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August 29, 2011

Black Swans, Dark Clouds, and Silver Linings

Russ Banham writes, "Thanks to the global financial meltdown, we now know what a 'black swan' is. But do we know from which direction the next one will swim into view, and what to do when it does?" ["Disaster Averted?" CFO Magazine, 1 April 2011] The term "black swan" is now commonly used in the business world. It came into common usage thanks to Nassim Nicholas Taleb, author of the book entitled Black Swan. Banham provides his definition of the term:

"Black swans are, of course, those highly improbable but painfully consequential events that strike from the blue — or from the streets of Cairo, or from an offshore oil rig, or from a poorly designed car part. They can destroy a company's reputation, cripple its financial performance, and perhaps even kill it outright. Because they are rare and almost impossible to predict, black-swan events tend to fall outside the scope of most companies' risk-management programs (assuming a company has such a program at all)."

In a previous post, I noted that Ann Grackin, from ChainLink Research, insists that just because some events are rare it doesn't mean that we can't or shouldn't forecast them. That may sound oxymoronic, but Grackin writes, "Creating a resilient enterprise is critical to customer protection and employee welfare, as well as securing the financial viability of the company. Yet many firms think that since rare events are unpredictable, then there is no sense in doing much about them other than 'risk transfer' (purchasing a risk product, if one is available, such as product liability, property and casualty and so on). ... Modelers and forecasters look through a faulty lens; they discount these events because they are rare." ["Black Swan? Hardly! Revolutions and Tsunamis Come and Go!" 5 April 2011]

Drawing from Taleb's work, Grackin goes on to argue that forecasts can take into account rare events using history and a little common sense as a guide. She concludes:

"Crying out 'Black Swans' may be chic, but many of those who do may not understand Mr. Taleb. He challenges the notion that these are random and therefore unpredictable events, so we can't plan and predict better to avoid being impacted. His perspective is that they are not as random as you think and that a lot of common sense—and evidence in plain sight—would lead people to more enlightened behaviors and preventions."

I agree with Grackin. We know that bad things can and will happen. For example, hurricanes, like Irene, that run furiously up the East Coast of the United States into New England are rare, but not unprecedented. The recent Virginia-centered earthquake is another rare, but not unprecedented, occurrence. Events, like hurricanes, earthquakes, tornadoes, and flooding, can affect all commercial sectors in an affected area. We also know that each industry sector has some unique "bad things" that can affect business. Although I agree with Banham that we don't know the specifics about these events, for planning purposes, generalities are as good as specifics. Clearly, Banham and Grackin believe that lack of specific information is no excuse for not doing some planning and preparation in advance -- because bad things do happen.

The Great Recession continues to cast a dark cloud over the economy; however, as the old adage goes, "Every cloud has a silver lining." So what is the silver lining of this particularly dark cloud? According to Banham, the good news is that there's been so much bad news that Enterprise Risk Management may take off. He writes:

"Hope springs eternal for the proponents of enterprise risk management (ERM), a 10-year-old integrated approach to managing a broad spectrum of risks. A recent spate of black-swan events, combined with an equally long list of regulatory imperatives, will now, they say, spur widespread uptake of ERM. ERM is, above all, a strategy for overcoming the once-common siloed approach to risk management in which different people within a company focused on different kinds of risk, with little to no interaction between them. In contrast, ERM offers a 'holistic methodology' for identifying, assessing, quantifying, and addressing strategic, operational, market, financial, and human risks in order to optimize the risk-return profile."

I couldn't agree more with Banham's point about the unsoundness of taking a siloed approach to risk management. In a recent post, I wrote, "Segmenting risk management rather than addressing it holistically is like trying to keep water out of a boat filled with holes." [Supply Chain Risks: Who's in Charge and What are They Looking At?] Banham claims there are three trends "converging that may, in fact, propel ERM to a new level of acceptance and maturity: corporate boards are under regulatory pressure to address risk management explicitly; proponents of ERM are making progress in having it acknowledged as a best practice for overall risk management; and new technologies are enhancing companies' ability to evaluate, measure, and prioritize risks, and to test and report on their potential impact." Banham continues:

"For large companies, there is little choice. 'There is enhanced [regulatory] scrutiny of how organizations manage risk,' says Henry Ristuccia, a partner with Deloitte & Touche and U.S. leader of Deloitte's governance and risk-management practice. 'Sitting by idly is not a solution.' That scrutiny takes many forms. The Dodd-Frank Wall Street Reform and Consumer Protection Act establishes new requirements for board risk oversight and reporting. Rating agencies, led by Standard & Poor's, now factor ERM criteria for financial and nonfinancial entities into the ratings process. The Committee of Sponsoring Organizations (COSO) rolled out COSO II (referred to by many as 'COSO ERM') in 2004 to establish requirements for risk identification, management, and reporting. And the Securities and Exchange Commission has sharpened its stance on risk management, creating a division in 2009 to, in part, create what Ristuccia describes as 'new requirements for enhanced proxy disclosure on how a board is executing its fiduciary responsibility for risk oversight.' All this activity should not escape the attention of CFOs, because, as Ristuccia notes, 'while more companies are now appointing chief risk officers, many don't have that position, and therefore responsibility for risk management ends up with the board and the CFO.'"

To learn why some analysts believe that defaulting to the CFO is a bad idea, read my post about "Who's in Charge" mentioned above. Returning to the subject of Black Swans, Harold L. Sirkin, a Chicago-based senior partner of The Boston Consulting Group, believes that companies can prepare for such events. ["How to Prepare Your Supply Chain for the Unthinkable," HBR Blog Network, 28 March 2011] He writes:

"Companies are always shocked when low-probability events such as an earthquake or a tsunami disrupt their supply chains ... because of two fallacies. One is the mistaken belief that no corporation can prepare for such events; they can't even be predicted. ... The other is the persistent feeling that supply chains represent a cost. Most companies focus on minimizing costs rather than maximizing flexibility, which would entail making large investments in supply chains."

Had Sirkin made that last remark in a keynote address at a supply chain professionals' conference, I'm sure he would have received a standing ovation. Sirkin's remarks, however, are aimed at CEOs. He asserts, "CEOs can take several measures to tackle the Black Swans that may affect their supply chains." His first recommendation is: "Be prepared to react." He explains:

"Could anyone have anticipated a 9.0 earthquake, a tsunami, and a nuclear power plant crisis? The question is irrelevant. Companies don't have to anticipate such events; they only have to be prepared to respond to them. They can ensure that by:

"Diversifying supply bases. It isn't enough to have several suppliers if they're all clustered in the same country or region. For example, many US companies depend on China as a supply base. What would happen to their costs if the renminbi's value rises overnight from RMB 6.5 to RMB 4.5 to the US dollar? How would they cope if the price of oil quickly jumped to $150 per barrel? Companies have to develop suppliers in different places — some close to home, some further away.

"Locking up supplies. Companies must lock up supplies the moment a low-probability event occurs. As soon as the earthquake hit Japan, a few smart companies placed large orders with suppliers outside that country and rerouted materials, so they could continue supplying products to customers. When shortages persist, only their competitors will pay the price."

Sirkin's next recommendation is to invest in flexibility. As I have noted in past posts, lean supply chains may save money, but they are also brittle -- and brittle things can break. Sirkin writes:

"Companies keep costs down by building supply chains that generate economies of scale. That was effective when companies made products in their home markets using locally produced components. Supply chains now span the globe. Japan, for example, produces approximately 40% of the world's electronic components including parts and materials for semiconductors, computers, automobiles, radios, telephones, and other communications equipment. Companies need to create dynamic supply networks that can adjust rapidly to sudden changes. They can do that by:

"Producing locally. Scale generates economies, but companies often find they have to make costly tradeoffs when they consolidate manufacturing units. A large consumer products company thought it could reduce costs by setting up a few regional manufacturing hubs rather than numerous local ones, for instance. It discovered that although costs did fall, the delivered price to customers rose. Local manufacturing had enabled the company to tailor products and to shift production from one facility to another when commodity prices differed or demand shifted.

"Variabilizing costs. Companies can lower their fixed costs and increase those that fluctuate with the market. One way of doing that is to outsource production. Many vendors, who apportion fixed costs among different companies, charge on a per unit basis. Alternately, companies can sign short-term contracts that carry few obligations. Variabilizing costs requires constant management attention as well as flexible suppliers. The advantage is that it gives companies more maneuvering room to buy, sell, or cancel orders as needs and costs change. The disadvantage is that they will have to pay market prices for fuel, raw materials, and components."

Sirkin concludes, "Static supply chains may save companies some money, but they have hidden costs that rise precipitously when unforeseen events occur. The Japanese crisis should convince executives that they can manage risk best by creating dynamic supply chains." Adrian Gonzalez believes that when it comes to dealing with Black Swans companies can create their own luck. ["Supply Chain Resiliency: Make Your Own Luck," Logistics Viewpoints, 20 April 2011] He writes:

"If you weren't significantly impacted by the Japan earthquake, or any other recent supply chain disruption, was it luck or preparation? ... [I'm] reminded ... of the book 'The Luck Factor' by Dr. Richard Wiseman, a psychologist based at the University of Hertfordshire in the UK. In a 2003 article published in Fast Company, Dr. Wiseman was interviewed by Daniel H. Pink (a best-selling author himself) about the book and his research findings related to luck. Here is an excerpt of their conversation that caught my attention:

"Isn't there a distinction between chance and luck?

"There's a big distinction. Chance events are like winning the lottery. They're events over which we have no control, other than buying a ticket. They don't consistently happen to the same person. They may be formative events in people's lives, but they're not frequent. When people say that they consistently experience good fortune, I think that, by definition, it has to be because of something they are doing [emphasis mine].

"In other words, they make their own luck.

"That's right. What I'm arguing is that we have far more control over events than we thought previously. You might say, 'Fifty percent of my life is due to chance events.' No, it's not. Maybe 10% is. That other 40% that you think you’re having no influence over at all is actually defined by the way you think.

"More than likely, if you've emerged relatively unscathed from a supply chain disruption, it’s because you’ve taken action ahead of time to eliminate the risk, minimize the impact, or ensure a rapid and effective response. ... The bottom line: Luck happens or you make it happen. Supply chain leaders should always opt for the latter."

I believe that all of the experts cited above would agree with Gonzalez that companies that make determined preparations for dealing with disasters are improving their chances that fortune will smile upon them when Black Swans occur. In other words, instead of looking for silver linings, start sewing a few for yourself.

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