Competition, Complexity & Risk

“Due to the systemic nature of emerging risk, and the severe potential impact of such events, companies with slight advantages in detecting and managing emerging risks can obtain significant competitive opportunities.” Accenture, 2011.

Accenture is actually talking about Brian Arthur’s Law of Increasing Return[1] (although it is doubtful they are aware of this) where a tiny advantage early on can produce amazing compounding effects over time.  They need to translate a beautiful theory into something tangible the client can understand. Here’s an example…

In 2000 Philips had a “clean room” fire in its microchip/wafer plant in New Mexico. Both Ericsson and Nokia bought chips from Philips. Philips estimated about a week’s delay in production. Nokia played it safe and sent teams around the globe to get other sources lined up. Ericsson’s response was more laid-back. As described in Sheffi in The Resilient Enterprise [2] the head of Ericsson’s consumer electronic division didn’t hear about the chip problem until weeks after the fire. Once they realized the magnitude of the problem, it was too late. Nokia had already locked up all the surplus capacity. The plant was down for 9 months. Ericsson took a $2.34 billion loss in the company’s mobile phone division and ended-up being forced into a JV with Sony. During the first 6 months of the crisis Nokia’s market share went from 27% to 30% of the handset market. Ericsson’s went from 12% to 9%  That’s the competitive advantage of risk management and crisis management joined at the hip ….oops, I meant fully integrated across silos.

Complexity — The consequences for being caught napping are even worse today. We’re actually dealing with multi-tier risk — interconnected vulnerabilities and consequences that are often as opaque as they are deadly.  They cannot be truly understood with prevailing ERM methodologies. It’s like trying to repair a computer with a hammer.  You might get lucky but odds are you will just make matters worse.  The varying degrees of interdependence and interconnectivity between capital markets, manufacturing and consumer products markets exhibit eye-crossing complexity.  Optimizing everything from supply chains and flight schedules to capital market trading has made a lot of money…and made us more vulnerable to catastrophic failure, made the nets more fragile.

Two Paradigms

I think we’re going to have two paradigms, both operating simultaneously and dealing with completely different sorts of risks. One deals with fairly well known risks that use self-assessments, risk registers, and the traditional tool kit. The other deals with Complexity Enriched Risk[3] or CER and uses a different approach. In the CER environment the “ERM Assessor” morphs into an “ERM Consultant” as the overall operational and financial environment becomes “enriched” by complexity. We need to understand and help our clients to understand this strange new environment. I think we all will become more and more familiar with these terms in risk management….

• Complex Adaptive Systems
• Resilience – ecological models and engineering models
• Agent Based Modeling
• Network Theory and Network Analysis
• Behavioral Economics
• Tiered Risk
• Non-Linear Behavior and Non-Linear Modeling
• Thresholds, Tipping Points & Phase Changes
• Stationarity

To add value in a CER environment the consultant must provide expert, substantive advice, not just on the ERM process but on specific risks at hand. This is outside the comfort zone of many ERM practices.

It’s all about rules for auditors, it’s all about relationships for consultants. Both are going to have to learn about complexity at the tool kit, grass roots level to meet 21st century risk.

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[1] http://tuvalu.santafe.edu/~wbarthur/Books/I_R_Book.html

[2] Yossi Sheffi, The Resilient Enterprise, MIT Press, 2005, pp. 8-9.

[3] Coined by John Marke…kinda catchy eh?