. It does business globally so it has bank accounts in a number of countries and has both payables and receivables in different currencies.

There are a number of strategies for reducing foreign exchange risk, but to manage the risk effectively you need to know what is happening with rates as well as how your bank account balances, payables, and receivables are changing.

If this company only has the ability to understand its foreign exchange risk once a month, in other words its monitoring of this risk is only monthly because that is the only time it is able to obtain all the necessary information and calculate its exposure, the risk is much higher than if it has the processes, people, and systems to monitor its exposure daily or better.

However, the investment necessary to upgrade the risk monitoring from monthly to daily may be significant. The company has to decide whether the reduction in exchange risk that can be improved by upgrading risk monitoring justifies the additional expense.

Until it upgrades risk monitoring, there is a risk that the information provided by risk management is insufficient. Management needs to decide whether that is an acceptable level of risk.

If management decides that the level of risk is too high, then I would say that the risk management program is less than effective. It is not providing the information necessary for management to take the right risks. But if management decides that the level of risk is acceptable, then that would not prevent me from assessing risk management as effective.

Let’s take another situation. An organization is concerned about its reputation risk. It has engaged a company to monitor reputation risk indicators (using social media analytics) and report once each quarter. However, it is in an industry where customer satisfaction can move quickly and significantly.

Quarterly risk monitoring creates a risk that the risk management program is not providing the information necessary to manage risks to the enterprise objectives. As in the prior example, management will need to decide whether an investment in more frequent reputation risk monitoring is justified by the potential reduction in reputation risk (because it would increase the ability to respond to customer complaints, etc.)

If management decides that quarterly risk monitoring represents a risk outside acceptable ranges, I would say that the risk management program is less than effective. It is not providing the information necessary for management to take the right risks, and management has determined that this is a risk (the risk of a bad decision) is unacceptable.

One final example. The company has an excellent risk management framework, formal policies and procedures, processes, and enabling systems. However, in the last year the level of staff turnover among the champions of risk management in the executive ranks and among the risk officers themselves means that the experience of the individuals relied upon to monitor, understand, assess, evaluate, and respond to risks has diminished.

There is an increased likelihood than in prior years that risks will not be managed as desired, the wrong risks taken, and that risk information that flows to top management and the board may not be reliable.

This is a deficiency in the operation of risk management and may represent a risk to the achievement of objectives because it results in less than reliable risk information on which decisions are based. If the risk is unacceptable, then until it is treated and brought back to within acceptable ranges I would say that the risk management program is less than effective.

So, where am I going?

If we revisit the objective of risk management, we see that we rely on it to provide management and the board with the information they need to run the business, make better decisions, and take the right risks.

But risk management is not and never will be perfect.

It is impossible to monitor every risk, including new risks, in real time and provide useful information – also in real time – to the people who need to act on it.

There will always be risk champions who are new to the company and because they don’t understand the business and their risk-related responsibilities, will fail in that respect.

There will be times when the people required to provide expert insight when assessing and evaluating risks are on vacation, sick, or otherwise unable to participate.

There will always be a risk that the risk management program fails to provide the information necessary for decision-making.

The key is whether that risk is known and is considered acceptable.

If the risk is acceptable, then I would consider the risk management program as effective.

That is not to say that all the principles described in ISO 31000 are not necessary, or that the components discussed in COSO ERM are not required. But, that is the structure of the program and that doesn’t mean it is effective and produces the results necessary for the organization to succeed.

Bottom line: CROs and executive management should assess their risk management program (auditors can help) and determine whether the level of risk that it will provide insufficient information to run the business, make informed decisions, and take the right risks is acceptable.

OK, I understand that this is a little complicated and a very different way of thinking about effective risk management. Does it make sense?

I welcome your views.

The Practitioner Leader

April 6, 2014 5 comments

Being a leader means taking risks. Nobody leads if they sit in their office reviewing files and talking to their staff on the phone.

No, true leaders are people who are followed.

Who is followed? The leader that inspires you to grow and be fulfilled; the individual that people listen to and who is able to motivate change; the manager that listens to you more than he talks to you; the one that other leaders and people you respect look up to.

Any practitioner, whether staff or management, can be a leader.

But it takes being willing to take some risks.

Acknowledge what you don’t know and find ways to learn what you need to know.

Keep your mouth shut when you need to listen (which is the majority of the time) and only open it when you have something useful to say.

It means being willing to share your professional opinion based on business grounds without hiding behind professional standards or firm policies.

It means being willing to share both the bad and the good news, even when that will be unpopular or meet resistance from executives. (Why are we so reluctant to say things are done well?)

Everybody should be able to see the elephant in the room after we have given our report.

It means taking a new approach when that is better than what is “customary”, and showing the path to others.

Leaders don’t keep knowledge to themselves. They are open and willing, without bragging, to share and enable the whole team to grow.

A leader puts the priorities of others alongside or even ahead of others. Your problem is their problem.

Leaders not only care about others but are known to care.

Are you a leader? Do you know how to improve your leadership skills?

I welcome your comments.

Missing the boat on IT and technology

March 29, 2014 8 comments

When you look at surveys of CEOs, such as the ones by PwC in 2014, McKinsey in 2013 and IBM in 2012, they reflect what we should all know: that the innovative use of technology is one of, if not the primary, enabler of business innovation these days. Whether it’s connecting with the customer (as referenced by IBM), obtaining market insights (through analytics including Big Data analytics – see this discussion of a McKinsey report), or simply finding new ways to deliver products and services to customers, technology is a critical driver of business success.

As PwC says:

“CEOs told us they think three big trends will transform their businesses over the next five years. Four-fifths of them identified technological advances such as the digital economy, social media, mobile devices and big data. More than half also pointed to demographical fluctuations and shifts in economic power.”

“The smartest CEOs are concentrating on breakthrough, or game-changing, innovation. They’re explicitly incorporating it in their strategies. And they’re using technology not just to develop new products and services, but also to create new business models, including forging complete solutions by combining related products and services. In fact, they don’t think in terms of products and services so much as outcomes, because they recognise that products and services are simply a means to an end.”

“Breakthrough innovation can help a company rewrite the rules and leapfrog long-established competitors.”

Organizations that fail to leverage new technology are likely to be left behind by customers and competitors. In an ISACA report on Big Data, the point was made that failing to take a risk with new technology is very often a greater risk than any risks created by the new technology.

(Please see these earlier posts on IT Risk and Audit, Deloitte says mid-market companies are  using new technology to great advantage, and Digital Transformation.)

Now we get a couple of reports and discussion documents that indicate that companies, executives, and consultants that aim to guide them are all missing the boat!

A new report from McKinsey, IT Under Pressure, says that dissatisfaction with IT’s effectiveness is growing. They start the report with:

“More and more executives are acknowledging the strategic value of IT to their businesses beyond merely cutting costs. But as they focus on and invest in the function’s ability to enable productivity, business efficiency, and product and service innovation, respondents are also homing in on the shortcomings many IT organizations suffer. Among the most substantial challenges are demonstrating effective leadership and finding, developing, and retaining IT talent.”

McKinsey points out that in their survey only 49% felt IT was effective when it came to helping the organization introduce new products and 37% said IT was effective in helping enter new markets.

Even IT executives said that they were failing when it came to driving the use of technology and innovation: just 3% were fully effective and only 10-17% very effective in related areas.

Fully 28% of IT executives and 13% of other executives came clean and said the best way to fix the problem was to fire current IT leadership!

I suggest reading the entire McKinsey piece and considering how it relates to your organization.

Deloitte’s prolific thought leadership team has weighed in with advice for the CFO, who often has IT within his organization. Evaluating IT: A CFO’s perspective starts with some good points:

“Ask finance chiefs about their frustrations with information technology (IT), and you are bound to get an earful. Excessive investments made. Multiple deadlines missed. Little return on investment (ROI) achieved. The list goes on.

“To complicate matters, many CFOs simply do not know if chief information officers (CIOs) are doing a good job. What exactly does a good IT organization look like anyway? How should IT be evaluated? And what are the trouble signs that the enterprise is not prepared for the future from a technology standpoint?”

But then they stray from the need to get IT to drive the effective use of new technology for both strategic and tactical advantage. Instead, they focus on “IT is typically the largest line item in selling, general, and administrative expense.”

This is the attitude, managing cost at the potential expense of the business, which gives CFOs a deservedly bad name!

I will let you read the rest of this paper, but when the first question it suggests for CFOs to use in assessing IT performance is “Have you tested your  disaster plan”, I am more prepared to fire the CFO who asks that as his first question than I am to fire the poor CIO who reports to him.

My first question for the CIO is “How are you enabling the organization to innovate and succeed?”

PwC asks some good questions as well:

  •          What are you doing to become a pioneer of technological innovation?
  •          Do you have a strategy for the digital age? And the skills to deliver it?
  •          How are you using ‘digital’ as a means of helping customers achieve the outcomes they desire – rather than treating it as just another channel?

Risk and internal audit professionals should consider whether the risk of missing the technology boat is at an unacceptable level in their organization.

Board members should ask how the leaders of IT are working with the business to understand and use technology for success.

CFOs should worry less about the cost of IT and worry more about the long-term viability and success of the organization if they become barriers to strategic investment.

I welcome your comments.

The continuing failure of the risk appetite debate to focus on desired levels of risk

March 22, 2014 11 comments

I have written often and with passion about the concepts of “risk appetite” and “risk tolerance”. In order of date, from earliest to latest:

I am drawn to write about this flawed concept yet again by two developments. First, a respected risk practitioner told me that he has found that in many banks (and presumably other financial services companies) the board agrees on risk limits and appetite statements with management, but those limits are not shared with everybody that has day-to-day responsibility for running the business and staying within desired levels of risk.

This is the primary area with which I have a problem when it comes to the idea of a risk appetite statement. Something that satisfies the needs of the board and top management to establish and monitor aggregate risk across the enterprise fails if it does not direct the actions of those people who are taking risk every day, not only in transactions but in decision-making.

Then, my good friend (and that is an honest statement with which that I believe he will agree) Jim DeLoach of Protiviti penned a piece on risk appetite and tolerance for Corporate Compliance Insights.

Jim shares some truths:

“Risk levels and uncertainty change significantly over time. Competitors make new and sometimes unexpected moves on the board, new regulatory mandates complicate the picture, economies fluctuate, disruptive technologies emerge and nations start new conflicts that can escalate quickly and broadly. Not to mention that, quite simply, stuff happens, meaning tsunamis, hurricanes, floods and other catastrophic events can hit at any time. Indeed, the world is a risky place in which to do business.”

“Value creation is a goal many managers seek, and rightfully so, as no one doubts that successful organizations must take risk to create enterprise value and grow. The question is, how much risk should they take? A balanced approach to value creation means the enterprise accepts only those risks that are prudent to undertake and that it can reasonably expect to manage successfully in pursuing its value creation objectives.”

But then the discussion veers towards the too-common misperception that the only limit that should be set on risk is the upper level – a constraint that stops management from taking too much risk.

In fact, as Jim points out, companies will only succeed if they take risk: “a company may choose to drive growth through extending more credit to its customers, entering certain third-world markets or investing in a completely different line of business”.

So, it is important to ensure that not only does management not take on too much risk, but they do not act timidly and fail to take on the risk that will drive performance and value creation.

I know Jim well and have total confidence that he appreciates that companies need not only ceilings but floors on the levels of risk they should take (and not limit their risk criteria to quantitative factors) to ensure they are taking the right risks.

I just wish his paper focused less on the negative (with comments like “What ceilings are placed on capital expenditures, M&A activity, R&D and other investments? In what areas are there policy restrictions (e.g., avoidance of certain markets and use of certain financial instruments)?”) and helped organizations recognize when to take more risk.

I also wish that Jim brought into his pieces a greater appreciation of the perspective on risk and uncertainty reflected in the ISO 31000:2009 global risk management standard, instead of limiting himself to the concepts (some of which, like risk appetite, I believe to be flawed) of COSO ERM.

I welcome your comments.

Please see this related story about an internal auditor that recommended that the company consider taking on more risk.

New Paper on Risk Assessment and the Audit Plan

March 15, 2014 14 comments

One of the software vendors that have been providing solutions for internal auditors for many years is Thomson Reuters. With annual revenues of nearly $13 billion, they are one of the few large software companies in this space. So when they speak, I tend to pay attention.

Thomson Reuters recently published a paper written by a former senior manager with E&Y. Entitled “Get Your Internal Audit Risk Assessment Right This Year” (registration required), the paper purports to share best practices for internal audit risk assessment.

Unfortunately, it fails to deliver on that promise.

While it includes some useful guidance for the discussions every internal audit team should have with management, it barely touches the surface of the issue.

I do agree with this statement: “the Internal Audit Risk Assessment presents an oft-missed opportunity for internal auditors to understand their organization’s evolving objectives and implement a more dynamic risk-based approach to the internal audit process.”

The last sentence in the report starts to get to the real point: “With no sign of the pace of changes affecting your organization slowing down, internal audit’s risk assessment must be dynamic, not static, and needs to be improved from year to year, using a top down approach, beginning with management interviews and input.”

Here are the two main problems with that last sentence:

  1. The internal audit assessment of risk and updating of the internal audit plan should be far more frequent than the annual cycle implied by the report. Many departments are moving to a quarterly update, and best practice (in my opinion and which I personally followed) is a rolling quarterly plan that is updated as often as the risks change.
  2. While management interviews and input are useful, they are hardly the best place to start. The internal audit team should understand whether and how the organization as a whole has identified the more significant risks to the achievement of its objectives. While not clearly stated in this report, I will give credit to the author for understanding that internal audit should focus on risks to the organization as a whole, and not risks to a location, business unit, or process. However, the organization’s risk management program is not mentioned as a source of information that drives, at least in part, the audit plan! It is also critically essential that internal audit has a deep understanding of the business, its processes, systems, organization and systems, sufficient to challenge management’s assessment of risk – or make its own assessment when there is no ERM in place.

My recommendation: read the report for tips on how to interview management. But, go into that set of discussions with either the organization’s risk ‘register’ or another document that can drive a discussion about which are the risks to the organization that matter – and where the assurance and consulting/advisory services provided by internal audit can be of value. (I have shared a number of files on Box, including a Risk Universe slide you may find useful. Please go to this tab on my web site to download.)

Ask yourself this: do your internal audit plan and the process around it ensure that appropriate engagements are performed on the risks that matter to the organization, when that assurance or advisory service is needed?

Risk Officers on the Front Lines of the Big Data Analytics Revolution

March 8, 2014 3 comments

I was intrigued to read that when McKinsey gathered together “eight executives from companies that are leaders in data analytics …. to share perspectives on their biggest challenges”, they included not only chief information officers and marketing executives, but the chief risk officer from American Express.

The McKinsey Quarterly report that reviews the discussion doesn’t have any ground-breaking revelations. They say what has been said before, although it is still important for all of us to understand the enormous potential of Big Data Analytics.

One key point is that the existence of Big Data by itself has very limited value. It’s the ability to use emerging technology (from companies like SAP, Oracle, and IBM) to not only mine the data but deliver insights at blinding speed (using in-memory technology) that will bring amazing results.

But I was looking for more, which I explain after these quotes.

Big-data analytics are delivering an economic impact in the organization… The reality of where and how data analytics can improve performance varies dramatically by company and industry.

Companies need to operate along two horizons: capturing quick wins to build momentum while keeping sight of longer-term, ground-breaking applications. Although, as one executive noted, “We carefully measure our near-term impact and generate internal ‘buzz’ around these results,” there was also a strong belief in the room that the journey crosses several horizons. “We are just seeing the tip of the iceberg,” said one participant. Many believed that the real prize lies in reimagining existing businesses or launching entirely new ones based on the data companies possess.

New opportunities will continue to open up. For example, there was a growing awareness, among participants, of the potential of tapping swelling reservoirs of external data—sometimes known as open data—and combining them with existing proprietary data to improve models and business outcomes.

Privacy has become the third rail in the public discussion of big data, as media accounts have rightly pointed out excesses in some data-gathering methods. Little wonder that consumer wariness has risen.

Our panelists presume that in the data-collection arena, the motives of companies are good and organizations will act responsibly. But they must earn this trust continually; recovering from a single privacy breach or misjudgment could take years. Installing internal practices that reinforce good data stewardship, while also communicating the benefits of data analytics to customers, is of paramount importance. In the words of one participant: “Consumers will trust companies that are true to their value proposition. If we focus on delivering that, consumers will be delighted. If we stray, we’re in problem territory.”

To catalyze analytics efforts, nearly every company was using a center of excellence, which works with businesses to develop and deploy analytics rapidly. Most often, it includes data scientists, business specialists, and tool developers. Companies are establishing these centers in part because business leaders need the help. Centers of excellence also boost the organization-wide impact of the scarce translator talent described above. They can even help attract and retain talent: at their best, centers are hotbeds of learning and innovation as teams share ideas on how to construct robust data sets, build powerful models, and translate them into valuable business tools.

What I was disappointed in was a lack of reference to how Big Data Analytics could and should be a fantastic opportunity for risk officers and internal audit executives.

All practitioners should be familiar with the concept of Key Risk Indicators (KRI). A useful paper by COSO defines KRI:

“Key risk indicators are metrics used by organizations to provide an early signal of increasing [ndm: they should have said ‘changing’] risk exposures in various areas of the enterprise. In some instances, they may represent key ratios that management throughout the organization track as indicators of evolving risks, and potential opportunities, which signal the need for actions that need to be taken. Others may be more elaborate and involve the aggregation of several individual risk indicators into a multi-dimensional score about emerging events that may lead to new risks or opportunities.”

Some vendors (including MetricStream, IBM, and SAP) are showing us the way in which Big Data Analytics can be used to produce KRIs that are more powerful and insightful than ever before.

However, I am not convinced that practitioners are seizing the opportunity.

I fear that they are concerned about the risks as their organizations embrace Big Data Analytics to drive performance while remaining blind to the opportunity to develop KRIs so that business executives can take the right risks.

I would appreciate your views. Is it a matter of cost? Or are happy simply unaware of the potential?

New book on risk management for government decision makers

March 4, 2014 2 comments

The authors of “Managing Risk and Performance: A Guide for Government Decision Makers” were kind enough to send me a copy for my review and comment here. (The above link is to the Kindle edition, but it is also available in hardcover).

Intended for those charged with oversight or performance of the risk management function in government, Stanton and Webster have provided us with a great deal of material to ponder. In addition to their own work, the book has chapters from a number of others – including my good friend, John Fraser.

I confess to being let down by the book. I don’t think it spends enough time talking about the need for decision-makers at all levels to consider the potential effects of uncertainty (both upside and downside), or the need for risk-adjusted performance management. It focuses almost exclusively on the narrow definition of risk as being something bad, rather than including opportunities for success.

But it does have some good information, including how enterprise risk management was implemented in one government agency, and always useful information about Hydro One’s program.

If you are in government and charged with either oversight or execution of the risk management program, this book has value that justifies buying it. Just be aware that there is more to mature risk management than is covered in these 284 pages.

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