Corporate Strategy and Risk Management - A Review
(With focus on Housing and US Auto sector debacle)


By

Prof R.K. Gupta
Professor and Director
Centre for Advanced Training in Management
Chandigarh
E-mail: rkgupta@rkgupta.in / cityju@rediffmail.com
 


Key words: Corporate Startagey ; US Auto sector ; Auto Industry ; Risk Management

The crisis in financial institutions and the imminent failure of the US-based automobile producers (1) have raised the issue about whether use of the Balanced Scorecard (BSC) (2) would have helped these companies avoid the disasters that occurred. Let us explore the possibilities.

Many of the failed or failing organizations suffered from having a much too narrow focus on short-term financial performance. This is exactly the problem that the BSC was designed to mitigate. And the BSC's financial perspective is the natural location for enterprise risk management (ERM) objectives and measures.

The high-level objective in BSC's financial perspective is growing and sustaining shareholder value. Traditionally, there are two methods to drive shareholder value: Revenue growth and Productivity improvements . The third method for sustaining shareholder value, missing in many companies' strategies, should be risk management. Most companies find that their challenge is to find valid metrics of risk management, a key driver of sustainable value creation.

All financial institutions have metrics related to risk exposure, such as "value at risk." (3 ) But almost all the financial institutions, and almost certainly the ones that failed, treated risk management as a regulatory and compliance function, somewhat like internal controls for Sarbanes-Oxley Act, and not as a strategic issue. Their local risk management metrics met regulatory rules, but did not reveal the strategic exposure the companies actually had since they were based on invalid data. The value-at-risk measures used extensive data from the past six to eight years, a period of continually climbing housing prices, which showed that housing delinquencies and foreclosures were uncorrelated events. With zero or low correlations, portfolios of highly risky assets can appear less risky. When housing prices decline, however, delinquency and foreclosure correlations become extremely high. Thus, even with a BSC that included metrics of risk exposure, the metrics - calculated on data that did not reflect a complete cycle in the housing market - would have failed to reveal the high risk that financial institutions had assumed by taking highly-leveraged positions in mortgage securities.

A comparable story is true in the automobile industry. The US-based producers earned all their profits in vehicles that people were willing to purchase as long as oil sold for less than $40 per barrel. But when oil prices doubled and tripled, consumers abandoned the light truck and SUV markets, and the companies had few cars that people wanted to buy. The car companies had failed to measure accurately the risk of their highly-concentrated product strategy. Currently the docks in various countries are full with cars waiting dispatch orders.

Compounding the challenge for these--and other--companies is that we don't, at least at present, have good measurement tools to quantify these rare, or black swan, events.

But here are three steps companies can take on their own to begin to get a clearer sense of their risk exposure:

1. Start by attempting to identify the macro-economic variables that have the greatest potential to put your strategy at risk; housing prices for highly-leveraged financial institutions investing heavily in mortgage-based securities, petroleum prices for automobile companies earning all their profits on high gasoline consuming vehicles.

2. Estimate the impact on profitability from potential changes in these macro-economic variables; e.g., an 8-10% decline in housing prices (not that unlikely after an 8 year period when average housing prices jumped from 3x to 4x of consumer income), or a doubling of petroleum prices (also not that unlikely given very limited new supply, and rapidly increasing demand from developing nations, particularly China, India and Brazil).

3. Aggregate the risk exposure onto the company's BSC to stimulate discussion at monthly strategy review meetings about the risks of the current strategy. The discussions could have led executives to decide to reduce certain asset positions, and certainly decrease the leverage against those asset positions, thereby allowing the companies to survive better when the adverse events did occur.

Beyond these measurement challenges, the most important factor is for senior executives to reduce the exuberance of highly-incented managers to increase short-term profits by taking on more risky asset positions, especially highly-leveraged bets. Even with the best of data, if the CEO is unwilling to make the tough decisions to sacrifice some short-term profits in return for increasing the probability of surviving a downturn, the BSC will not be the savior of the company.

Sub note 1: Mismanagement. Antiquated business models. Uncontrolled costs. Bad marketing. There seems no end to the causes of American automakers' woes. So how do they fix it? A few interesting articles on this are hyper-linked below.

    * John Quelch: How GM Violated Your Trust
    * Bill Taylor: Memo to an Auto Industry CEO: Less Head, More Heart
    * Umair Haque: Detroit's 6 Mistakes and How Not To Make Them
    * John Baldoni: Detroit's Leadership Failure
    * Jeff Stibel: Detroit CEOs Take the Low Road

Sub note: 2 The Balanced Scorecard (BSC) revolutionized conventional thinking about performance metrics. When Robert Kaplan and David Norton first introduced the concept in 1992, companies were busy transforming themselves to compete in the world of information; their ability to exploit intangible assets was becoming more decisive than their ability to manage physical assets. The scorecard allowed companies to track financial results while monitoring progress in building the capabilities needed for growth. The tool was not intended to be a replacement for financial measures but rather a complement--and that's just how most companies treated it. Some companies went a step further, however, and discovered the scorecard's value as the cornerstone of a new strategic management system. In this article from 1996, the authors describe how the balanced scorecard can address a serious deficiency in traditional management systems: the inability to link a company's long-term strategy with its short-term financial goals. The scorecard lets managers introduce four new processes that help companies make that important link. The first process--translating the vision--helps managers build a consensus concerning a company's strategy and express it in terms that can guide action at the local level. The second--communicating and linking--calls for communicating a strategy at all levels of the organization and linking it with unit and individual goals. The third--business planning--enables companies to integrate their business plans with their financial plans. The fourth--feedback and learning--gives companies the capacity for strategic learning, which consists of gathering feedback, testing the hypotheses on which a strategy is based, and making necessary adjustments.

Sub note: 3: In financial mathematics and financial risk management, Value at Risk (VaR) is a widely used measure of the risk of loss on a specific portfolio of financial assets. For a given portfolio, probability and time horizon, VaR is defined as a threshold value such that the probability that the mark-to-market (4) loss on the portfolio over the given time horizon exceeds this value (assuming normal markets and no trading) is the given probability level.

For example, if a portfolio of stocks has a one-day 5% VaR of $1 million, there is a 5% probability that the portfolio will fall in value by more than $1 million over a one day period, assuming markets are normal and there is no trading. Informally, a loss of $1 million or more on this portfolio is expected on 1 day in 20. A loss which exceeds tha VaR threshold is termed a "VaR break."


The 10% Value at Risk of a normally distributed portfolio

VaR has five main uses in finance:

Risk management, risk measurement, financial control, financial reporting and computing regulatory capital. VaR is sometimes used in non-financial applications as well.

4: http://en.wikipedia.org/wiki/Mark_to_market_accounting

5: http://en.wikipedia.org/wiki/File:VaR_graph.png

Acknowledgement: The concepts & definitions have been taken from Harvard Business Publishing and
Wikipedia for review and linked at appropriate places for further reading online.
 


Prof R.K. Gupta
Professor and Director
Centre for Advanced Training in Management
Chandigarh
E-mail: rkgupta@rkgupta.in / cityju@rediffmail.com
 

Source: E-mail March 3, 2009

          

Articles No. 1-99 / Articles No. 100-199 / Articles No. 200-299 / Articles No. 300-399
Articles No. 400-499 / Articles No. 500-599 / Articles No. 600-699 / Articles No. 700-799
Articles No. 800 to 899 / Back to Articles 900 Onward / Faculty Column Main Page