Black Swans

Opening eyes, minds and ears to the unpredicted rare events that can transform the swan song kiss of death into a resuscitating lifesaver for your company.

Abstract

Black swans emerge out of the ordinary unpredicted events that can take a company under. In today’s flattened global world, black swans can fly in from out of the blue—or they can surface from internal waters. Because black swans are so extraordinary, it is human nature to want to deny that such events can happen to the corporate cultures in which we live. And while denial is bliss, at least for its duration, denial of threats—real or potential like black swans—has leveled many a company and been at the heart of the end of life for individuals, organizations and entire cultures.

Short-term success and longevity, in personal and marketplace health, requires moving beyond denial to open eyes, ears, and minds to the lowest probability threats—internal and external black swans. In this paper, we highlight why it is natural to deny danger, the price of maintaining a stance of denial, and the value of opening eyes and minds to high probability threats and lowest probability black swans. We also introduce a simple methodology for identifying and eradicating denial in order to identify and address risks, including the black swans that may be lurking in the waters outside or inside of your organization.

Black Swans Can Save Companies

What would a catastrophic event mean to the shareholder value of your company?  The possibilities are endless, ranging from short-term losses to the end of dynasties and companies.  A company can evaporate if the founder denies external competitive forces; Compaq driven into oblivion by desktop computers in every home. An organization can be taken down if senior leaders deny what customers want; Mom-and-pop stores replaced by big box Wal-marts. While denial of the unlikely black swans may provide a sense of security and control, you don’t ever want to experience the infecting limitlessness an internal or external black swan can develop.

John Corzine managed to keep MF Global above water from March 2010-12 only to bring the company spiraling down in bankruptcy, lawsuits and federal investigations.  MF Global is still unraveling its demise and continues to be sued as the turmoil unravels. With over 1.2 billion dollars still missing in customers’ funds, John Corzine made the fateful decision of becoming CEO without adequately understanding the risk MF Global was facing. Without opening his eyes to the risks posed by more ordinary white swans or the potential risks of extraordinary black swans, Corzine may have appeared to provide leadership but, in reality, he blindly led the company on a catastrophic swan dive.

Or maybe we just need to look to last year’s headlines highlighting the disruption of the supply chain for the automotive industry.  According to senior advisors at Booz & Company in 2011, two major ‘black swan’ style catastrophes, the Japanese tsunami and the flooding in Thailand, forced automakers, including Toyota, Honda, and others to curtail production around the world.  We would bet that there was a full range of risk measures and detailed contingency plans put into effect by the Japanese auto industry. But these were developed to deal with more predictable and common risks, the white swans, did not consider the low probability external natural disaster of the tsunami and the impacts of such a black swan event including the devastation of the supply chain in Japan for many months to come.

While we are not advocating a ‘doom and gloom’ approach or over-analysis paralysis to management and leadership decision-making, we are suggesting that the bliss of denial has hard-hitting, fatal impacts when the risks of low-probability black swan events are not considered. In fact, our brains are hardwired to avoid black swans, as this is the way our furrier ancestors survived. Today’s avoidance is aided by our more developed brain. Rather than strictly fleeing or hiding under a pile of rocks, we harness more evolved mechanisms for survival—denial reigns. “It’ll never happen to us” or “what are the chances of…” and with a shrug of the shoulders we go about our merry business, hiding under piles of work that assure us that no black swans will raise their heads here. Somewhere between the bliss of denial and the paralysis of the-sky-is-falling analysis lies a smart approach to predicting, assessing and readying for risk, the high and low-probability kind. We call this approach risk-readiness and with risk-readiness and the strategies to up your risk IQ, you can learn to look out to the risky horizons ahead—and to get smart in the face of risks that make others stupid.

How about you? Are you looking ahead to risky horizons? Are you risk-smart thinking clearly to make decisions and take action with due diligence as opposed to inadequate diligence that leaves you exposed- or too much diligence that leaves you stuck on the starting line of ‘paralysis by analysis’ while your competitors leap to the front of your competitive pack?  Are you ready for the corporate tsunamis that can be hurled by the competitive marketplace or the global economy – think Compaq, Bear Stearns?  Have you truly considered and identified the internal curve balls, the low-probability black swan risks that leaders and teams bring to each other when they resort to protecting their own turf at the expense of shareholders, customers and trusted team members – think Dennis Kozlowski of TYCO? Just ask Roger Clemons or any professional hockey player who watched from the penalty box as his team was scored against in a playoff game—when we do not consider the risks associated with high-probability or unusual ‘black swan’ events, we leave ourselves, our teams and team members, our organizations and cultures open to be taken down.

So if considering and planning for risk is critical to short-term success and longevity, why isn’t everybody busy working the strategic risk plan? The answer is simple and grounded in human nature—uncertainty is at the root of denial. We humans defend against anything that is uncertain because uncertainty leads us to feel threatened. Uncertainty generates a sense of perceived threat that leads to the flood of chemicals associated with stress. These chemicals literally make us stupid and limit our ability to realistically assess or deal with risk. What we know from brain science research is that the natural chemicals released in the face of uncertainty, change, perceived threat and loss actually shut down the front part of the brain that lies just beneath the forehead. This is the part of the brain that enables us to think abstractly, strategically, and innovatively—i.e., to consider and deliberate potential solutions and to make a well-informed decision. That’s because, too, the natural chemical deluge released also limits the ability to shift attention, to take different points of view, to consider alternate choices. Instead, in the face of uncertainty, we narrow in to the one point-of-view that is our natural style—

Denial of risk, of swans of light or black color, is the most risky business—can end lives and ruin the quality of any life left—or of shareholder value.

Risk is a top priority of public companies since they are now starting to learn that compliance is not enough—commitment is required. With risk as a top priority, there is increased pressure on Boards to assure that potential catastrophes are identified and strategies developed to deal with even the extremes such as the ‘black swans’. Black Swan events are defined as unlikely events that are random and unexpected like a life-threatening curve ball or winning the World Series when your team is down x in the last 3 minutes of the game. The unlikely events that happen in sports move markets and billions of dollars not unlike the events that have happened on Wall Street over the past three years.  2011 is to be known as the year of 70 bank failures in the US and with 17 banks racking up billions of dollars of additional lawsuits still to come. Also, the 15 worst data security breaches in history has happened right on top of these bank failures exposing Intellectual Property and Personal Identifiable Information into the double digit billions.

Black Swans can save your company and they are easy to identify, mitigate and transfer. Well actually, the only aspect of a Black Swan that is easy is that it is extremely unlikely that a Black Swan will occur.

Perhaps it is appropriate timing for boards to focus on such unlikely events and predictable surprises for lately the frequency of occurrence of extremely unlikely events and predictable surprises has been increasing. Predictable Surprises have three characteristics: at least some people are aware of the problem; the problem gets worse over time; and eventually the problem becomes a crisis much to the surprise of most. On this definition Japan’s tsunami was a black swan but the sub-prime was not, as several money managers made fortunes by betting on the market’s collapse.

To demonstrate the immediate need for Board’s and Senior Executives to consider Black Swans we only need to look at current events.  There have been so many devastating events of late that there is debate as to what events are being considered “Black Swan versus White Swan Events”—or are they just predictable surprises coming from our frail and weakened global financial structure.  Did all of these events happen because Boards, Management and their prevailing Enterprise Risk Management (ERM) systems failed to detect predictable surprises and early warning symptoms? Did they have a strong management system and, even so, an event still occurred?  Regardless of whether we label these potentially devastating events as predictable or extraordinary, as white or black swans, identifying and planning for risk is critical to success and longevity in the marketplace. Given that denial of risk and devastation is natural, it is even more critical that ‘black swan’ events be identified and that the risk be evaluated and plans made to mitigate or deal head-on.  Because, what we know for certain is this—such high-magnitude and low frequency events could bring down your company; destroy your brand and decimate shareholder value.

Just as athletes in sports must assess the risk of one move over another and plan for contingencies and curve balls, corporate leaders and Board Members must override the natural tendency to tighten up, run, fight, or freeze in response to the uncertainty inherent in risk. They must learn to get smart and stay smart in the face of high- and low-probability swans in order to assess risk and plan for it- the good, the bad, and the ugly, the white common birds and the black extraordinary swans.

Assessment—a full-brained assessment of the horizon opens the lens to see the whole truth, to expand beyond the stress-makes-us-stupid-in-the-face-of-uncertainty shortsightedness. To fully assess high and low-probability threats and risk, it is critical to harness the 4 lenses of attention: internal narrow, external narrow, internal broad, and external broad.

Assessment includes identifying the probability of the events occurring. One way for a board to evaluate the potential for such events is to require senior management to identify the top two or three events –three maximum-  for the enterprise.  Even if it turns out there is no Black Swan event exposure the process of arriving at this determination is very useful.  T he next step is that the board requires senior management to mitigate and/or transfer such risk.

Public Company Boards: Managing Enterprise Catastrophic Risks

Risk is a top priority of public companies with intense financial scrutiny by investors, creditors, Dodd Frank Act, SEC Mandates for Governance and Compliance, not to mention the “financial plague” hitting Europe.  Over the past 3 years we have experienced a global epidemic of failing banks and institutions that make us all question the risk oversight process currently in place for these institutions. Too many current boards still ignore their risk-oversight responsibilities to the detriment of their shareholders and the economy.

According to a 2011 IBM survey of 1200 CFO’s only 10% of major corporations employ Chief Risk Officers. Many current boards are taking action to revamp their risk oversight process by forming risk management committees at the board level and new risk oversight positions within the top management of their companies. Yet, given the appalling 10% identified by IBM, one could question the process for risk oversight at the board level.

The greater the uncertainty of the task the greater the amount of information that has to be processed between decision makers during the execution of the task to achieve a certain level of performance. (Galbraith, 1974:28) Are boards getting relevant and timely information about risks and are they able to control the information supply to board to make decisions? This is where an awareness of the natural tendency to deny risk is critical in order to keep the clear heads required to search over the horizon to look risk in the eye and then, with clarity of an engaged brain, to generate and lead the implementation of smart solutions.

It is imperative that board members work together with their management teams to develop risk management framework that ensure that the right and relevant information be delivered in a timely manner to the whole board when there is a surprise event or occurrence happening and, better yet, when such an event looms on the horizon.  The framework for this process needs to be put in place with planning prior to any Black Swan event.  The board and management must share this process; according to many public company board members interviewed for this paper the most common theme is that boards do not readily discuss risks that are complex and hard to understand.  Also, risks that need a lot of data points to be understood are often overlooked due to their complexity.  Many board members rightfully are looking for senior management to “boil the ocean of data down to its simplest form so it is relevant and understood by all board members and stakeholders.

Risk oversight at the board level should not be complex. It’s usually proof of exceptional understanding of their jobs when senior managers can “boil an ocean of data down” to elegant and salient points for the board. Here is the key element: the board must demand and accept nothing less than exceptional managers who have the ability to explain what they do simply. It needs to be a living process updated and used by all relevant stakeholders. Fundamental to implementing such a process is to assure that both Board Members and senior leadership hold the critical information and data; to change their ways of working together, and to shift their minds about the reality of risk and how to proactively approach risk so as to minimize the likelihood, occurrence and impact when curve balls are hurled from the sidelines.

Most company’s risks are as unique as their business models.  A risk audit and gap analysis can be done for any size company with the right framework and common mission of identifying gaps in the risk oversight process that can be monitored, mitigated and managed.

According to a Fortune 500 Board Member who chairs an audit committee and is a member of three public boards the number one priority for risk oversight is to enact a business continuity plan at the board and enterprise level that is tested and monitored.  This type of risk planning could save the company their brand and from their own financial demise.  Also, the board may find that you have all the process but not the right people to carry out the best practices on risk management. According to several other board members interviewed the risk oversight process lacked the right human capital and leadership to overcome some of the enterprise wide risks that were identified. In these examples most of the board members exercised their fiduciary duty and made the changes in positions or leadership that enabled the organization to manage the risks more effectively.

While it is management’s duty to set the enterprise risk appetite and tolerance, the board ultimately must approve these measures. Boards can help identify “Black Swans” by challenging basic business assumptions and provide first-mover advantage.

Some of the basic principles Boards need to put on their agendas include:

  • Define the corporate risk appetite and risk tolerances that will reduce the risk of ruin
  • Identify the causes of failure and execute a business continuity planning for the enterprise
  • Develop a crisis management plan that activates a speedy response and recovery
  • Verify sources and the reliability of information for quality decision-making and factor in sustainability by taking a long-term perspective when they make short-term decisions

So if you are a board member or a senior manager reading this paper we hope you ask your self the following questions:

  • Has your Board been presented with the top enterprise catastrophic risks?
  • Do you know how the three top catastrophic risks and their affect on the financial value of the entity and its brand equity?
  1. www.investopedia.com/terms/b/blackswan
  2. FTfm, Financial Times, Vince Heaney, The Last Word, August 8, 2011.
  3. Footnote:  see “The Black Swan” by Nassim Taleb
  4. The Winner’s Way; A Proven Method for Achieving Your Personal Best in Any Situation (McGraw-Hill, 2004) by Dr. Pam Brill

Authors:

Mary Beth Borgwing, Author and Partner, Risky Horizons J/V

Michael Wiebe, Wiebe Associates, LLC