Resilience for the Default

In a speech given at the NY Stock Exchange, RISKVIEWS said that there are four paths to Resilience, depending upon the economic environment:

• Boom – During the boom, the best resilience strategy is to grow!
• Bust – Triage is the strategy best-suited resilience strategy for the bust.
• Moderate – During the moderate phase steadily improving is the best strategy.
• Uncertain – And the best strategy during uncertain times, as you have all figured out the hard way, is to diversify your business.

Many people and companies have been sticking with the Uncertain stage strategy – some for several years now.  The political uncertainty has made that the sanest strategy.  But when there is an actual default situation, we will all be faced with assuming that we will be continuing on with the drabness of the Uncertain stage or will we be popping into the Bust stage?

It makes a big difference to corporate and personal actions.

Under a continuation of the Uncertain phase, the best strategy is to continue with the small decisions to incrementally grow or shrink operations.  Not making any big commitments or any big decisions.  The firms that emerge successfully when the economy finally climbs out of Uncertainty are those who are already doing something that becomes a booming growth area.  But only if they quickly recognize that the Uncertainty has ended and they shift into growth mode.

If the default creates a Bust environment, the companies who will be best off will be those who most quickly realize that and who immediately start to trim their less successful activities and associated expenses.  These firms will deplete less of their resources defending a losing business and be better prepared to protect their core business through the Bust period.  The ultimate winners will also need to recognize the end of the Bust and still have the resources to support the slow (or fast) growth that marks the end of the Bust.

This is where those scenarios come in handy.  A company that has worked its way through the scenarios of the changes in environment will be better prepared to make these decisions about shifts in the environment.

 

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Efficiency can harm Resilience

Business people with Financial and Analytical training are schooled in the Improve approach to business management.  With the Improve approach, the business operations are subjected to continual process of looking for ways to get more out of the same resources or to use less resources to get the same results.  The Improve approach can be applied at a micro level, to each separate activity of the business.  It can also be applied at the macro level, where macro planning exercizes such as capital budgeting seek to get better returns for the available amount of capital.  An optimization process is the ultimate objective of an Improve mindset, where optimization seeks to find the best return that can be achieved with the available capital.   

 

For many situations, the Improve strategy can work well.  But there are situations when the Improve strategy starts to erode Resilience.

You all likely to remember fondly your first big win with an Improve approach.  You came in and quickly identified something that was ripe for a change.  Something where the operations were highly inefficient and you made sure that things changed and a big turnaround happened.  You really felt that you added to company value and to your own reputation. 

 

 Over time you were able to make many such improvements, on this picture, moving virtually everything on to the efficient frontier. 

Then you felt the need to find more wins.  You were imagining that you could help to completely change the game, to move the possibilities upwards.  Onto a new and more favorable frontier.  But in some cases, what happened instead is that you did change the game, but what you did was not exactly improve efficiency of the system, instead, you started to reduce the amounts of redundant resources of the system.  That improves the expected returns, but often drastically reduces Resilience.  On the picture above, you wanted to move from A* to A++ and instead you moved to A–.  You got the extra return that you wanted but increased the risk and reduced the resilience.  Some of the slack that you removed from the system was really needed, the system becomes very fragile without it.   You were not actually moving to a new more efficient frontier, you were simply adding risk and return. 

A simple example of this is with supply chain risk.  There are two examples of how supply chain choices can look like improvements in efficiency but are at least in part a decrease in resilience.

• The company had been dealing with 5 suppliers.  Those suppliers had different levels of costs and their competitiveness among them varied quarter by quarter.  You make a long term deal with one supplier to deliver the item at a fixed cost that is lower than what you had ever paid to the most competitive of the 5 suppliers.  The argument was that with the certainty of demand, they could be more efficient and pass along that efficiency to you with the lower price.  However, as many firms who relied upon a single Japanese supplier in 2011, the supply chain was now very sensitive to events that disrupt the single supplier. 
• The company has been manufacturing a key part to its main product forever.  However, under pressure to win a major contract, the company decides to sub contract the manufacture of that part to a low bidder.  The product is delivered and the sub contracted part fails.  Quite possibly, the savings that the sub contractor was able to deliver was achieved by reduction in expensive quality control.  When you selected the supplier, you were promised a level of quality control that was at least as strenuous as your own processes.  However, you had saved even more money by doing very little monitoring of the actual quality control.  By outsourcing, you had created a risk that the sub would not meet your quality standards and you did not recognize that assurance of those standards was something that you could not afford to outsource.  So the savings were achieved through increase in risk.  Again, not a move to a new frontier, but instead a rightward move along the old frontier to an option that you had all along when you manufactured the part yourself. 

Four Components of Resilience

Excerpt from The Resilience Renaissance

1. Resilience thinking requires an acknowledgement of the fact that systems must learn to live with uncertainty and that change is inevitable. ‘“Expecting the unexpected” is an oxymoron, but it means having the tools and the codes of conduct to fall back on when an unexpected event happens’; these tools and codes can spring from memories held by societies of similar events in the past.
2. Diversity is important to building resilience as it extends multiple options for dealing with perturbations, reducing risks by spreading them. This diversity can be nurtured ecologically through high biodiversity, both economically through livelihood diversification and through the inclusion of diverse points of view in policymaking processes.
3. To build resilience, different types of knowledge should be appropriated in any learning process. This can be done through the appropriation of local knowledge in policy processes; ‘the creation of platforms for cross-scale dialogue, allowing each partner to bring their expertise to the table, is a particularly effective strategy for bridging scales to stimulate learning and innovation’.
4. As renewal and reorganisation are essential parts of natural cycles, the ability of systems to reorganise is a critical determinant of their resilience. This is possible through strengthening community-based management and ‘maintaining the local capacity for social and political organization in the face of disasters. Response by the community itself, through its own institutions, is key to effective response and adaptation’. Also, building linkages across scales of governance is another component of giving communities the ability to self-organise; community organisations need to work with regional and national organisations. ‘The creation of governance systems with multilevel partnerships is a fundamental shift from the usual top-down approach to management’.

Lastly, … a dynamic learning component is crucial for providing a rapid ability to innovate in terms of the capacity to create new responses or arrangements. Such learning can be improved by adaptive co-management, defined as a process by which institutional arrangements and environmental knowledge are tested and revised in a dynamic, ongoing, selforganized process of learning-by-doing. Learning organizations allow for errors and risk-taking behaviour as part of the learning process.

Summary of Four components of resilience from Understanding Uncertainty and Reducing Vulnerability: Lessons from Resilience Thinking (Berkes 2007)

Resilience in the Long Run

[A speech delivered at the New York Stock Exchange, June 19, 2013 by Dave Ingram]

Did any of you notice last fall when New York City shut down for a week?

That wasn’t on my list of likely problems for 2013.

That experience brought home to me the difference between Risk Management, the idea that I have been selling for over 10 years, and Resilience.

When I looked around during that week, I saw first hand what Resilience looked like.  And also what it looked like to be fragile.  The Resilient people and firms were going about their business.  The Fragile were waiting in lines for gas and picking up the pieces of their businesses and dwellings.

And that is when it struck me that Resilience is what people and businesses want, not Risk Management.

So today, I am going to take you on a quick tour of Resilience.

The first time I can find that someone used the term Resilience in the way that we now use it was in 1973.  CS Holling, a biologist, wrote a paper titled “Resilience and Stability of Ecological Systems”.  Hollings main point was that the EQUILIBRIUM idea of  natural systems that was then popular with ecologists was wrong.  Natural systems went through drastic, unpredictable changes – such systems were “profoundly affected by random events”.  He defined resilience as

A measure of the ability of these systems to absorb changes . . . and still persist.

He also talked about how natural systems going through a four phase cycle.  A cycle that is amazingly like what we experience in business.

To illustrate those four phases to you, I will use a graph that you are doubtless all familiar with, not necessarily this exact graph, but you are all very aware of how housing prices have performed over the past 10+ years.

For the first 20+ years of this graph, housing prices were moderately volatile.  There were some large swings as well as short term bounces in housing prices.  We will call that a Moderate period.  Then for a few years, prices went almost straight up.  We will call that phase a Boom.  Which as we all well know as followed by a Bust.  But the unusual thing about this chart is that it very clearly shows the environment that we all have been struggling with for the past 3 – 4 years.  A time when things do not seem to be going in any direction.  An Uncertain phase.

What I came here to tell you is that Resilience means something different in each of these four phases.  And the firms that are the most Resilient will take advantage of the best strategy during each phase.

During the Boom, the best Resilience strategy is to Grow!  Triage is the strategy best suited Resilience strategy for the Bust.  During the Moderate phase steadily Improving is the best strategy.  And during Uncertain times,  as you have all figured out the hard way is to Diversify your business.  The good thing is that these four phases will be repeated and  some version of these four strategies will always be the best Resilience strategy for your firm.  Let me now take you beyond the one word description.

The strategy of the Boom is Growth.  That is not obviously a Resilience strategy.  But here is where I borrow the most from the biologist, Holling.  In Holling’s view of living systems, the species that had the best long-term resilience were those that took advantage of the best times to grow to be the most numerous and the strongest.  So Grow your business and Grow your balance sheet during the boom.  It is not hard to notice the start of the Boom.  Either your sales start to jump, or else, you notice that your competitor’s sales will jump.  During the Boom, your job will be to help to fund that expansion of capacity that is needed to grow.  The thing to watch out for is that at the end of the Boom, many, many firms have borrowed very heavily to fund their growth, and some of them are stuck with one plant too many, possibly even an unfinished plant built entirely with borrowed funds.  So for the Boom, you want to make sure that your firm can grow and take advantage of the great environment but you need to be on the look-out for the end of the Boom and help to steer your firm away from making that one too many expansionary steps.  A tricky call to make and not likely to be a popular position at the time.

The strategy of the Bust is Triage.  Trimming away those pieces of the operation that are not self supporting and not reliably profitable.  This is a drill that many of you have gone through several times now.  The Bust phase is not hard to recognize, as you know.  The bottom falls out, sometimes very quickly, and other times gradually over a few quarters.  This Triage operation needs to be started as soon as the Bust is clearly upon you.  There may not as much resistance to the Triage during the Bust.  The problem is to make sure that your firm will still have the resources for growth that will come with the end of the Bust.  The Biologist view of this phase is that the Resilient species is that the most Resilient species are the ones that can both survive their worst environment but also be healthy enough to successfully go around the cycle one more time.  So minimal survival is not sufficient.

The Moderate environment is when the somewhat boring strategy of Improving is best.  In this environment the little things add up.  Your engineers and quants and other expert employees are the best asset of the company.  Improve is a resilience strategy because these improvements are small and carefully implemented.  The Moderate environment still is dangerous and changes must be made carefully.  It is a little tricky to see the start of a Moderate environment, the indications of its start are mostly negative – extreme events, both good and bad become less and less common.  Those of us with a financial background will mostly feel at home in the Moderate background.  If your among the older half of the audience today, you doubtless remember well the Greenspan led “Great Moderation” from 1984 to 2001, a long time with only moderate ups and downs in the economy.  Our abilities to help to carefully fine tune a company to maximize its efficiency were very valuable and in demand.

But it is important to realize that that very push for efficiency gradually starts to reduce Resilience and in some ways that Great Moderation with the almost 20 year period of Improve strategy created the fragility that helped to make the Great Recession so toxic.

More on this in a minute.

Finally, in Uncertain times Diversity is the best Resilience strategy.  That means that you need to move away from the strategies that concentrated all of your investment into those things that you did best and instead limit the degree to which your firm is dependent on any one product, or territory or distributor or supplier or manufacturing process.  You have also been building up your firm’s cash position.  And as the Uncertain times persist, you start to see opportunities to acquire smaller firms who can help to broaden your base even further.  With the Diversify strategy, you are admitting that you are not really sure what will come next.  That any of your business units may be the next growth opportunity or any might well tank completely.  However, you need to be aware that the Diversify mindset is toxic when the Uncertain period ends.  Then you will need to shrug off the slow and careful decision-making and the undercommittment.

So what is next?  That will certainly vary by sector.  Some sectors, like energy extraction have already entered a new Boom.  But for most of us, the most likely course is for the Uncertanly to gradually reduce and for our environment to slide into a Moderate phase.  That may have already happened in your sector.  Have you noticed it?

And when it does, you will be back in the game of promoting Efficiency and Improvement as the Resilience strategy of the firm.  Slow and gradual growth of business and of margins.

Since I expect that the Moderate environment is most likely next and because the Improve strategy that is the best Resilience strategy for that period is the strength of us financial types, I want spend just a little more time looking at how the Improve strategy works, when it is working well and what happens when it starts to erode Resilience.

You all likely to remember fondly your first big win in a Moderate environment.  You came in and quickly identified something that was ripe for a change.  Something where the operations were highly inefficient and you made sure that things changed and a big turn around happened.  You really felt that you added to company value and to your own reputation.

Over time you were able to make many such improvements, on this picture, moving virtually everything on to the efficient frontier.

Then you felt the need to find more wins.  You were imagining that you could help to completely change the game, to move the possibilities upwards.  But in some cases, what happened instead is that you did change the game, but what you did was not exactly improve efficiency of the system, instead, you started to reduce the amounts of redundant resources of the system.  That improves the expected returns, but often drastically reduces Resilience.  On the picture above, you wanted to move from A* to A++ and instead you moved to A–.  You got the extra return that you wanted but increased the risk and reduced the resilience.  Some of the slack that you removed from the system was really needed, the system becomes very fragile without it.

So far I have been very theoretical here.  Let’s think of this in terms of Outsourcing.  Outsourcing often looks like a game changer, moving to A++.  But the reduced costs of outsourcing are only a game changer if your subcontractor maintains a similar or better resilience as your insourcing alternative.  If what you are getting is paying less for less Resilience, then you have moved to A–.  More return but at a possibly markedly increased risk.

And if you are Outsourcing something that is of primary importance to your business, then you have shifted the required key competence for your firm to succeed.  If you key competence had been to manufacture Part XYZ, and you Outsource that work, then the key competence that you now need is the management of subcontractors.  Some of the savings that you think that you are getting comes from the fact that you did not necessarily factor in enough cost for management of the subcontractors.  And a key questions becomes whether you can be sure that your firm can keep the same degree of resilience so that it really is an A++ move and not an A—move that trades off cost for Resilience.

Leverage or debt is that way that we get this wrong in the financial sector where I work.  In our sector, the relationship between equity capital and risk is the key to resilience.  But many banks and insurers will lever up their business, increasing profitability for shareholders while decreasing Resilience.

One of the key problems in even noticing this issue of decreasing Resilience with increasing efficiency is that the problem is hard to see.  Resilience is clearly a corporate asset, but it does not appear n the balance sheet.  Accounting gives exactly wrong signals about risk and resiliency.  Reducing resiliency will usually be reported on an accounting statement as an improvement in financial condition.  It is profitable.  That is a big problem because RISKS IN THE LIGHT SHRINK AND RISKS IN THE DARK GROW.  (Ingram’s Law of Risk and Light).

Now let’s look at how these ideas apply to the risks that concern us the most.  A survey conducted by Allianz Insurance Group produced this list of Top Risks for 2013:

1. Business interruption, supply chain risk
2. Natural catastrophes
3. Fire, explosion
4. Intensified competition
5. Changes in legislation and regulation
6. Market fluctuations
7. Theft, fraud, corruption
8. Loss of reputation or brand value
9. Commodity price increases
10. Credit availability

Let’s look at how these ideas about Resilience apply to some of these top risks:

Supply Chain

This is usually a major part of your basic business.

•  Grow – Have suppliers or alternates that can handle big increases in your orders
•  Diversify – Multiple really different options
•  Improve – Need the most efficient supply chain BUT highest efficiency is VERY FRAGILE
•  Triage – Trim without killing supplier

Natural Catastrophe

Natural Catastrophes are one of the random elements that can trigger shifts in the Environment. The year after the SF EQ of 1906 saw a major recession in the US with a 30% drop in industrial production. In recent years, major cats like Katrina have not triggered such a shift.  Seeing Sandy shut down NYC for much of a week was a shock.  A few buildings not two blocks from here were not back in operation until the end of May. In 1995, Kobe earthquake caused an unexpected drop in the Japanese stock market which led to the failure of Barings Bank

You assess RESILIENCE to Nat Cats with stress testing.  I would suggest testing stress scenarios that are two times the worst prior event

Fire, Explosion

•  Grow – Will be adding buildings quickly
•  Diversify – Don’t concentrate operations – no single fire can hurt much
•  Improve – Concentrate operations for max efficiency.  Outsourcing means your resilience is affected by theirs – Bangladesh mill collapse
•  Triage – Resilience is a factor in choosing which buildings to close

 Competition

•  Grow – Big First mover advantage – popular to say that you are fast follower, but some followers get in fast enough to get the highest margin business, some delay just enough that they get none of the best business, Some are moving in just as the first movers are moving on to some other category killer.
•  Diversify – Watch out for others who are diversifying into your market.  They will heedlessly reduce margins.  Make sure that you are not playing that role in some market that you are diversifying into.
•  Improve – Arms race with competitors.  Do not try to believe that cutting costs is a long term strategy for a company.
•  Triage – Temptation to keep looking over at your target competitors.  Don’t do that during the Bust.  That can be fatal.  You can end up following them off of the cliff.

Disclosure

I want to say just a few words about disclosure for two reasons.   First, because it is a new hot topic and second because I want to repeat something that I heard an insurer CRO say that I wanted to share.  The hot topic part of this is that the SEC has recently spoken out about risk disclosures – specifically saying that boilerplate was not sufficient, that meaningful risk disclosure was required.  And for the most part, all US firms risk disclosures are boilerplate.  And in fact, not particularly thoughtful boilerplate.  So, in advance of a major loss event, you need to make an attempt to disclose the risk that might lead to the loss.  Then comes the question of disclosing risk mitigation and other risk management activities.  Most companies do not disclose.  That decision is highly questionable in my mind.  If you are a company that is doing all that you can to promote Resilience thinking and actions, you look no different from the firm that does exactly nothing.  My guess is that these decisions are made based upon a risk only analysis, rather than a risk reward analysis.  However, after you have suffered a major loss, from a practical point of view, it is more or less mandatory to start disclosing those practices.  I am having trouble understanding that logic tree.  Maybe you do.

The idea to share, that you may want to consider when you reevaluate your policy regarding these disclosures is that a perception among investors that you are acting responsibly towards your risks that is formed from your repeated disclosure of those activities would go a long way towards putting you in the position of not needing as much apology after the loss and will regain full investor confidence sooner than your competitors who do not tell such a story in years when there were no losses.  Think about it, how does that sort of thing work within your companies?

Conclusion

Holling said that the species that were the most resilient grew enough when the environment was right so that there were still enough members left at the end of the bust.  And they also were able to avoid making any fatal errors in any of the other environments.

So my final advice is:

• Choose the right Resilience strategy in each environment so that the company has the capacity to both survive the next bust, but also come out of it strong enough to thrive and grow in the following cycle of Moderate and Boom environments
• Take care not to unconsciously destroy resilience when increasing efficiency
• Shine a light on those risks in the dark
• Stress Test your most dangerous risks to find weaknesses
• Pay attention NOW to what you will need for the next environment