Risk and Strategy
Understanding the relationship between RISK and STRATEGY is an extremely important step in incorporating ERM into strategic decision making.
Management and the Board need to decide which of three fundamental relationships that the firm expects to persue over the near term (next several years):
- The Firm can GROW the business and the risks taken by the business significantly faster than the growth of capital.
- The Firm can MAINTAIN the relationship between the capital of the firm and the risks of the firm at the current level.
- The Firm can STRENGTHEN the firm by growing capital faster than the business grows.
If management and the board do not understand these three fundamental choices AND have a clear idea of which choice that the Firm is persuing, it is highly unlikely that conversations about risk and risk management will go anywhere. In fact, what will happen is that they will spin in whirlpools of changing topics and inconsistencies.
The choice among these three ideas is not permanent. But it should be a choice that is set down for a multi year period of time. It should reflect management and the board’s understanding of both the level of resources of the firm as well as the opportuinities in the marketplace.
GROW – This choice represents the understanding that there are very good opportunities in the marketplace and that the firm has excess capacity to take risks. That excess capacity might have arisen because of some non-repeatable gains. The underlying profitability of the business of the firm is not high enough to fund the growth of the firm for some period of time. The firm either cannot obtain additional outside funding for the growth or else the available funding is too expensive or restrictive. This strategy cannot be the long term strategy of the firm because the firm will grow ever more risky over time and will eventually experience a loss that will impair the firm.
MAINTAIN – This choice comes from a conclusion that the firm can fund its desired growth level by the profits of the business of the firm. It might also mean that some of the growth will be funded from outside and that with the funding and the growth and the retained profits, the firm will be able to maintain the level of security that it has had over the recent past. This strategy is sustainable over a long time period.
STRENGTHEN – This choice is often made after a loss event weakens the firm. It can be accomplished by increasing profit margins or by limiting growth. Often, increasing profit margins will limit growth. This can also be a necessary choice after growth that has far exceeded the level that can be sustained by the earnings of the business. It can also be a choice that is made during a period when the markets are particularly soft and the choices for profitable growth are poor. Firms may choose to “keep their powder dry” and to increase their capacity for future growth once market opportunities improve.
The choice among these three strategies is made by every firm, either consciously or unconsciously resulting from their other choices.
A good starting point for bringing Risk into the Strategy discussions is to have a direct discussion of this choice and to find out whether it is possible to get management to clearly understand the choice that is needed at the time for the firm.