volume 1 perspectives on RISK the risks that will ... · the risks that will determine your company’s future ... we are pleased to introduce our inaugural ... double-digit rate

perspectives on the risks that will determine your company’s future

the oliver wyman

RISK jouRnalvolume 1

1RISK JOURNAL

Complex risks increasingly define the global

competitive landscape. Volatile commodity

prices, recent political unrest in the Middle

East and Japan’s earthquake all underscore how the pace, scale and impact of risks are increasing. In many

ways, rapidly changing risks put on hold by the financial crisis are returning with a vengeance, as reflected

in commodity prices that have rebounded back to the historical highs they first reached in 2008. While not

all of these prices may spike up much further, it’s clear their volatility will continue and possibly even

increase, creating new threats and opportunities for companies across the board. Companies can develop a

significant competitive advantage if senior executives make risk-adjusted decisions and anticipate how

these risks will reshape their industries. For this reason, it has never been more important for senior

executives to consider how they will respond to risks and their knock-on effects.

In recognition of this new reality, we are pleased to introduce our inaugural edition of the Oliver Wyman

Risk Journal. This publication is a collection of perspectives on what we consider to be key risks that will

determine many companies’ futures. Oliver Wyman’s Global Risk & Trading practice is launching this publi-

cation, which includes contributions from many different parts of the organization. It reflects our firm’s

broad expertise in risk management as well as the research we produce with the Oliver Wyman Global Risk

Center and top professional associations, non-governmental organizations and academic institutions on

issues that involve multiple industries and countries.

Many of the topics in this journal are intensely urgent. Our issue opens with a discussion of how volatile

commodity prices are rewriting the rules of industries ranging from airlines to food manufacturers by intro-

ducing unpredictability in their earnings. We then examine how commodity trading paradigms must

change—and swiftly—if trading organizations hope to benefit from the return of volatility to the markets.

Other stories explore how companies can better prepare for a number of other significant risks, such as

supply chain disruptions and information technology failures, or emerging risks that may initially appear

unrelated to a company’s business until an unanticipated event occurs. We also examine the difficult

trade-offs that countries and companies face when they pursue clean energy, the risks inherent in large

investment projects and a fundamental reason why banks still struggle to achieve their financial goals—

the data on which they base decisions is often faulty.

In each case, the authors offer practical advice on how to tackle trends that are increasingly redefining the

rules for business. Our goal is for these articles to inform as well as to provoke a reexamination of how your

organization conducts risk-adjusted decision making. I hope you will enjoy reading these perspectives and

that this publication will spark some interesting thoughts along these themes that we can discuss.

Roland O. Rechtsteiner

Managing Partner

Global Risk & Trading Practice

IntroductIon

2 RISK JOURNAL

VOlatile COmmOdity PRiCes

4 Volatile commodity prices should be on the CEO’s radar screen John drzik

8 Volatile agricultural prices are rewriting the rules for the food industry michael denton, mark Robson, alex Wittenberg

14 Airlines need a new game plan for hedging fuels – now Cantekin dincerler, mark Robson

Changing tRading PaRadigms

18 How to overcome implementation risks when setting up a new commodity trading business Cantekin dincerler, ernst Frankl, Roland Rechtsteiner

26 Why traders need more comprehensive risk and pricing frameworks in a fundamentally changed business environment michael denton, alexander Franke, Christian lins

34 Six lessons for commodity traders from the tragic events in Japan alexander Franke, Boris galonske, Christian lins

contents

3RISK JOURNAL

eneRgy sustainaBility

40 What country leads the world in providing stable, affordable and clean energy? The answer is that no one does. And that’s a problem John drzik

suPPly Chain disRuPtiOns

46 Why companies need to behave more like their own credit rating agencies michael denton, Boris galonske

emeRging Risks

54 Companies need to improve their ability to identify and prepare for emerging risks

alex Wittenberg

inFORmatiOn teChnOlOgy FailuRes

60 A new framework for boards of directors to manage IT risks Jonathan Cohn, mark Robson

mismanaged laRge PROJeCts

68 The “missing link” in infrastructure finance John larew, mark Robson

FinanCial Risks

74 Why do banks still struggle to achieve their financial goals? The data on which they base decisions is seriously flawed James mackintosh, Paul mee

4 Risk JOuRnal

COmmOdities Hot

John drzik

volatIle commodIty prIces sHould be on tHe

ceo’s radar screen

5Risk JOuRnal

Japan’s nuclear crisis and political unrest in the middle east have triggered price spikes and supply disruptions in everything from oil to wheat to gold. it might be tempting to view these recent price swings as a temporary phenomenon. they’re not. they are the new normal.

Changes in both supply and demand dynamics are likely to create a long period of sustained commodity price volatility, with significant downstream implications for many businesses. The recent Global Risks 2011 report published by the World Economic Forum with partners including Oliver Wyman revealed that 580 experts, business leaders and policy makers believe it is likely the world will experience extremely volatile energy prices, commodity prices and consumer prices in the next ten years.

There are a number of structural reasons for the sustained increase in commodity price volatility. Global demand for commodities such as food and energy will grow at a double-digit rate over the next decade due to population growth and increases in per capita usage driven by economic development. This rising demand will likely fuel investment in commodity extraction, encouraging players in these businesses to consider increasingly risky projects that will be more prone to disruption.

Supply disruptions will also be more frequent due to changing climate patterns and the increasing number and magnitude of extreme weather events that they will cause. Floods, droughts, hurricanes and many other types of extreme weather events are all projected to increase in the next decade. Shortages in some regions will likely be further exacerbated by a rising number of governments taking unilateral actions to cope with their scarcity of resources. In the last twelve months alone, Russia, Pakistan, India and Vietnam have all restricted exports of agricultural commodities ranging from grain to cotton to rice.

Further price swings might also be created by political choices related to the trade-offs inherent in addressing interconnected resource shortages. For example, the International Energy Agency predicts the globe will need 3.2 million barrels per day of biofuels to meet policy incentives related to reducing vehicle emissions. However, producing those fuels could amplify food shortages and put further pressure on water shortages as well. The range of geopolitical and environmental uncer-tainties surrounding commodity supply will also likely fuel financial speculation in commodities—amplifying price volatilities even further.

volatIle commodIty prIces

$1 trillionHow much more

companies and

consumers will

need to pay for

oil in 2011 if us

oil contracts

remain at $110

per barrel

6 RISK JOURNAL

PER

CEI

VED

IMPA

CT

IN B

ILLI

ON

US

$

PERCEIVED LIKELIHOOD TO OCCUR IN THE NEXT TEN YEARS

ECONOMIC RISKS

Asset price collapse

Extreme commodity price volatility

Extreme consumer price volatility

Extreme energy price volatility

Fiscal crisis

Global imbalances and currency volatility

Infrastructure fragility

Liquidity/credit crunch

Regulatory failures

Retrenchment from globalization

Slowing Chinese economy (<6%)

GEOPOLITICAL RISKS

Corruption

Fragile states

Geopolitical conflict

Global governance failures

Illicit trade

Organized crime

Space security

Terrorism

Weapons of mass destruction

ENVIRONMENTAL RISKS

Air pollution

Biodiversity loss

Climate change

Earthquakes and volcanic eruptions

Flooding

Ocean governance

Storms and cyclones

SOCIETAL RISKS

Chronic disease

Demographic challenges

Economic disparity

Food security

Infectious diseases

Migration

Water security

TECHNOLOGICAL RISKS

Critical informationinfrastructure breakdown

Online data and information security

Threats from new technologies

unlikely likely very likely

1000

500

250

100

50 Space security

Extreme consumerprice volatility

Threats from new technologies

Ocean governance

Online data andinformation security

Infrastructure fragility

Global governance failures

Economic disparity

Extreme energy price volatility

Climate changeGeopolitical conflict

Fiscal crises

Migration

Air pollution

Critical informationinfrastructure breakdown

Slowing Chinese economy

Weapons ofmass destruction

Regulatory failures

Food security

Retrenchmentfrom globalization

Extreme commodityprice volatility

Infectious diseases

Earthquakes andvolcanic eruptions

Storms andcyclones

Biodiversity loss

Flooding

TerrorismIllicit trade

Corruption

Organizedcrime

Fragile states

Demographic challengesChronic diseases

Water security

Global imbalances andcurrency volatility

Liquidity/ credit crunch

Asset price collapse

Higher perceivedlikelihood

Higher perceivedimpact

GlObAl RISkS lAndSCAPE 2011

Source: Global Risks

2011: Sixth Edition,

World Economic Forum

and partners including

Oliver Wyman

Commodity price volatility, and its management, have always been critical issues in some businesses. For example, they have been on the agenda of airline CEOs since jet fuel prices (and their hedging) have been a strategic issue for some time. Similarly, CEOs of energy, chemical, pharmaceutical and food companies have had to grapple with commodity price volatility over the past several years. now, however, no matter whether a company competes in the technology sector, and therefore depends on rare earth minerals, or automotive and

cell phone sectors, and relies on semiconductors, commodity price volatility impacts the profitability of firms across the board.

nevertheless, many businesses treat commodity price volatility as a tactical management issue to work through periodically. Going forward, this issue should move up the agenda of many companies since the degree of impact of commodity price swings on the volatility of overall earnings will rise and be more than a temporal effect.

7RISK JOURNAL

The stakes are rising. Consider: On April 7, US oil contracts exceeded $110 per barrel for the first time in two and a half years. If oil prices remain at that level, we estimate that companies and consumers will need to figure out a way to pay $1 trillion more for oil this year than they did in 2010. but that estimate just scratches the surface of the costs that companies and consumers will need to bear since there have been recent increases in the prices of many other commodities as well.

As a result, businesses ranging from manufacturers to retailers to bakers are all struggling to manage the volatility that raw material prices are introducing into their earnings. Some are discovering that the cost of their electricity supply, for example, is becoming a core driver of their earnings. Others are being forced to renegotiate contracts with their suppliers—if they don’t accept higher prices, their suppliers are at risk of going bankrupt as they are paying much higher prices for raw materials.

CEOs need to determine the degree to which taking commodity price risk fits with their risk appetite and shareholder expectations. It might be that their investors expect the company to have this risk, and fully expect to see the resulting increase in earnings volatility that stems from increasing commodity price swings. However, it might also be that the bet investors are making on the company lies in other factors, such as superior opera-tional management or customer distri-bution. In these businesses, CEOs will likely want to mitigate the effect of commodity price swings on earnings.

These companies need either to invest in the risk management capabilities necessary to manage through a long-term pattern of heightened commodity price volatility or to redefine their business models (for example, through supplier contract structures) so they are not directly exposed to the risk. Separately, all companies should consider investing in methods and technologies that ensure more effective and efficient usage of resources and commodities to reduce their overall exposure to volatile prices.

We are entering a new age of commodity price volatility, likely to extend for ten years or more. The impact on the earnings volatility of many companies is likely to be substantial and sustained—resulting in a meaningful effect on shareholder returns. These companies need to consider whether they change their business model or management approach or both to align their commodity risk exposure to their risk appetite. CEOs should have this issue on their radar screen and take the lead in arriving at an answer.

John drzik is the CEO of Oliver Wyman Group

It is likely the world will experience extremely volatile energy prices, commodity prices and consumer prices in the next ten years Global Risks 2011: Sixth Edition


sePaRating the Wheat

8 Risk JOuRnal

from tHe cHaff

9Risk JOuRnal

michael dentonmark robsonalex Wittenberg

volatIle agrIcultural prIces are reWrItIng tHe rules for

tHe food Industry

First, wildfires damaged wheat crops in Russia, prompting the government to ban exports. next, heavy rains reduced Canada’s wheat crop outlook to its lowest level since 2002. then, massive floods in Pakistan threatened to turn asia’s

third-largest wheat producer from a wheat exporter to a net importer.

Growing concerns about wheat shortages worldwide are sending prices soaring. So far, these price spikes are not as dramatic as those experienced in 2008, which triggered bread riots in Pakistan and Egypt. And some analysts have started to openly question the validity of current fears about a return of food price inflation.

Regardless of whether wheat prices correct, it is clear that agricultural prices have entered a new age of volatility. Food companies, ranging from processors to manufacturers to restaurants, need to better prepare for a new market reality in which ingredient prices will increasingly impact their earnings.

For much of the second half of the 20th century, agricultural prices declined fairly steadily. In more recent years, many have tripled and remained at a high level over several seasons. In 2010, wheat prices jumped roughly 50 percent. Volatility more than tripled to 62 percent in the third quarter of 2010.

We believe such sudden shifts in agricultural prices are here to stay for several reasons. First, the global demand for food is increasing. As populations grow and become more affluent, people are consuming more protein and processed food.


10 RISK JOURNAL

Second, the frequency of agricultural shocks has been rising as the number of extreme weather events has tripled since 1980, according to reinsurer Munich Re. devastating floods in Pakistan damaged an estimated $1 billion of crops and left millions of people without food, shelter and water.

Finally, fluctuating agricultural prices are attracting financial trading participants who are contributing to unpredictable price movements. For example, british financier Anthony Ward helped send cocoa prices to their highest level since 1977 in July of 2010 by holding 241,000 tons of cocoa, according to the Wall Street Journal.

The potential impact of sharp swings in ingredient prices on the food industry is significant. If wheat prices remain at the level they reached in the second half of 2010, food companies will have to absorb an additional $2 billion in costs on an annual basis or pass them on to

customers. Since the sluggish global recovery makes it difficult to pass on a large portion of this cost to consumers, higher wheat prices could put a significant strain on some food companies’ working capital and margins. They may also drive more consumers to less expensive substitutes like private label products.

A reversal in wheat prices could create a whole new set of problems. Many companies have been benefiting from systematically buying a fraction of their future grain consumption for 12 to 24 months in the future. by buying far ahead in a slowly rising market, their actual costs have tended to be lower than the alternative of buying a full month’s supply at today’s higher prices. but that strategy will no longer work when the markets correct.

Food companies need to develop more sophisticated cost and margin

nATURAl CATASTROPHES ARE InCREASInG

Updated value due to

reanalysis of March 31,

1973, thunderstorm

event in Georgia and

South Carolina. The

previous economic loss

value for the 1970-

1979 period was

US$ 52 billion.

Source: Munich RE

0

10

20

30

40

50

60

1950-1959 1960-1969 1970-1979 1980-1989 1990-1999 2000-20090

50

100

150

200

250

300

350

400

EVENTS

EVEN

TS

ECONOMIC LOSSES

ECO

NO

MIC

LO

SSES

($B

ILLI

ON

S)

11RISK JOURNAL

WHEAT PRICES ARE SOARInG

Source: bloomberg


0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

$0.00

$2.00

$4.00

$6.00

$8.00

$10.00

$12.00

$14.00

2/8

/00

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/8/0

0

6/8

/01

2/8

/02

10

/8/0

2

6/8

/03

2/8

/04

10

/8/0

4

6/8

/05

2/8

/06

10

/8/0

6

6/8

/07

2/8

/08

10

/8/0

8

6/8

/09

2/8

/10

10

/8/1

0

PRICE ($/BU)

ANNUALIZED VOLATILITY

management capabilities to cope with agricultural price swings over the long term. Here are five ways your company can gain a competitive edge by limiting the impact of volatile agricultural prices on your results:

1) REExAMInE yOUR RISk AnAlyTICS Wheat flour accounts for as much as 30 percent of the cost of producing baked products like bread and cereal. And yet, food companies devote substantially more resources to managing changes in consumer behavior than they do to price shifts in key ingredients.

Savvy food companies should take advantage of this disconnect by developing decision frameworks to help reduce the impact of one of the most significant causes of uncertainty in their results—volatile raw material prices. looked at another way, agricultural price fluctuations have become a key lever to

stabilize profits. Food companies should consistently trace and review how highly variable ingredient costs reduce, or increase, profit margins. A well-defined decision framework includes both a recommendation based on evolving global market conditions and a playbook that defines the conditions under which a decision will be revisited.

2) THInk MORE lIkE A TRAdER Many food companies passively hold call options that protect them from price spikes until maturity because they mistakenly believe they are behaving like speculators if they unwind a hedging instrument earlier. In fact, restructuring a trade is often the most prudent step a company can take to achieve its commodity price risk management goal. Studies show that 70 percent of options turn out to be worthless once they expire. Food companies should regularly reevaluate whether earlier hedging trans-actions are still reducing the risk created

12 RISK JOURNAL

4) SCRUTInIzE yOUR EnTIRE SUPPly CHAIn Companies need to constantly reevaluate the earnings impact of formerly uncor-related prices of crops moving in lockstep, or if an entirely different class of commodity—like oil or natural gas—suddenly decouples. As the wheat crisis illustrates, that calculation is becoming much more complicated. The price of oats has already become more correlated with wheat because they are both grown primarily in Russia and Canada. At the same time, wheat prices have decoupled from the prices of other crops that are usually correlated like corn and soybeans.

5) InClUdE THE IMPOSSIblE In yOUR STRESS TESTInG It has become more crucial than ever for food companies to analyze if their products will remain price competitive even under new and unfamiliar conditions, especially given the rise of extreme weather events. Food manufacturers need to examine how immediate and longer-term commodity price shifts will impact their margins in a wide range of scenarios on both a hedged and unhedged basis. They should also consider the potential impact of events that are both historical and hypothetical across a broad range of commodity classes. Equally important, they need to scrutinize how macroeconomic events and funda-mental changes in the food industry, such as the growing popularity of private label products, could alter their results.

by agricultural price volatility in the current market. If not, they need to re-balance their portfolios.

3) ExPlORE AlTERnATIVE WAyS TO STAbIlIzE THE COST OF kEy InGREdIEnTS As agricultural price shifts increasingly create uncertainty in food manufacturers’ earnings, companies need to consider adopting measures beyond financial hedging instruments to lessen their impact. For example, they should explore alternative ways of acquiring supplies at a stable cost, such as long-term purchase arrangements that use a combination of fixed and indexed prices. Some food manufacturers, like nestlé, are even training farmers to grow coffee and supplying them with coffee trees. To be effective, companies must simulta-neously establish regular communication across departments ranging from procurement to treasury so that senior managers can evaluate if the organiza-tion’s entire range of commodity price risk management practices fits with its corporate objectives.

$2 billionthe additional

amount of

money food

companies

may have to

absorb in

extra costs

13RISK JOURNAL

As has occurred in the markets for energy, metals and minerals, the agricultural markets have permanently and funda-mentally changed. large agricultural price swings could potentially hurt unprepared food companies’ earnings and force them to make difficult trade-offs. Instead, they should build up the risk management capabilities that will allow them to effec-tively manage sharp shifts in the prices of key agricultural commodities like wheat.

michael denton, mark Robson and alex

Wittenberg are partners in the Global Risk

& Trading Practice


It is more crucial than ever for food companies to analyze if their products will remain price competitive even under new and unfamiliar conditions

14 Risk JOuRnal

starIng Into tHe eye of the stORm

cantekin dincerler mark robson

aIrlInes need a neW game plan for

HedgIng fuels - noW

15Risk JOuRnal

It may seem like a distant memory, but major airlines lost an estimated $8 billion on their jet fuel hedges in 2009. as crude oil prices spiked, tumbled, and then doubled back to about $70 per barrel, we estimate such hedges soared to become more than half of top airlines’ total

losses. after a period of minimal volatility, large fuel price swings are once again returning. the only question is which airlines will emerge from the turbulence in the strongest position.

The main reason why airlines are once again experiencing larger fuel price fluctuations is that energy markets have fundamentally and permanently changed. Jet fuel prices will continue to be volatile in nature in part because demand for all refined petroleum products often outstrips supply. Oil drilling has become more problematic and politicized just when fast-growing countries like India and China use more fuel than ever.

Complicating matters, energy trading participants like investment banks and hedge funds who benefit from fuel price swings are contributing to their unpredictability. To curb trading activities, the US Congress has passed financial legislation that will limit the size of trades for anyone not hedging fuel with the intent of actually using it. but banks and hedge funds will remain significant players.

Given the speed at which fuel prices are shifting, airlines should not be tempted into thinking this new law will solve many of their fuel hedging problems. Consider: Traditionally, jet fuel prices have appreciated by about 5 percent annually. Today, they move by that much on a weekly basis.

Most airlines are poorly equipped to respond to such price swings. After being blindsided by fuel price spikes in the last couple of years, many have imple-mented rigid and programmatic hedging strategies determined on an annual basis. Some airlines have abandoned hedging jet fuel prices altogether.

There is a better approach. now is the perfect opportunity for airlines to invest in fuel hedging programs and capabilities that can mitigate the instability jet fuel prices introduce into their earnings. Jet fuel is one of the largest expenses for many airlines and now accounts for about 25 percent of airlines’ total costs. Carriers have already extensively managed to lower labor, maintenance and other operation costs. As a result, fuel is arguably one of their largest unresolved risks. The amount of margin—or collateral—that airlines must deposit with counter-parties to carry out fuel hedges can put a strain on working capital that otherwise could be used for other parts of their operations. yet airlines employ many more full-time employees to handle the risk of potential operational problems than they do to control risks created by volatile jet fuel prices.


16 RISK JOURNAL

recommended buying shares in Asian airlines in part because these airlines are expected to increase their fuel hedging positions with lower risk profiles.

The critical first step for an airline to steady its fuel hedge positions is for it to develop a set of analytics that make regularly evaluating fuel hedging recommendations manageable. Such tools rapidly process a wide range of data to truly capture the jet fuel market’s dynamics. Savvy airlines base hedging recommendations on fast-changing information available in jet fuel research like Jet Fuel Intelligence newsletters, ARGUS International papers and industry analyst reports. In addition, they examine thousands of potential scenarios involving risks like fuel price spikes that collapse immediately and the sudden decoupling of traditionally correlated currencies and energy prices.

Most software programs designed to calculate an energy portfolio’s total value at risk cannot currently take such a wide

Some airlines recognize that introducing more sophisticated fuel hedging capabilities will distinguish them from their competitors. One airline recently built up a substantial energy trading team and invested in its own jet fuel storage so that it can supply fuel to other airlines. by doing so, the airline not only gains better visibility into what its fuel will cost, but also can potentially reduce the total into-wing expense.

Other stakeholders are placing a greater value on airlines’ fuel hedging capabilities as well. In May of 2010, Morgan Stanley

now is the perfect opportunity for airlines to invest

in fuel hedging programs and capabilities that can mitigate

the instability jet fuel prices introduce into their earnings

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

4/2/90 10/3/93 4/5/97 10/6/00 4/8/04 10/10/07 4/12/11

DO

LLA

RS

PER

GA

LLO

N

lARGE FUEl PRICE SWInGS ARE RETURnInG

Source: U.S. Energy

Information

Administration

17RISK JOURNAL

variety of factors into account. They are also designed only to monitor risks—not to form a strategy based upon them. As a result, hedging strategies developed using these tools often provide protection in some scenarios but cause significant fuel hedging losses in many others. by examining a much broader spectrum of issues in 2008, Oliver Wyman was able to design a framework that allowed one airline to meet its fuel hedging objectives in a much wider range of potential scenarios. It also reduced the volatility in the airline’s energy portfolio in a cost-effective manner.

For these tools to be effective, airlines must also introduce the appropriate infra-structure to conduct deep reviews of hedging recommendations on at least a monthly basis. Following a hedging strategy set at one particular point in time will not fix a fuel hedging portfolio’s problems. In fact, that may create more difficulties.

Carriers need to determine what type of hedging transaction makes the most sense for their portfolio at any given moment. Instead of pursuing trans-actions without upfront fees, they may need to use more sophisticated hedging instruments with upfront costs to protect them against the potential downside in their earnings resulting from the cost of fuel or hedge settlements. One way airlines can gain some clarity around these benefits is simply by estab-lishing more regular communi-cation between their purchasing and treasury departments regarding their current fuel price assumptions.

At the same time, airlines require a clear reporting structure that enables them to make important fuel hedging decisions quickly based on changing market infor-mation. Responsibility for market analysis, potential hedging strategies and their execution must be appropriately segregated. A risk oversight committee with authority to approve hedge recommendations should also be formed.

Coping with volatile jet fuel prices will continue to be a challenge for the airline industry. In the long run, the price of air travel will adjust to reflect the cost of fuel. However, large fuel price swings could potentially force unprepared airlines to make difficult trade-offs in the short term. Significant fuel hedging losses could compel airlines to cut back growth plans, slash other costs or raise their prices more than their competitors.

Some airlines are already making a preemptive strike to gain control over how increasingly complex energy markets impact their earnings. Oliver Wyman has developed proven approaches and tools that ensure the benefits of airline jet fuel hedges will far outweigh potential losses.

Cantekin dincerler and mark Robson are

partners in the Global Risk & Trading Practice


25% the portion of

airlines’ total

costs that jet fuel

accounts for

18 Risk JOuRnal

veneratIng VOlatility

cantekin dincerler ernst franklroland rechtsteiner

HoW to overcome ImplementatIon rIsks WHen

settIng up a neW commodIty tradIng busIness

19Risk JOuRnal

Most companies curse the unpredictability that volatile commodity prices introduce into their earnings. But traders have a very different point of view. For them, volatile prices spell opportunity. Without them, many struggle to eke out

above-average earnings. indeed, our research shows that commodity traders earned 35 percent less in revenues in 2010 than they did in 2009 in large part because commodity prices remained relatively stable until the end of that year.

With volatility racing back to the markets in 2011 and the success of commodity traders such as Switzerland-based Glencore, which is currently preparing for an initial public offering estimated to be worth more than $55 billion, it is not surprising that organizations ranging from vertically integrated oil and gas players to independent commodity traders are now racing to ramp up new trading operations. Commodity producers who used to sit on the sidelines, letting other traders capture trading margin, are now setting up their own trading businesses. For example, Saudi Arabia’s Saudi Aramco, South korea’s kEPCO and Abu dhabi Resources have all announced plans to enter the commodity trading business in the past few months. They are betting that current commodity market conditions will continue due to factors ranging from increasing global supply- demand imbalances, to extreme weather, to political unrest.

but setting up new trading operations isn’t easy. As with any large project, it involves myriad details that need to be worked out diligently. Only then will a company be able to launch a new trading business on time, within budget and with an end result that is what was originally envisioned.

In our experience, mastering three key risks will determine whether a new commodity trading operation will be successful. Overcoming these three areas of implementation risk involve: articulating a future trading model clearly, aligning stakeholders and achieving excellence in execution. Trading organizations that focus on these critical success factors for setting up new trading operations in a timely manner will set themselves apart from their competitors.

VOlatility

cHangIng tradIng paradIgms

20 RISK JOURNAL

1318

24

12

7

7

8

4

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9

4

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1

2

1

1

10

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2007 2008 2009 2010 2011e

OIL NA P&G EU P&G NICHE METALS INVESTOR

$39-42 BN

$51-53 BN

$54-57BN

$34-37BN

COMMOdITy TRAdERS EARnEd 35% lESS In REVEnUES In 2010 THAn THEy dId In 2009

Source: Oliver Wyman

ARTICUlATInG A TRAdInG bUSInESS MOdEl ClEARlyMost of the trading businesses now being launched are basing their business models on physical production from their parent company. In theory, this gives them the advantage of securing long-term supply positions from the very start. In practice, however, it is difficult to

reach a decision on what part of, and how much of, the physical supply should be transferred and at what price. That means a well-governed process needs to gain support from many stakeholders for this advantage to actually pan out.

To gain broad support, the amount of physical production that will be trans-ferred to the trading business, the new trading model, as well as the plans for building the new business, all need to be decided in detail. They also need to be communicated proactively in a clear and transparent way.

Moving from trading physical flows in order to optimize their value to proprietary trading for profit is a major shift in a business paradigm. Most vertically integrated oil companies are unfamiliar with the nature of proprietary trading. In fact, many have made a point of steering clear of buying and selling third party volumes for a profit or entering into positions that can not easily be offset by their own physical positions in the past.

Making matters more complicated, there is a high barrier to entry into trading. For

most vertically integrated oil companies are unfamiliar with the

nature of proprietary trading

21RISK JOURNAL

PRIMARY FOCUS OF ASSET TRADERS PRIMARY FOCUS OF

INDEPENDENTS AND BANKS

instance, for an oil trading company to be successful, it must build substantial operations. Consider: A world-class oil trader requires the equivalent of the amount of oil that Spain and France each use in a day, or 1.5 million – 2 million barrels of oil per day, to generate gross margins ranging from $400 million – $600 million. In our experience, a company will need to build an organization with 50 to 120 traders and approximately 150 to 400 support staff, to support handling that amount of physical product and the associated paper deals.

AlIGnInG STAkEHOldERSAnother key success factor is to engage key stakeholders continuously throughout the project from early on. For vertically

integrated oil and gas companies, the trading company will be a new entity within an organization that has tradi-tionally been made up of a strong upstream, midstream and downstream business. That means the establishment of a new trading company could have impli-cations for these other business units. It might even weaken their positions since a strong trading company can act as a central optimizer of all of the parent company’s commodity risks.

An effective and continuous communi-cation strategy must ensure that all of these key stakeholders are part of the design and implementation. Their voices should be heard and their contributions acknowledged.

dIfferent types of commodIty tradIng requIre dIfferent Business PaRadigms

PROPRIETARy TRAdInG

f Outright/ directional bets on market developments

f Arbitrage on cross-commodity, cross-location and inter-temporal pricing relationships

dEAl STRUCTURInG/ORIGInATIOn

f Selling of structured deals (e.g. writing options, selling virtual power plants) and collection of deal premium

f Gaining insight into market perspectives of other players

HEdGInG

f Reducing earnings volatility for physical business

f Management of risk exposures toward desired risk profile

ASSET OPTIMIzATIOn

f Monetizing flexibility in physical assets (e.g. adjusting product mix, scheduling and commodity delivery)

f Timing of buy/sell decisions for physical positions (e.g. Oil major - long crude)

MARkET MAkInG

f Enhanced insight into market development on the back of providing liquidity to other market participants by matching supply and demand

f Capitalizing on bid/offer spread



22 Risk JOuRnal

six suggested WORk stReams for successfully buIldIng a neW commodIty tradIng operatIon

WORk STREAM kEy RESPOnSIbIlITIES

WORk STREAM 1 – Overall Project Management

f Create detailed plan

f Track and question the progress continuously and rigorously

f Identify potential delivery risks and support/conduct quality assurance of deliverables proactively

f Support communication between project and stakeholders and among work streams

WORk STREAM 2 – Chief Executive Officer

f Promote the business model and business

f Establish organizational design

f design and agree interface definitions/agreements (trading vs. exiting business)

f design HR/Compensation

f Create ‘day one plan’

WORk STREAM 3 – Chief Commercial Officer

f Provide clear vision on the future activity set

f Support recruiting efforts and talent selection

f design new front office processes

f Ensure sufficient link to established parent company front office processes

WORk STREAM 4 – Chief Risk Officer

f Create an independent and powerful CRO and control function that also supports the business

f Align risk appetite of key stakeholders and operationalize through risk limits

f Create and implement a set of comprehensive best-in-class risk policies and processes

f Ensure link to existing (parent company) risk management approach

WORk STREAM 5 – Chief Financial Officer

f Ensure access to financing and other banking services and develop financing strategy

f Create tax-optimized company set-up

f develop all back office processes and policies to support and control the business

f Ensure alignment with group finance functions and treasury

WORk STREAM 6 – Chief Information Technology Officer

f Establish system architecture to support business model and manage work stream requirements to a realistic level

f Ensure early selection and quick implementation of IT systems

f Manage multi-vendor/contractor environment


23RISK JOURNAL

The first step to achieving this is to have an influential project sponsor who can represent the project team at the same level of key stakeholders and steer the project team safely through the complex maze of corporate relationships. We recently observed a case where a project was executed very effectively in large part because a client made the company’s chief operating officer and a board member the project’s sponsor. As a result, he could represent and manage the new trading operation’s interests at the executive management and board level vis-à-vis other members.

ACHIEVInG ExCEllEnCE In ExECUTIOn Finally, a comprehensive plan for setting up a trading organization is crucial. With a well-structured and executed plan, a company can set up a new commodity trading organization in 12 months. Without one, there is a much higher risk that it will be executed poorly and take more than 18 months.

While many companies build work streams around the support functions needed for an individual trader, projects organized along the key responsibilities of the company’s top five senior executives—the chief executive officer, chief commercial officer, chief risk officer, chief financial officer and chief information technology officer—are much more effective. That’s in large part because the second approach clarifies the ownership of each of the required work streams.

Successful project management requires proactively coordinating people who can manage work stream interfaces and dependencies. The greatest challenge is

striking the right balance between the pace at which a project is being carried out and the pace at which it is gaining broad support. Stakeholders who are crucial to the success of a new trading business can easily lose interest if the project is moving forward too fast without sufficient communication. The project team leadership’s detailed knowledge of commodity trading can dramatically reduce delivery risk by continuously and rigorously tracking the project and asking key questions, while proactively identifying potential delivery risks.

TOP ExECUTIVE WORk STREAMSAt a higher level, the CEO should be handling many important initiatives. For example, the CEO needs to promote the business model and the business contin-uously internally and externally in a

coordinated manner. It’s also up to the CEO to make sure the commodity trading business is designed so that it will function well within its parent organi-zation, and yet have enough independence to meet a company’s desired financial targets.

As part of achieving that goal, the CEO should be intimately involved in recruiting the right people to lead the new business and define their reporting lines both within the trading business as well as in the broader organization. In our

projects organized along the key responsibilities of the company’s top five senior executives are much more effective


24 RISK JOURNAL

experience, clients who have the foresight to recruit and appoint the top and middle management of a new trading organization early on benefit from these managers participating and contributing to the project almost from the start. Otherwise, a client may have to revisit the project team’s decisions every time a new manager is appointed since each new manager will have his or her own perspective on issues partic-ularly pertaining to his or her area of responsibility.

The CEO should also take charge of defining the tasks and responsibilities that need to be performed from the first day of trading, including defining what will need to be checked. Clients can potentially suffer significantly if the aspirations and requirements of the first day of a new trading operation are not well-articulated. In our experience, there’s a serious risk that the project team can become confused about what the endgame is, resulting in a potentially significant delay.

At the same time, the CCO should be working on a third work stream that involves developing and sharing the details of the future business. Unless this executive develops a clear and detailed vision of the trading business model, the scope of trading activities as well as the

interface requirements with other business units, stakeholders may draw different conclusions about how risks should be transferred from business units to the new trading operation. Indeed, without the right leadership, even with clearly defined principles, drafting commercial contracts that govern transfer mechanisms can take more than a year.

The CRO’s main responsibility is organizing an independent and powerful risk management function. Few trading businesses succeed unless a risk and controls culture is firmly established. One step to achieve this is for the CRO to develop the risk analytics capabilities necessary to support the trading business’ complex analysis. However, this can only be achieved if the CRO has a clear picture of the scope of trading and the risks that will need to be managed by the new trading operation. In complex situations that involve large and cross-commodity portfolios with many stakeholders, such clarity does not necessarily emerge quickly, preventing a CRO from properly building up his or her organization on time.

On a different front, the CFO needs to establish an organization capable of supporting a new trading business finan-cially. Since traders will need access to financing instruments as well as short and longer-term funding, the CFO should be solidifying a financing strategy and stable banking relationships. He or she also needs to make sure the tax regime that the trading business operates in is well-understood.

Finally, the CIO needs to be involved early on to evaluate the optimal information technology systems for the trading

clients can potentially suffer significantly if the aspirations and

requirements of the first day of a new trading operation are

not well-articulated

25RISK JOURNAL

operation from several perspectives. First, the CIO needs to asses to what degree the trading company has specific needs that necessitate its systems being run on a stand-alone basis. next, the CIO should select the trading business’ systems as early as possible so that enough input from the other work streams can be gathered to tailor the system to the business’ future needs. Then, the CIO must select and manage the appropriate vendors.

We have seen more than one case in which systems have been selected without taking into consideration how the business will evolve. This has resulted in multiple legacy systems on the trading floor that are not seamlessly inter-connected or connected to the risk management and back office systems. As a result, they become prohibitively expensive to maintain and possibly simply left idle.

SUMMARyHighly volatile commodity prices and changing market structures are creating huge potential opportunities for new trading businesses. but these new players are entering an increasingly competitive environment. Companies that place the responsibility for the success of a new trading business squarely on the agenda of their top executives early on will have a much greater chance of successfully estab-lishing new businesses on budget and on time. The firm foundations of these new trading businesses will also be a key differentiator of their performance over the long term.

Cantekin dincerler, partner, ernst Frankl,

senior associate, and Roland Rechtsteiner,

managing partner, are in the Global Risk &

Trading Practice


1.5–2 million barrels the amount of oil a trader requires every

day to generate gross margins of at least

$400 million

WHy traders need more compreHensIve rIsk and prIcIng

frameWorks In a fundamentally cHanged busIness envIronment

michael dentonalexander frankechristian lins

26 Risk JOuRnal

maxImIzIng valuein VOlatile COmmOdity maRkets

27Risk JOuRnal

Political unrest in the middle east combined with the aftermath of Japan’s earthquake and tsunami have ushered in a new stage of volatile commodity prices. after remaining relatively stable last year, crude oil prices have spiked up by more than 20 percent in the

last several months to settle above $105 per barrel, while many fossil fuel prices have risen by more than 7 percent since Japan’s earthquake on march 11. Wheat, corn and milk prices all initially jumped up by at least 10 percent as well.

Anticipating greater commodity price volatility, commodity trading firms, major oil and gas players, as well as companies with significant exposure to fuels have all been rapidly expanding their trading capabilities everywhere from the United States to Europe to the Middle East. Indeed, at least a dozen new trading operations were registered or announced last year in Switzerland alone.

yet while many companies are increasing their trading capabilities, only a rare few are building out the risk and pricing resources needed for them to capture the optimal value from the higher risks they’re assuming in their expanded operations. As a result, they risk reducing the profitability of their structured products by up to 90 percent by potentially neglecting to take into account important factors such as market liquidity. To take advantage of volatile commodity markets, traders need to develop a single perspective on a wide range of different risks to evaluate the true aggregated impact on their organi-zation. doing so is critical to safeguard not only the profitability of traders’ day-to-day operations, but also their high performance over the long term.

There are several reasons why many firms are rushing to expand their commodity trading arms and to establish entirely new commodity trading operations. leading commodity trading firms are building out global networks of operations to gain direct access to commodities, including their storage, refining and blending. That way they can fully exploit physical product knowledge in their trading. Others are moving into alternative commodity markets to develop more diversified portfolios. large Asian and Russian oil and gas producers like PetroChina, Sinopec and Gazprom are branching out into the US, Europe and the Middle East to gain better insights into global pricing strategies.

At the same time, companies with significant exposure to energy like new york-based bunge, the world’s second-largest sugar trader, are expanding

90%How much traders

may reduce the

profitability of

structured

products if they

neglect to take

into account

market liquidity


28 Risk JOuRnal

stumBling BlOCks In maxImIzIng value

gOal What’s WROng tOday hOW tO Fix it

extract optimal value from deal and portfolio

f Focus is purely on risk compliance f Focus on risk-adjusted value capture and capital efficiency paired with best-practice governance

f Employ a single methodological framework for deal valuation and risk quantification

maintain optimal amount of capital, processes and mitigation measures to withstand market stresses

f Only parametric and historical VaR used, rarely with adjustments for market illiquidity

f Asset optionality is ignored

f Use Monte Carlo simulation engine to incorporate empirical properties of commodities

f Apply Earnings at Risk framework to reflect available market liquidity in close-out scenario

f Incorporate physical characteristics of assets

Optimize capital, processes and mitigation measures to cope with counterparty credit risk

f Focus solely on current exposure and Credit VaR (if established) metrics computed on standalone basis

f Only ad hoc requests for third party credit information with limited predictive power – often too late to mitigate against counterparty default

f develop life cycle perspective on counterparty credit risk and link to market scenarios allowing for an integrated counterparty valuation approach

f Actively manage and trade credit risk at portfolio and deal level

allocate risk capital with optimal efficiency

f Risk is evaluated in silos with a limited amount of diversification considered between subportfolios

f lack of integrated view on market and credit risks

f Overall risk contributions of each branch of trading activity are not captured

f Quantify overall risk impact of a single deal and derive implications for valuation at the aggregated book, subportfolio and overall portfolio levels

f Consider cross-commodity and inter-temporal diversification as well as individual book or framework risk contributions

f Evaluate commonalities of risk drivers between market and credit risks

establish liquidity and contract management sufficient to support growth strategies

f Contract management solely focused on legal stipulations

f limited insight into mid to long-term liquidity needs

f Adopt contract management with rigid governance around securities employed

f Integrate working capital management as well as cash and net debt management with market and credit scenarios

f link different types of risk to increase the accuracy of liquidity planning

f Support structured trade finance initiatives in illiquid assets

their trading operations into physical oil in order to trade around their natural short position in fuel oil. by doing so, bunge can improve the margins in its shipping operation.

Many companies’ risk and pricing capabilities trail far behind their ambitious

expansions. Recent experiences from the financial crisis have highlighted weaknesses in risk quantification and valuation frameworks both in financial services companies as well as in commodity trading firms. Still, the common shortcomings have remained the same over the last couple of years as


29Risk JOuRnal

recent events have generally not led to structural improvements.

Worse, the recent ramping up of commodity trading operations is making the task of managing the risks embedded in them even more complex. Many companies are bringing together various trading operations with motley collections of risk management frameworks. Most need to be aligned for firms to capture the optimal value across their consolidated asset and customer portfolios.

Why then do so many commodity traders seem to ignore the need to evaluate their risks on a more comprehensive basis? Some don’t realize the magnitude of their risk exposure. Others don’t know that they are potentially forgoing opportunities for higher trading margins by inefficiently using their risk capital.

Adopting more comprehensive integrated risk and pricing approaches can resolve many of these issues. by developing deep insights into all of the fundamental value drivers in a trading portfolio, an integrated framework provides the radar for risk exposures across all trading activities. This enables risk managers to identify the tangible market and credit developments to which the firm’s financial performance and liquidity are particularly sensitive.

Profitability can be improved in a consistent way if the risk quantification methodologies used can capture the characteristics of the underlying asset base accurately. For example, a trading operation can understand the risks that it is facing and negotiate an appropriate margin for keeping the risk on its books. deals that reduce the overall portfolio risk can be

priced more aggressively than deals that increase risk, thereby creating an incentive for traders to develop an aggregated portfolio view on risks across all desks.

Indeed, price simulation engines that account for the key empirical properties of commodities paired with models capturing asset optionality are not only powerful tools in trading risk management, but also in strategic decision making as they help executives to understand the life cycle of a trading strategy.

This article highlights seven of the more common and onerous types of oversights that exist in commodity traders’ risk and pricing frameworks. We then suggest broad strategies for correcting these shortcomings and preventing new ones from springing up.

SEVEn blInd SPOTSThere are seven areas of risk that commodity traders often do not take into adequate account that can lead to dangerous underestimations of their true risk exposure:

1) Market liquidity – Many asset-backed traders hold positions that are more than 100 times their daily transacted volumes. As a result, the risk resulting from these long holding periods may be more than 10 times greater than what has been quantified with a standard VaR approach. One European energy trading company recently discovered this the hard way after it was hit with tens of millions of dollars of losses from a losing position even though its VaR was well within acceptable limits. The problem was that the firm had not accounted for the market liquidity associated with its losing

many asset-backed traders hold positions that are more than 100 times their daily transacted volumes


30 RISK JOURNAL

position, which it suddenly could not close because other players were simultaneously trying to do the same thing. Oil and gas traders face a similar dilemma since they are often engaged in longer-term commitments that become costly to hedge in the absence of liquidity.

2) Methodology – Relying on insuf-ficient and inconsistent method-ologies can result in significant miscalculations of the value and the risk of a contract. A lack of

adequate modeling techniques can create a structural impediment to capturing higher trading margins by forcing a trader to forgo the benefits of advanced market analysis techniques. For example, the profitability of oil trading in 2010 was reduced significantly when compared to 2009 and 2008, in large part because only a few traders had considered the risk of the forward curve flattening. As a result, many found it difficult to recoup the premium paid on large amounts of contracted storage capacity.

3) diversification effects – If properly diversified, the market risk of a large commodity trading portfolio can be reduced by as much as 70 percent. However, many trading organizations lack the structural prerequisite for realizing such diversification benefits because they are unable to harmonize their risk quantifi-cation methodology across each of their trading books and risk types. As a result, they are missing out on potential savings: by increasing the scope of risks quantified and examining cross-commodity as well as inter-temporal correlations within a trading portfolio, Oliver Wyman recently

identified $700 million in potential savings in risk capital for a large commodity trading firm. Further benefits were achieved after measuring the extent of diversification of the portfolio’s market and credit risk.

4) Physical characteristics of real assets – The risks in structured deals and associated hedging activities are often incorrectly represented because traders rarely take into account the flexibility and optionality of assets like power plants, natural reserves, storage or transportation infrastructure. It is common practice to hedge out the portions of risk that are not well-understood or to disregard them in less sophisticated commodity trading operations. This often reduces the profit-ability of deals by more than half.

5) Credit risk – Few organizations quantify expected or unexpected credit losses when they measure credit exposure, and even fewer reflect this in profitability calculations on a deal level. yet taking credit losses into account can funda-mentally change the profitability of a trade, especially for asset-backed traders, who have the bulk of their credit exposure with non-financial services counterparties. For example, the fact that a rating migration from bbb to bb may quadruple the expected loss is often not considered adequately upon the inception of a deal.

6) liquidity and collateral management – At a time when the recently passed dodd-Frank Act will likely increase the volatility in exchange-traded and over-the-counter commodities, many large commodity trading operations still have difficulty quantifying their true liquidity needs for a limited number of days

70%How much the

risk in a large

commodity

trading portfolio

can be reduced

if it is properly

diversified

31RISK JOURNAL

ahead. This is in large part because they fail to examine all of their available sources of liquidity and commitments. In fact, many large operations have trouble assessing how much they are trading against open credit or third party guarantees. As a result, they have little understanding of the potential impact of collateral or margin calls on their liquidity.

7) Replacement cost – A combination of counterparty defaults and market turmoil may force a trader to source expensively at a spot price in order to compensate for physically missing forward volumes. nevertheless, few firms consider the replacement risk that can result from the potential inability of a counterparty to deliver contractually agreed physical volumes. The impact may not only be limited to an opportunity cost but also could become a material loss.

SIx RECOMMEndEd STEPS TO dEVElOP A MORE COMPREHEnSIVE RISk FRAMEWORkToday, most commodity traders can count on missing out on potential margins because they are inaccurately measuring risks or inefficiently using their risk capital. Fortunately, they can take steps to develop a more integrated perspective of their portfolio and its potential impact on their organization.

1) Treat risk management as a risk-adjusted value creator. The main purpose of a business enterprise is to capture rewards equivalent to the risks taken. And yet, many commodity trading organi-zations take a compliance-oriented view of risk management. As a result, they miss out on the potential benefits of developing a more comprehensive risk framework.

Trading and risk management teams need to raise top management’s awareness of the benefits of integrated risk and pricing frameworks. Maximum commercial leeway should be granted to traders under an effective governance framework that ensures that the targeted return is commen-surate with a level of risk that is in line with the entire organization’s risk appetite.

2) Establish adequate risk quantification methodologies. Commodity trading organi-zations need to develop processes to ensure that key risks such as the seven mentioned above are all considered and that their risk capital is quantified efficiently, taking into account the benefits of diversifi-cation for an organization’s entire portfolio. These methods need to be tailored to a company’s asset portfolio and risk governance principles so that the company can stay in control of them and understand the risks that have been quantified.

3) Enable consistent integration into a governance framework. A comprehensive governance framework is necessary to ensure that a broader set of risk infor-mation is used appropriately to steer a trading business. Risk-adjusted performance measures need to be linked to traders’ compensation in order to encourage them to use risk capital more efficiently and ultimately achieve greater profitability. Risk-adjusted financial planning for the holding company ensures that its strategic plan remains feasible and that any financial impact from trading operations in adverse conditions will be manageable. This way, the organization can be sure that it has sufficient cash liquidity to prevent being forced to pull out of positions prematurely.

most commodity traders can count on missing out on potential margins because they are inaccurately measuring risks or inefficiently using their risk capital


32 Risk JOuRnal

CeO PeRsPeCtiVe

Objective Required Action

f Sell high-margin products to monetize embedded asset optionality

f Set up adequate, accurate and comprehensive risk quantification methodology that takes into account commodity and asset properties

f Apply consistent and compatible methodologies for deal valuation and risk quantification

f Ensure competitive yet adequate pricing by accounting for effect of transaction on overall portfolio

f Share trade and risk analytics to leverage advanced financial and econometric methodologies

f Steer existing operations and strategies based on risk/return principles in line with the organization’s risk appetite

f Capture and synthesize key portfolio risks, e.g. market, credit and liquidity risks

f Identify and quantify upside and downside of strategic alternatives – allocate capital accordingly

f Foster understanding of fundamental drivers and their impact on trade performance

f Provide basis for performance measurement

f Monitor regulatory landscape and reflect on implications for commercial strategy

CFO PeRsPeCtiVe


f Financial stability f Ensure adequacy and accuracy of risk capital requirements

f Identify financial vulnerabilities of trading operations and implement mitigation measures

f Monitor key financial covenants in light of current and future operations

f Finance strategic growth initiatives

f Meet transparency requirements of existing financing structures and potential structured trade finance innovations

f Account for all major risks and diversification effects in portfolio, e.g. maximizing scope of risks captured and capital efficiency

f Model key financial covenants in light of current operations and strategic undertakings

f Install comprehensive working capital management linked to market and credit risk management

CRO PeRsPeCtiVe


f Quantify future risks with required accuracy and comprehensiveness

f Establish adequate risk quantification methodologies accounting for commodity properties, physical asset characteristics and market conditions

f Institutionalize interaction between centralized risk management functions

f Ensure that the operational risk team has enough time to think about specific risks in the portfolio outside of the standard daily process and to define specific stress scenarios

f Facilitate ongoing model validation

f Maintain flexibility to keep up with commercial strategy

f Assume modular view in set-up of risk and pricing infrastructure

f define flexible system interfaces as a prerequisite for design and implementation

f Increase operational efficiency f Harmonize risk and pricing methodologies within the organization

f Adopt stable reporting processes, automated to the extent possible

RISk And PRICInG IMPlICATIOnS FOR THE C-suite


4) Institutionalize interactions between centralized risk management functions in an integrated framework. Critical infor-mation must be shared effectively. This implies that market and credit views will be synthesized and adequately reflected in liquidity risk metrics. A liquidity and collateral management team needs to ensure that sufficient liquidity is available to support profitable trading strategies.

5) develop stable reporting processes. day-to-day trading operations must be supported with current risk information. data must be captured and stored centrally to ensure all information is simultaneously available across the whole trading portfolio. Processes need to be largely automated to reduce operational risks and to free up reporting teams’ time to investigate where specific risk exposures such as market, credit and liquidity risk reside in the trading portfolio.

6) Conduct ongoing model validation. An organization’s processes and compe-tencies to manage model risk are vital elements in ensuring that risk capital efficiency does not come at the cost of additional model risk. This can be achieved by supplementing risk quantification tools with independent testing. Models optimized for capital efficiency should be regularly scrutinized through back testing and standardized validation routines.

SUMMARyCommodity trading organizations that recognize an integrated risk and pricing framework contains tools for creating value will develop a significant competitive edge, particularly in highly volatile commodity markets. Custom tailored risk quantification methodologies that incorporate the

elements described above are crucial for revenue growth, profitability gains and financial stability.

Integrated risk and pricing practices will decrease operational risk dramatically. The combination of a centrally controlled methodology and an adequate governance framework reduces operational risk, partic-ularly when a trading organization has experienced significant inorganic growth or undergone a period of consolidation.

Management teams as well as shareholders will also have a better understanding of what capital buffer is required to realize strategic plans in a way that permits the trading organization’s cost of debt to be stabilized. Unlike using a standard VaR approach for determining the appropriate level of the capital buffer necessary, a more compre-hensive Earnings at Risk framework increases the accuracy of risk quantification, especially for positions that cannot be easily liquidated. It also has the potential to improve risk capital efficiency significantly when paired with adequate market price scenarios.

All of this will become increasingly important as commodity markets become more volatile in today’s fundamentally changed business environment.

michael denton, partner, alexander Franke,

associate partner, and Christian lins,

associate, are in the Global Risk & Trading

Practice


33Risk JOuRnal

34 Risk JOuRnal

embracIng tHe

highlyimPROBaBle

alexander frankeboris galonskechristian lins

sIx lessons for commodIty traders from tHe tragIc

events In Japan

Risk JOuRnal 35

The tsunami-induced nuclear crisis in Japan reinforced a lesson that many organizations first learned from the financial crisis: Risks considered extremely unlikely can, and increasingly do, happen. many commodity trading organizations discovered

themselves on the wrong side of the market when power, natural gas, coal and carbon emission prices suddenly increased by double digits shortly after the events in Japan and government decisions to shut down nuclear plants in europe. this is likely to result in losses that will have a significant impact on their upcoming quarterly earnings results.

Agricultural commodity prices like corn, wheat, rice, sugar, soybeans and milk rebounded after dropping in reaction to fears of lower Japanese imports. Uranium also tumbled initially more than 20 percent as increasingly divided views about the future of the nuclear industry spread around the world. Some speculative market participants unloaded positions while plant operators and producers stepped in and bought the fuel raw material. Similarly, Australian coal fell more than 5 percent as Japan’s coal infrastructure and generation capacity declared force majeure and new buyers had to be sought for cargos.

The chain of incidents that led to Japan’s nuclear emergency highlights the structural deficits that many commodity trading organizations suffer from in their ability to cope with tail events. Well-established standard practices for preparing for highly improbable events such as nuclear conflicts in the Middle East and widespread power outages have existed for many years. And yet, many organizations do not embrace these practices with a sufficient sense of urgency under normal conditions.


36 Risk JOuRnal

We believe the time has come for trading organizations to incorporate impossible events into their regular risk management routines. To this end, we suggest that every commodity trading organization should embrace the following six broad strategies:

f Supplement stress tests for risk reporting – Process a static set of stress scenarios consisting of extreme price movements; correlation coupling and decoupling; and liquidity decreases on a recurring basis. Make sure that the associated monitoring of stress test outcomes is a key element of the risk governance framework.

f Consider market liquidity – Regularly evaluate the market liquidity of each position. Asset-backed traders can hold positions that are more than 100 times the daily transacted volumes. As a result, any quantification of risk can be significantly distorted if the liquidity of a trading position’s market is not taken into account.

f Apply proven methods – Identify key historical incidents that had a detrimental impact on risk drivers and use them as inputs for standardized stress scenarios that are evaluated on a regular basis. This approach becomes especially relevant once full portfolio diversification benefits have been realized in favor of capital efficiency. Senior executives should also reevaluate whether they are using adequate stress testing tools. False security supported by insufficient models leads to severe financial consequences.


37Risk JOuRnal

70%

80%

90%

100%

110%

120%

130%

10-Mar 14-Mar 16-Mar 18-Mar 22-Mar 24-Mar

IND

EXED

PR

ICES

POWER (GERMANY BASELOAD) EMISSIONS (CERTIFIED EMISSION REDUCTION)

COAL (API2, CIF NORTHWEST EUROPE) COAL (API6, FOB AUSTRALIA)

NATURAL GAS (DUTCH) URANIUM (NYMEX, OXIDE CONCENTRATE U3O8)

70%

80%

90%

100%

110%

120%

130%

10-Mar 14-Mar 16-Mar 18-Mar 22-Mar 24-Mar

IND

EXED

PR

ICES

RICE (CBOT)

CORN (CBOT)

WHEAT (CBOT)

MILK (CME, CLASS III)

SOYBEANS (CBOT)

SUGAR (NYMEX)

MARCH 10, 2011 = 100 %

MARCH 10, 2011 = 100 % AGRICUlTURAl PROdUCT PRICES

Initial concerns about

lower agricultural

product demand swiftly

disappeared.

Source: bloomberg

EnERGy And CARbOn EMISSIOnS PRICES

Concerns about nuclear

power affected the

prices of fossil fuels

and carbon emissions.

Source: bloomberg

COmmOdity PRiCe Changes tWo Weeks after tHe Japanese tragedy

38 RISK JOURNAL

f Conduct reverse stress tests – Examine the level of loss that would pose a significant threat to the trading organization. Such a critical loss could result from occurrences ranging from missing annual performance targets to traders’ reputations being damaged because they could suddenly trigger a need to hold a higher level of collateral, for example. A breach of a financial covenant requiring immediate refinancing of debt at a significantly higher margin or the failure to fulfill an obligation set forth by a contractual agreement could also jeopardize a trading organization’s survival in the mid to long term. developing stress scenario and associated thresholds of risk factors and their dependencies fosters a thorough understanding of the firm’s risk environment among all stakeholders. For senior management, reverse stress tests provide an excellent basis for prioritizing risk mitigation measures and allocating resources based on the vulnerabilities and dependencies of the firm’s businesses. Insightful reverse stress cases account for market, credit, liquidity, operational and legal implications as well as the specificities of the underlying physical asset base.

f define combined stresses for commodity price developments and correlations – Trading organizations increasingly need to develop stress tests and more sophisticated risk aggregation methodologies that take into account risks related to not only commodity price fluctuations, but also alterations in their correlations. Under extreme market conditions, commodities often become either much more positively or negatively correlated, increasing the basis risk in a hedge portfolio significantly. For instance, the observed change in the spread between South African coal delivered into Europe and coal shipped from Australia may become a standard example of a correlation suddenly decoupling. In terms of credit risk, the correlation between a potential counterparty default and the replacement value of a structured contract may also be suddenly, and dramatically, changed.

f Incorporate a checkpoint prior to stop-loss close-out procedures – Some commodities’ initial price shocks leveled off in the weeks following the initial tragic events in Japan. For instance, the 12 percent price increase of dutch natural gas in the first week shrank to less than half of that only a week later. Stop-loss limit procedures should be structured so that commodity traders must explain losses to senior management before hard limits are triggered. Furthermore, they should allow, in exceptional cases, a trader to leave a position open if a convincing case for the persisting fundamental rationale of the trade can be made.

the time has come for trading organizations to

incorporate impossible events into their regular

risk management routines

39RISK JOURNAL


Standard risk metrics or basic stress tests are often overly reliant on simplified model assumptions and historical data that assume a given pertinent set of funda-mental risk factors continues to drive risk in an unchanged manner at all times. Under extreme market conditions, however, risk factors behave and interact differently.

The earthquake and tsunami that hit Japan on March 11 and their aftermath highlight how vulnerable modern society is to events that are often inadequately assessed because they may be deemed impossible. For a trading organization, it is critical to maintain an adequate financial buffer to protect the company from a negative impact that is beyond its risk appetite. To achieve this, trading organi-zations need to reconsider how they are coping with lingering tail risk.

alexander Franke, associate partner,

Boris galonske, partner, and Christian lins,

associate, are in the Global Risk & Trading

Practice

tHe neW rules of eneRgy sustainaBility

40 Risk JOuRnal

WHat country leads tHe World In provIdIng stable,

affordable and clean energy? tHe ansWer Is tHat no one does.

and tHat’s a problem John drzik

41Risk JOuRnal

Canada is a world leader in terms of supplying stable and affordable energy, though it doesn’t rank in the top ten nations when it comes to clean energy, according to research conducted by the World energy Council in collaboration with Oliver Wyman. switzerland, a

big user of nuclear and hydro power, is one of the top five in terms of delivering stable and clean energy. But it does not lead the pack when its energy is measured in terms of affordability. Brazil and italy excel at providing energy that is both clean and reasonably priced. But no country scores well on all three measures.

One fundamental reason why countries are not leaders in terms of all three of these criteria is that no form of energy satisfies all of these requirements. As a result, energy policymakers, accustomed to operating in a relatively stable environment with a clear direction, are struggling to balance the often conflicting agendas of developing secure, affordable and clean energy. In the process, the worst thing possible for long-term energy investments is happening: Energy policy is becoming clouded by potentially paralyzing uncertainty. The traditional model for energy policymaking is no longer working. Policymakers need to cut through the ambiguity these tensions are creating by rethinking their approach to energy sustainability—and soon.

The world needs more energy. Global demand for energy is expected to grow by 1.5 percent every year from now until 2030, according to the International Energy Agency. That growth is already testing the limits of existing energy resources and infrastructure. new energy sources must be opened up, aging infrastructure upgraded and new plants and networks developed—all in the context of ensuring that energy remains clean and affordable for consumers. The IEA estimates that countries need to invest about $1.1 trillion each year, on average, to maintain and replace existing systems as well as to meet growing demand and environmental objectives. That is equivalent to 1.8 percent of the world’s $61 trillion GdP.1

energy sustaInabIlIty

1 World bank, 2008.

This article has been excerpted from an address delivered at the World Energy Congress.

42 Risk JOuRnal

And yet, while investment in energy overall is increasing, many crucial initiatives are being scratched or postponed worldwide. Changing market circumstances and national priorities are contributing to significant levels of variability in policymaking and in the quality of policy implementation. In July of 2010, for example, the Ontario government announced a dramatic cut in how much it will pay some producers of solar energy, creating uncertainty around potential future investments in its clean energy programs.

The recession has underscored the dilemma that policymakers now face by making the trade-offs that exist between different energy criteria more contentious. Germany and Spain, some of the world’s leaders in renewable energy, were forced to reduce financial incentives for clean energy technologies to lessen the short-term burden on their nations. At the same time, in California, citizens launched a ballot initiative to halt

the enforcement of the state’s law mandating greenhouse gas reductions until its unemployment rate improves.

EMbRACInG COMPlExITyThe challenge for policymakers, then, is to figure out how to embrace this complexity. Energy policies need to be designed to fit agendas that are much broader and more fluid than they have been in the past. That means they must incorporate many options rather than be based on fixed commitments to a single technology, type of energy or strategy.

The first critical step to achieving this is for policymakers to conduct a much fuller cost-benefit analysis that examines measures to improve both their energy supply and demand characteristics. If countries conduct this more compre-hensive portfolio analysis and use it to frame their policy choices, they may take different courses of action.

top 5 leaders measured by sustaInabIlIty dImensIons

ENERGY SECURITY

1. Canada2. Switzerland3. Denmark4. Finland5. Japan

E�ective management of primary energy supply from domestic and external sources; the reliability of energy infrastructure; and the ability of participating energy companies to meet current and future demand. For countries that are net energy exporters, this also relates to an ability to maintain revenues from external sales markets.

SOCIAL EQUITY

1. United States2. Japan3. Germany4. Canada5. United Kingdom

The accessibility and a�ordability of energy supply across a population.

ENVIRONMENTAL IMPACT MITIGATION

1. Switzerland2. Sweden3. Norway4. France5. Denmark

The achievement of energy e�ciencies and the development of energy supply from renewable and other low-carbon sources.

Bold text indicates top five leader in 2 dimensions

Source: World Energy Council/Oliver Wyman, *WEC member countries with GdP/capita > USd 33,500

43Risk JOuRnal

dIVERSIFyInG RESOURCESOn the supply side, countries’ energy policies need to reflect how drastically the world’s energy mix is changing. Over the last two decades, the overall mix has remained relatively stable. but now, a wide range of alternatives are disrupting that natural order. That means countries need to commit large sums of money to long-range plans on which the final verdict will often be uncertain for many years to come. Renewable energy is becoming more popular in a number of countries. natural gas has also become comparatively more attractive. And there is an expected 30 percent increase in nuclear capacity worldwide by 2020. Sixty-one nuclear reactors are under construction worldwide, with a further 158 on order or planned and an additional 326 at the proposal stage, according to the World nuclear Association.

China’s approach to supplying the energy necessary to keep up with its breakneck economic growth illus-trates how more countries appear to recognize the need to develop a wide range of energy resources. It could have just developed gas and coal resources, which are inexpensive and expedient. but the country has also focused on developing cleaner types of energy such as nuclear, wind, biomass and solar energy.

As a result, China is becoming better positioned to provide energy on a sustainable basis no matter what the future may hold. In 2009, China invested $34.6 billion in clean energy—more than any other nation and pushing the United States into second place, according to research by the nonprofit The PEW Charitable Trusts.


545the total number

of nuclear reactors

worldwide that

are under

construction,

planned and

proposed

TOP 10 COUnTRIES In TERMS OF ClEAn EnERGy InVESTMEnT In 2009

Source: bloomberg

new Energy Finance,

Pew (2010), Oliver

Wyman analysis

INDIA

ITALY

CANADA

GERMANY

BRAZIL

SPAIN

UNITED KINGDOM

UNITED STATES

CHINA

2009 INVESTMENT �USD BILLIONS� GROWTH IN INVESTMENT �2004�2009�

148.0%

103.0%

127.0%

79.7%

148.0%

75.3%

70.2%

111.0%

72.0%

34.6

18.6

11.2

10.4

7.4

4.3

3.3

2.6

2.3

44 Risk JOuRnal

More countries are also beginning to embrace international cooperation to cope with potential risks to their energy security. To reduce the risk of repeated supply disruption from Russia’s disputes with the Ukraine and belarus, Europe has made significant efforts to develop alternative supply routes. Germany’s active sponsorship of the nord Stream pipeline between Russia and Europe may make the country, which imports 86 percent of its natural gas needs, a new hub for Russian supplies. At the same time, plans have been proposed to develop a “super-grid” to connect planned concentrated solar power generators in north Africa and the Middle East with European consumers. If this grid achieves the scale anticipated by its proponents, it could meet as much as 15 percent of Europe’s electricity demand by 2050 while powering desalination plants in north Africa.

The greater challenge for many policy-makers seems to be managing energy demand. Policymakers should devote as many resources to managing their demand for energy as their supply. To date, most countries’ programs designed to reduce greenhouse gases focus on promoting renewable technologies. but energy efficiency programs have been proven to be the cheapest, fastest and cleanest way for utilities to meet customers’ energy needs. Instead of incurring economic costs, nations gain immediate economic benefits and savings when businesses and individuals simply begin to conserve energy.

COnSERVInG EnERGyCalifornia’s energy efficiency programs, for example, have provided hundreds of millions of dollars in savings to customers and reduced the annual global warming pollution by the equivalent to emissions from three million cars, according to the

1.5% How much

global demand

for energy is

expected to

grow by every

year from now

until 2030

44 Risk JOuRnal

45Risk JOuRnal

natural Resources defense Council. by focusing on energy efficiency, California has managed to cut its growth in demand for energy to one quarter of what it was projected to be.

To be effective, policies designed to conserve energy need to cut through layers of subsidies based on past priorities so that consumers can become aware of the true cost of their energy and make informed choices. One way to achieve this is by introducing so-called smart grids.

When California tested smart meters several years ago, customers reduced their consumption by 4–7 percent. based on these results, California decided to introduce smart meters on a permanent basis. Ontario, too, is in the midst of a large-scale smart grid initiative, installing smart meters in homes and small businesses across the province. by the end of 2010, the system was expected to serve 1.3 million customers.

Policymakers should also develop decision frameworks that integrate a much broader range of factors than they have in the past. Effective efficiency programs need to be based on the structural make-up of a nation’s entire economy and reflect its consumption patterns. To achieve that, policies need to be coordinated across sectors that have not traditionally been considered part of energy policies. Efficiency programs require the coordi-nation of everything from the impact of upgrades to heating systems to low-emission vehicles to green appliances.

REWARdInG EFFICIEnCyFinally, energy efficiency improvements should be rewarded equivalently to energy

supply development to encourage strong public and private sector cooperation. Utilities need financial incentives for helping customers use less of their product. One way to do that would be to permit them to earn a small percentage of their efficiency programs’ net benefits. Policymakers should also play a role in encouraging manufacturers to make more ‘intelligent’ devices that will enable everything from a refrigerator to an elevator to use less energy.

In summary, today’s energy agenda is being shaped by a wide range of competing policy interests. Policymakers need to strike the right balance across potentially conflicting objectives and chart a course to create an energy supply that is at the same time stable, affordable and clean. In doing so, they should develop incentive frameworks that both help diversify their country’s energy sources and encourage energy efficiency. We are in a new age of uncertainty, with a wide range of possible outcomes. These steps should help position a country for success in whatever the future might bring.

John drzik is the CEO of Oliver Wyman Group


policymakers need to strike the right balance across potentially conflicting objectives and chart a course to create an energy supply that is at the same time stable, affordable and clean

46 Risk JOuRnal

tHe neW Weak lInk Inyour supply cHaIn:

suPPlieR CRedit

This article was developed as part of a Global Risk Center project in cooperation with the Association for Financial Professionals.

michael dentonboris galonske

WHy companIes need to beHave more lIke tHeIr oWn

credIt ratIng agencIes

47Risk JOuRnal

supply cHaIn dIsruptIons

you can see it in stubbornly high unemployment rates or from the hundreds of companies receiving credit downgrades. after several straight years of distress, global economic growth remains sluggish. this is exacerbating a weak link in companies’

supply chains: the deteriorating financial strength of suppliers.

Increasingly, suppliers’ weaker balance sheets are posing just as great a risk to companies as suppliers’ potential operational problems. by rationalizing their supply chains during the recession, many companies have inadvertently become more reliant on fewer suppliers at exactly the moment when their own finances have become shaky. Meanwhile, those same suppliers are seeking to use their customers’ balance sheets to fund their working capital requirements.

As a result, supply chain risks have moved from the province of engineers into the realm of chief financial officers and treasurers. To emerge from the global recession unscathed, companies should rethink their approach to supply chains by behaving much more like their own credit rating agencies—and fast.

While low interest rates have permitted many companies to refinance recently, rating agencies have begun to warn that current lower default rates may be unsustainable. If GdP growth in the United States remains stuck in a range of 1 percent to 2 percent in 2011, defaults will rise again, according to Fitch Ratings analyst Mariarosa Verde. She estimates that a low default rate is only sustainable at growth rates above 2 percent.

Moreover, corporate credit ratings are still declining at an alarming rate. Our research shows that credit rating agencies have downgraded the ratings of more than 500 companies in north America since April of 2010. The number of businesses that annually file for bankruptcy protection in the United States has soared by 126 percent since the financial crisis triggered the recession several years ago, according to data from US bankruptcy Courts.

48 RISK JOURNAL

PREPARInG FOR SUPPlIER CREdIT FAIlURESCompanies urgently need to prepare for supplier credit failures that could create a new nightmare for their supply chain. That means they must pay as much attention to evaluating the probability that their suppliers may default as they do to potential disruptions in their suppliers’ operations. It means they must evaluate the potential impact of a supplier default on their cash flow. And it means they must scrutinize suppliers on a much more holistic basis, reflecting the fact that a company’s operations, finances and the quality of its management are linked.

To achieve this, companies should develop their own predictive credit analysis frameworks. They can no longer rely solely on credit ratings prepared by credit rating agencies. Instead, businesses need tools that will help them anticipate future problems in a supplier related to the deterioration of both the supplier’s finances and operations.

dEVElOPInG PREdICTIVE AnAlyTICSdesigning forward-looking supplier risk analytics that can forecast suppliers’ credit problems in advance isn’t easy. Many companies still struggle to identify the touch points that enable them to shrink or expand their supply chains without putting their own businesses in jeopardy from an operational perspective. One reason for this is that efforts to improve and quantify the risks in their supply chains are conducted in silos. As a result, they usually fall short of a thorough view of the entire supply chain.

US nOn-InVESTMEnT GRAdE dEFAUlTS by TyPE In 2010

Source: Fitch Ratings

725.4

668.4

350.0

1,743.8

PAR VALUE ($MILLIONS)

41.6

38.3

20.1

100.0

PERCENT

Distressed Exchange

Chapter 11 Filing

Missed Payment

Total

49Risk JOuRnal

Adding to the challenge is the increasing complexity of supply chains, as companies purchase more products and services from firms located in lower-cost countries. In these locations, the credit of many companies is often not rated. Financial data is also often less reliable.

And yet, it has never been more important for companies to understand their suppliers’ financial vulnerabilities. The aftermath of a supplier bankruptcy can be devastating. For example, our research shows that when an auto parts supplier goes bankrupt, its parts prices can jump up by 10 to 15 percent.

The ultimate price tag of a supplier bankruptcy goes far beyond the direct cost of a business disruption in large part because supply chain management is now viewed as a company’s core competency. A supply chain failure can easily prompt customers to take their business elsewhere. Investors also punish supply chain failures disproportionately. Indeed, the impact of a


supply chain breakdown on a company’s market valuation can eclipse all possible cost savings achieved from leaner chains.

Far too often, the additional costs driven by dealing with a financially weak supplier are underestimated. That’s in part because the metrics companies use to evaluate the impact of a supplier failure are often too simplistic. Companies often fail to take into account that the more they push out to potentially less secure suppliers, the more they are often obliged to use their own balance sheets to support suppliers. Many also miss the fact that they are just one of a supplier’s many customers. If a major customer also defaults, the company could suffer losses across the entire spectrum of its supply chain.

companies must look far beyond simple financial ratios

COUnTERPARTy CREdIT EVAlUATIOn nEEdS COMPAREd TO RATInG AGEnCy InFORMATIOn


RATING AGENCY INFORMATIONCOUNTERPARTY CREDIT EVALUATION NEEDS

Provides relative credit rating information Absolute probability of default information to

calculate absolute cost impacts

Uses through-the-cycle methodology, for a long-term view of default risk

Early warning information

Indicates risk over multiple horizons, rather than a single, defined horizon

Indication of default probability over defined time horizon

Short-term accuracy of ratings (60-100 days)

Probabilityof default information

Timing Slow to downgrade to avoid procyclical e�ects and erosion of reputation

Confidence Investigations have revealed material weaknesses in agency methodologies

Full understanding and confidence in the ratings methodology

Demonstrated inability to forecast systemic risk

Incorporation of systemic risk into creditworthiness evaluation

50 RISK JOURNAL

CREdIT RATInG AGEnCIES In FlUxFurther underscoring the need for companies to conduct their own evalu-ations of financial weaknesses in supply chains is the fact that credit rating agency business models are also changing. The recent passage of new financial legislation in the US has made rating agencies more liable for the quality of their rating decisions. As a

result, some credit rating agencies are starting to limit how their ratings can be used. In July of 2010, some dominant credit rating agencies refused to let bond issuers use their ratings in documentation for new bond sales, according to a Wall Street Journal report.

IMPROVInG SUPPly CHAIn MAnAGEMEnT METRICS The first critical step in managing the increasingly strained financials of suppliers is for companies to acknowledge that credit has become a dominant driver of performance. Typically, companies select suppliers primarily based on their operational capabilities. but in today’s deteriorating

far too often the additional costs driven by dealing with

a financially weak supplier are underestimated

THE OTHER WEAk lInk: CustOmeR CReditA prolonged recession has weakened the balance sheets of not only suppliers, but also customers. As a result, companies are running an increasing risk of being squeezed from both ends of their supply chains.

Companies are extending longer payment terms to customers. At the same time, they are assuming greater inventory costs to cope with weaker suppliers. In the process, their working capital is becoming strained.

Consider it the curse of recovering from a prolonged global recession. To ramp up their businesses, many companies have started to sell more to less creditworthy customers than they did before the global financial crisis. At the same time, their existing customers’ financial strength has declined.

The trouble with this is that a cash-strapped customer can often have an even larger impact on a company's results than a weakened supplier. After a supplier went bankrupt, one global manufacturing company

quickly began to examine the financial strength of its entire supplier network only to discover that the company’s ability to forecast customer demand accurately was equally important to optimizing its supply chain.

As customer credit weakens, the volatility in supply chains will rise in part because some customers will try to change the pricing in their contracts. For example, Chinese steel mills have been trying to pay foreign mining giants for iron ore on a more frequent basis ever since

they reneged on quarterly contracts when spot ore prices tumbled in 2008.

So-called customer “soft defaults” will also become more common. Already, many customers are delaying their payments, instead of declaring a default or ending a contract. In the meantime, these customers are asking companies to extend them credit to pay for their products until they finally go bankrupt – and leave the company holding the bag.

51RISK JOURNAL

credit environment, a supplier’s operations and finances need to be given equal weight.

next, companies should reexamine their supply chain management metrics. Companies should evaluate the impact of a supplier default on their cash flow. Instead, most only examine the potential impact of a supplier’s default based on how much they are spending on its products and services.

Start with the impact of replacing a supplier’s contract on a company’s results. Ask yourself: How difficult will it be to replace a supplier if the company defaults? How tough will it be to find a

nEARly SIx TIMES AS MAny FITCH-RATEd COMPAnIES WERE dOWnGRAdEd THAn UPGRAdEd In 2009

*Compares beginning-

of-year rating to end-

of-year rating, and

does not count

multiple rating actions

throughout the year.

note: Rating changes

defined at the modifier

level, making a

distinction between

+/–.

Source: Fitch Ratings

FITCH GlObAl CORPORATE FInAnCE RATInG ACTIOnS by REGIOn – 2009*

FITCH GlObAl CORPORATE FInAnCE RATInG ACTIOnS by SECTOR – 2009*

DOWNGRADES UPGRADES

356235

2274

687

31.623.2

8.939.226.7

4867

70

122

4.36.62.80.04.7

No.% of

Sector Ratings No.% of

Sector RatingsSector

Banking & FinanceIndustrialsPower & GasInsuranceAll

DOWNGRADES UPGRADES

60223

3123

350687

18.530.916.723.228.226.7

263911

046

122

48.05.45.90.03.74.7

No.% of

Region Ratings No.% of

Region RatingsRegion

Asia/PacificEuropeL. Am. & CaribbeanMiddle East & AfricaNorth AmericaAll

customer to take the place of one that can no longer afford my products or services? And what will happen to my company’s cash flow during this search?

lOOk bEyOnd FInAnCIAl RATIOSIn order to enhance their credit risk management capabilities, companies need to develop predictive tools. This involves assembling a list of variables that could force a supplier or customer to default. We believe that companies must look far beyond simple financial ratios to span both a company’s operations and finances. After all, a company’s financial strength is dependent in large part on its operations. no company will remain financially sound for long if operational


52 RISK JOURNAL

measures, like the percentage of orders filled, begin to decline.

Companies should also consider quali-tative factors. A management team with a history of sound judgment may be more likely to chart a successful course through today’s troubled economic environment. To decipher whether the management team of a customer or supplier is up to this challenge, companies should examine everything from their ownership structure to their recent press coverage.

External risks must be examined. besides common risks like exchange rate volatility or political interference, companies should consider large liabilities related to pensions and the environment. They can

quickly reverse a company’s fortunes. So can events like strikes, terrorist attacks, corporate fraud or so-called acts of God like an earthquake or a plane crash.

Once companies have surveyed the full range of potential default factors, they need to determine which of these variables will be the most useful in predicting supplier and customer defaults and then assign appropriate weightings to them. That’s where an analytical tool becomes critical.

Applying statistical methods to determine the combination of opera-tional, financial and more subjective factors will do more than explain past disruptions. As new data becomes

WHy yOUR ExPOSURE TO A SUPPlIER dEFAUlT may Be higheR than yOu thinkWhen companies estimate their exposure to the potential default of a supplier, they often only evaluate how the loss of the supplier will directly affect their business. To understand the full potential impact of a bankruptcy, companies need to consider how a default will impact the remaining market participants as well.

For example, one energy market maker currently estimates that the direct and follow-on impacts of bankruptcies of the suppliers in its sector are only a fraction of its total exposure. At first, this firm only examined the replacement cost of the energy that would no longer be directly provided by the failed supplier. That replacement cost is based on a significant increase in spot prices, driven by a short-term shortage.

but many of these large suppliers use bilateral contracts, in addition to the market maker, to sell energy. If the supplier defaults, those bilateral customers will immediately begin sourcing energy from the spot market, using the market maker. As a result, the volume of energy to be replaced could be 20 times more than the direct volume.

Worse, the combination of the increased volumes moving through the spot market and higher prices from reduced supply creates potential credit exposures in excess of $100 million for this firm.

More robust diagnostics are crucial in developing a more realistic picture of what could actually happen if a supplier defaults – and in enabling a company to avoid that outcome.

53RISK JOURNAL

VARIABLES

OPERATIONAL

Credit rating/default

Supply breakdown

Financial default

Physical supply breakdown

Average lead times% on-time delivery% order fulfillmentReject ratesUnit costs

Debt to equity ratioDebt service coverageLiquidityTurnoverProfitability

Management competenceQuality of relationshipOwnership structurePress coverageReliability

FINANCIAL

JUDGMENTAL

THE CHALLENGE IS IN DETERMING WHICH AVAILABLE DATA HAVE REAL “PREDICTIVE POWER”

available, a model can be rerun to assess whether particular risks are increasing, and corrective management action can be taken before the problem materializes.

COMPlExITy EQUAlS OPPORTUnITy Making the potential impact of suppliers’ deteriorating credit a higher priority in supply chain management adds a level of complexity to an already complicated process. However, the very complexity signifies the magnitude of the opportunity. There are nearly limitless places for problems to spring up in supply chains. Companies that identify the full range of default factors—essentially becoming their own credit rating agency—will outma-neuver rivals who lack this level of sophistication.

A MOdEl FOR dEVElOPInG PREdICTIVE CAPAbIlITIES


Today, many companies are embarking on very costly measures to reduce the chance of a supply chain disruption. They are building up inventory and even purchasing their own sources of materials.

We believe conducting more thorough supply chain diagnostics—ones that incorporate the financial vulnerabilities of suppliers—is more cost-effective. The opportunity to match, or even surpass, the impact of such initiatives on a company’s bottom line should be well worth this manageable investment. developing such frameworks will enable companies to avoid supplier defaults not only today, but also in the future.

michael denton and Boris galonske are

partners in the Global Risk & Trading Practice


tHe HIddentRansFORmeRs

companIes need to Improve tHeIr abIlIty

to IdentIfy and prepare for

emergIng rIsks

54 Risk JOuRnal

alex Wittenberg

This article first appeared in the Ivey business Journal

tHe HIddentRansFORmeRs

55Risk JOuRnal

Volatile commodity prices, a shifting political landscape in the united states, and global trade conflicts are all reminders of the economic and regulatory uncertainties that continue to weigh on senior executives. the financial crisis was a wake-up call for all companies to improve their

ability to identify and prepare for risks outside of those encountered in their daily business. unfortunately, much work still needs to be done.

Most companies remain as vulnerable as ever to risks that may initially appear unrelated until an unanticipated event occurs. Emerging risks are risks triggered by unexpected events, such as the volcanic eruption in Iceland, and familiar risks in unfamiliar conditions, such as the souring mortgages that triggered the financial crisis. While many senior executives prepare for obvious business threats such as a prolonged global recession, only 10 percent incorporate potential threats related to environ-mental issues, societal risks and technological concerns into their risk indicators, according to a survey conducted by Oliver Wyman in collaboration with the Financial Times. Emerging risks are increasingly introducing volatility into companies’ earnings. Across industries and geographies, these risks are jeopardizing companies’ supply chains, impacting raw material prices and threatening the security of critical industrial information. In effect, they are transforming the very nature of many companies’ business models, while receiving little to no attention in the boardroom or the executive suite.

Companies need to prepare for a new reality in which emerging risks increasingly impact their earnings and long-term strategy. Those that develop the ability to manage emerging risks will gain a significant competitive advantage over rivals who lack this level of sophistication.

EMERGInG RISkS ExPlAInEd The inherent unexpectedness of emerging risks is the fundamental reason companies still struggle to identify and assess them. A survey of 650 senior executives we recently conducted with the Financial Times revealed that 90 percent of respondents’ organi-zations have made efforts to increase their capacity to identify emerging risks. nevertheless, 62 percent of senior managers still consider their firms to be “ineffective” or only “moderately effective” at incorporating these risks into their business decisions.

Companies need to develop the ability to integrate emerging risks into their decision making. Volatile commodity prices are becoming some of the largest and most unpre-dictable costs for organizations ranging from consumer products manufacturers to transportation companies to food processors. In november of 2010, German auto parts supplier Continental AG announced weaker-than-expected quarterly earnings because of rising raw material prices. Food distributor Sysco Corp. missed its earnings estimates because of surges in the prices of dairy, meat and produce. And Archer daniels Midland Co., the world’s largest grain processor, had weaker earnings because of rising commodity prices.

emergIng rIsks

56 Risk JOuRnal

GlObAl EMERGInG RISkS by RAnk

Source: Oliver Wyman/Financial Times Global Emerging Risks Survey

68.8%

34.8%

21.8%

50.2%

20.8%

16.0%

8.4%

4.8%

4.0%

35.8%

8.2%

5.8%

5.4%

5.2%

4.8%

2.2%

2.2%

10.8%

9.4%

3.0%

2.6%

6.0%

4.2%

0% 10% 20% 30% 40% 50% 60% 70% 80%

Liquidity/Credit crunch

Financial market volatility

Commodity price volatility

Global recession

Major country/economy collapse

Cost inflation

Supply chain fragility

Supply chain quality

Shifts in economic powerhouse

Regulation/Policy risk

Increased protectionism and associated policies

Terrorism/Acts of war

Expropriation/Political risk

Energy/Resource security

Pandemics/Infectious disease

Aging populations

Demands for sustainable/socially responsible business

Pace of technology change

Data/IP theft

Mobile/Pervasive computing

Cyber-terrorism

Natural catastrophe/Extreme weather

Climate ChangeEnvironmental

Technological

Societal

Financial

Macro-economic

Governmental

RISK CATEGORIES

“the biggest challenge is recognizing that the future will not look like yesterday.”Head of Internal Audit, Manufacturing Sector

57Risk JOuRnal

THE nEEd TO REdEFInE bUSInESS MOdElSWeaker-than-expected quarterly results are only a small portion of the much larger dilemmas that emerging risks create. In many ways, these risks are altering the essence of many companies’ business models.

Highly volatile raw material prices, for example, are rewriting the rules for how companies must conduct business. For much of the second half of the 20th century, agricultural prices declined fairly steadily. In more recent years, many crop prices have tripled and remained at a high level over several seasons. In the last year, sugar prices have ranged from 13 to 30 cents per pound, while wheat prices have surged by more than 100 percent.

Sudden shifts in agricultural prices will continue for several reasons. First, the global demand for food is increasing, straining agricultural supply. Also, as populations grow and become more affluent, people are consuming more protein and processed food, which requires additional agricultural inputs to produce. Second, the number of extreme weather events is rising, causing more frequent disruptions of supply and introducing volatility into increasingly tight agricultural markets. Finally, fluctuating agricultural prices are attracting financial trading participants who are exacerbating already unpredictable price movements.

Taken together, these developments are creating billions of dollars in potential new costs that will be difficult for the food industry to pass on to consumers, especially as the global economic recovery remains sluggish. That means food companies, ranging from processors to

manufacturers to restaurants, could feel significant strains on working capital and pressure on margins.

The same is true for airlines. Crude oil prices spiked, tumbled, and then doubled back to $70 a barrel in 2009: we estimate that jet fuel became more than half of top airlines’ total losses that year. CEOs of a number of airlines have expressed concerns about rising fuel bills in 2011 and the resultant impact on profitability. If airlines do not adjust their business models to account for these conditions, they will continue to remain vulnerable to jet fuel price swings.

WHEn nOn-CORE bECOMES COREAnother way that emerging risks are redefining organizations is by introducing uncertainty in earnings through non-core activities. Many companies are discovering that the commodities they use have more of an impact on their earnings than their ability to increase efficiencies or to boost the sales of their core products or services. CEOs of heavy industrial companies, consumer products companies and even restaurant chains are increasingly attributing missing earnings estimates to vacillating prices for electricity, diesel fuel and natural gas.

In some cases, emerging risks are prompting companies to embark on ancillary activities that are morphing into businesses that account for a significant percentage of their earnings. Often these activities are highly profitable, but they require a different skill set from senior executives and introduce a much higher level of volatility into a company’s overall business.

volatile commodity prices are becoming some of the largest and most unpredictable costs for organizations

emergIng rIsks

58 RISK JOURNAL

As a result, senior executives are being forced to make tough decisions about whether they want to be in businesses they never anticipated entering—like trading commodities and generating power—or to spin off these operations. For example, after commodity trading and merchandising operations started to account for a large percentage of the profits of ConAgra Food Inc., the food maker sold the operations to the hedge fund Ospraie Management for $2.8 billion. According to a Wall Street Journal report, ConAgra did this in order to remove volatility from its earnings and to focus on its consumer brands like Chef boyardee pasta.

A THREE-dIMEnSIOnAl APPROACHGiven the quandaries that emerging risks are creating for companies, senior executives cannot afford to ignore them. Instead, they must take a three-dimensional approach to tackling emerging risks.

The first dimension involves a reverse stress test of the financial resiliency of a

company’s operations. In addition to spending time identifying what highly improbable event could impair their companies, senior executives should pay increased attention to assessing the size of a financial shock that could destabilize their business. For example, they should determine the amount of financial deterio-ration that would need to occur before it would trigger a potentially debilitating downgrade of the company’s credit rating.

designing a framework to achieve this is not easy. Companies that operate in the same industry and even geography can have very different exposures to emerging risks, depending on their financial structure, the nature of their supply chain, their exposure to raw materials and other inputs, and their contractual relationships with customers and suppliers.

After determining how large a financial shock a company can endure regardless of its source, senior executives should examine the potential impact of emerging risks from a second dimension: risk-adjusted scenario

JET FUEl IS An InCREASInGly SIGnIFICAnT COST FOR AIRlInES

Source: US dOT Form 41 as

processed by PlaneStats.com,

WTI, 30 day volatility, Oliver

Wyman estimates

note: A 0.01 cent change in

cost per ASM ($0.0001)

translates into a $100 million

annual change in cost.1.71 1.77 1.64 1.61 1.70 1.60

2.77 2.64 2.79 2.87 2.87

3.653.44 3.28 3.28 3.32

3.32

1.332.92 3.37 3.52

5.26

0

2

4

6

8

10

12

14

Pre-2005 2005 2006 2007 2008 Future?

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ST P

ER A

SM (C

ENTS

)

0

20

40

60

80

100

120

140FU

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TILI

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AIRCRAFT OPERATIONS MATERIALS & SERVICE SALARIES & BENEFITS

FUELANNUALIZED FUEL VOLATILITY

2.50

?

59RISK JOURNAL

planning. by doing so, they not only gain insight into specific situations or a series of events that can result in a loss, but also understand how the range of potential outcomes will impact their company’s portfolio of businesses. These include both those events that are internally driven, such as a disruption in operations, as well as those tied to the external business environment, such as credit tightening. Such planning exercises can reveal not only how potential risks can impair a business, but also how risks can enable a company to gain a competitive edge.

The third dimension that senior executives have to consider is the impact of macroeconomic shifts outside of their control such as commodity prices, consumer demand, currency values and interest rates. While many companies may consider how one of these factors could impact the performance of the organization or the earnings of a business unit, it is important to examine the net effect of multiple macroeconomic shifts across the entire portfolio.

For this type of scenario testing to be effective, executives must also determine the impact of a wide variety of correlated macroeconomic shifts – both those that occur on an ongoing basis and as potential single events. For example, they must understand the combined implications of slowed Chinese GdP growth, interest rate increases and volatile crude oil prices.

A COMPETITIVE AdVAnTAGEby designing such frameworks, companies can anticipate outcomes and quickly respond when an event strikes.

They will be able to pinpoint areas of vulnerability under different market conditions and the net impact on the overall organization. These insights allow senior executives to focus on initiatives to mitigate emerging risks and to capitalize on the resultant market conditions.

Sometimes senior executives who succeed in identifying which emerging risks could cripple their companies are challenged to do anything about it. Some rationalize inaction by assuming that their competitors will suffer the same consequences. Others feel overwhelmed by the prospect of addressing events that are difficult to conceive of and complex.

business models are being transformed by emerging risks in powerful ways, whether companies choose to acknowledge this fact or not.

These changes have potentially severe consequences for those senior executives who are unprepared for them. but they also present a significant opportunity: business leaders who address these risks with a sophisticated, multidimensional approach will gain a significant competitive advantage over rivals who don’t.

alex Wittenberg is a partner in the

Global Risk & Trading Practice, and head of the

Oliver Wyman Global Risk Center

senior executives must take a three-dimensional approach to tackle emerging risks

emergIng rIsks

60 Risk JOuRnal

TAMInG inFORmatiOn teChnOlOgy rIsks

Jonathan cohnmark robson

a neW frameWork for boards of dIrectors to manage It rIsks

RISK JOURNAL 61

It used to be clear which firms were technology businesses. they were core providers of technology itself (iBm, microsoft, apple) or later, the leaders in the new technology-centric

internet culture (google, eBay, amazon, yahoo). But today, every business is a technology business. no matter what industry, companies rely on technology to squeeze costs, streamline processes, leapfrog competitors, and, where possible, transform whole industries. yet while some management teams have kept pace with rapidly changing technologies to succeed in today’s business environment, it is the very rare board that has been able to provide the governance and leadership that is so desperately needed in this area.

A recent survey of 204 board members by Oliver Wyman’s Global Risk Center and the national Association of Corporate directors (nACd) finds that nearly half (47 percent) of board members are dissatisfied with their boards’ ability to provide IT risk oversight. When you consider how much is riding on companies’ ability to use technology effectively, that figure is alarming. The world’s largest 500 companies lose more than $14 billion every year because of failed IT projects, according to an Oliver Wyman analysis. Therein lies an opportunity. Companies that receive valuable board direction and input on IT-related risk will have a significant competitive edge.

Jonathan cohnmark robson

Risk JOuRnal

This article was developed as part of a Global Risk Center project in cooperation with the National Association of Corporate Directors

$14 billionthe amount

that the world’s

500 largest

companies lose

every year

because of failed

It projects

InformatIon tecHnology faIlures

62 RISK JOURNAL

THE IT GOVERnAnCE dIlEMMAThe pace of technological change is continually accelerating: Think how different the technology landscape looked just ten years ago. In 2001, there were no iPhones delivering apps on the go, social media was in its infancy and few people had heard of cloud computing. keeping up with these advances and dealing with the threats and opportunities they create is extremely difficult for IT professionals, never mind for “laypeople.” It’s unfor-tunate, then, that fully half (51 percent) of those board members surveyed say they aren’t given enough information to perform their IT oversight duties. Few board members have extensive IT experience: Only 16 percent of survey participants report having been a CIO or senior IT executive earlier in their career.

While opinions differ on the degree of importance IT will have on the future of the companies they govern, there is near unanimous agreement that it will markedly change the company’s performance. More than 99 percent of survey participants believe that IT will have a significant impact on the organization in the next five years. More than a third (36 percent) expect IT to improve operational efficiencies, while 30 percent believe IT will provide a competitive advantage for their company in the next five years. nineteen percent harbor even higher expectations: They believe IT will transform their company.

What’s more, the vast majority of board members surveyed say that oversight of IT risk should be the board’s responsibility. boards want to provide counsel and direction, and shareholders and senior

. . . what boards

urgently need is a different

way to approach

the breadth of It-related

issues

STUMblInG blOCkS FOR bOARdS

Source: nACd, Oliver Wyman

Insu�cient expertise at the board level

Insu�cient communication on

company’s IT strategy and operations

Lack of integrated business IT strategy

picture presented by management to board

Rapid pace of IT change

Board does not address IT

Dedicating adequate time to discuss IT

matters at board meetings

Communications from the CIO

Adequacy of information regarding

competitors gaining significant IT advantages

Other

0% 5% 10% 15% 20% 25% 30%

27.5%

16.2%

14.7%

13.7%

11.8%

7.4%

2.9%

2.9%

2.9%

63RISK JOURNAL

management expect them to do so—especially on the most challenging issues that impact the future of the corporation. Clearly, then, what boards urgently need is a different way to approach the breadth of IT-related issues.

A nEW FRAMEWORkGiven the many areas of a business that IT touches, IT risk shouldn’t be viewed as a monolithic issue. Rather, boards should consider IT in the context of a wide range of business concerns. Our framework, consisting of four pillars of risk, will give boards and executives a common language to address IT-related risks. The four areas of risk the firm could be exposed to by ineffective management of IT are: competitive, portfolio, execution, and service and security. below is an exami-nation of each of these risks in turn.

1. Competitive Risk: Threats here include the risk of competitors getting to market faster, gaining market share or achieving an

insurmountable first-mover advantage. That may happen through the introduction of a new technology that changes the channel to the end-consumer, dramatically alters the pricing or economics of a given business or eliminates the need for the company’s products and services.

One well-known example is the iPod. Apple wasn’t the first company to introduce an mp3 player. It was the first one to revolutionize the way customers legally bought and downloaded music. The iTunes store was nearly an instant hit. It not only helped the iPod dominate the market, but it also dramatically altered the economics of the entire music industry.

It is critical for board members to understand how the top management team is managing such potential external threats. boards have a responsibility to determine how great the risk is that competitors’ innovative use of IT could alter their own business’s core value

a frameWork for It rIskCOMPETITIVE RISK

The threat of competitors getting to market faster, gaining market share or achieving an insurmountable first-mover advantage through the use of technology.

PORTFOLIO RISK

The danger that a corporation is spending too much of scarce IT dollars and resources on basic operational expenses instead of truly transformational investments.

EXECUTION RISK

The failure to execute IT programs e�ectively or not delivering critical capabilities to the business on time and on budget.

SERVICE & SECURITY RISK

The risk that systems aren’t available to support and/or service employees and customers as needed and that critical data assets of the firm are not properly secured.


64 Risk JOuRnal

proposition. How does the management team evaluate the evolving IT capabilities of their competitors? What steps are being taken to ensure that the company’s position and its ability to maintain margin and grow revenues are not threatened?

While the specifics of these answers will be unique to each company, management should be able to offer a structured, data-driven evaluation of these risks across product and business lines. This analysis is most helpful when supported by detailed and integrated input from business unit executives—not just from functional IT management. Scenario-based views that analyze the potential impact on revenue streams and margins across multiple business units or product lines should also be used.

If boards don’t hear these elements, they should consider it a red flag. That means they need to work with their management teams to improve the corporation’s ability to plan, prepare and respond to these disruptive IT risks that can jeopardize its future.

2. Portfolio Risk: The IT project portfolio can involve hundreds, if not thousands, of independent and challenging IT projects. Generally speaking, 70 percent of these are dedicated to “keeping the lights on.” They are business-as-usual operations—email, upgrades to existing systems and the like. Such projects are necessary, but they won’t fundamentally change the firm. The other 30 percent are transforma-tional—the applications or platforms that could give your firm a big leg up on the competition. boards need to be aware of the risk of spending too much of scarce IT dollars and resources on basic operational expenses and not enough on true transfor-mational investments.

tHe six QuestiOns boards sHould ask about It rIsk because IT touches every aspect of a company’s operations, the number of questions boards could pose about technology-related decisions is nearly limitless. but in our opinion, these six questions should be on every board’s agenda.

f How do you determine the strategic importance of IT to the business?

f How do you evaluate the evolving IT capabilities of competitors that could threaten our industry position?

f How do you allocate dollars across the portfolio of IT investments to ensure an efficient risk return?

f What trade-offs are you making in managing the IT portfolio?

f How are you effectively executing on major IT programs?

f How do you ensure that a breadth of best practice capabilities and processes are in place to protect the firm from operational and security risks – both now and in the future?

every corporation is engaged in a real and unfortunate “arms

race” with cyber thieves from all corners of the world

70%the

percentage

of large It

programs that

don’t reach

their goals in

the allotted

time and

budget


65Risk JOuRnal

For a large corporation with an IT budget of approximately $1 billion, effective portfolio management can have a huge impact on competitiveness. A firm that manages its portfolio well can reduce its “lights on” investment from the industry norms of 70 percent to 60 percent or even lower. This gain of 10 percentage points is a major competitive advantage. Over a typical, large, three-year-long transformational program, that translates into $300 million of capital available for developing new capabilities that can make or break entire product and market strategies.

It is also important to consider how the management team spreads IT dollars across the portfolio of projects to achieve an efficient risk/return ratio. boards with a high awareness of IT issues look for a structured and well-documented process for making allocation decisions, monitoring performance and reviewing the overall portfolio. Moreover, the executive team should be able to explain the trade-offs they have made clearly. That would demonstrate they are making thoughtful and measured decisions, as well as optimizing scarce IT capital and resources.

3. execution Risk: This type of risk involves a company not executing IT programs effectively or not delivering critical capabilities to the business on time and on budget. because IT initiatives are often enterprise-wide, they impact many people and must be integrated with multiple technologies. They often impact client service. The failure of large programs can also cause lasting damage to brand reputation and cause companies to lose market share.

One would hope that failure is a rare occurrence. but this is not the case. As many as 70 percent of large IT programs don’t reach their goals in the allotted time and budget, according to an Oliver Wyman estimate. Many great business strategies and plans fall apart because IT programs are poorly executed.

To manage execution risks, boards must focus on two areas: Monitoring the progress made in carrying out IT programs and insisting on their integrated management by both leaders in business lines and their counterparts in IT organizations. Management teams need to offer a thorough and consistent framework for reporting their progress in meeting IT commitments. Such a framework contains real-world IT program metrics that can act as an early warning system, rather than the typical “red-amber-green” IT status reports that show everything as “green”—until the promised delivery date is close, then the reports suddenly turn “red.” If IT status reports don’t show a healthy dose of “amber” throughout the program, then teams are at best too lenient in their judgment of their own progress. At worst, the full story is not being told for fear of repercussions.

business and IT managers should also present an integrated view of major IT programs. If they don’t, it’s a warning that vast capital is being spent on IT programs without full support from business management teams.

4. service & security Risk: The last category of risk refers to systems being available to keep a business and the data

66 Risk JOuRnal

within its systems secure. Poor service levels and often painfully public security breaches of sensitive client information can alienate customers and employees as well as seriously damage a company’s reputation. yet all too often, boards and senior executives leave these issues to their IT organizations. They need to place them squarely on their own plates.

boards should ask exactly how the firm invests in ongoing service and security management on a quarterly basis. Proper investments are not just in technology—they include critical employee education and process improvement that often are the weak links in overall firm security. The executive team should undertake regular and comprehensive security assessments that include the probability of service and security breaches, prevention and remediation plans, crisis plans and process improvement plans for areas prone to security risks.

It is important for boards to exercise leadership regarding security risks. They should ensure that their management teams understand that their companies’ most critical information assets are constantly under threat by internal and external parties, and may already be compromised. Those who claim to have this issue solved are, at best, overly optimistic. In december of 2010, the national Security Agency announced that it now assumes all computer networks within the most secretive branch of the US intelligence service have been compromised. This should alert every

corporation that it is engaged in a real and unfortunate “arms race” with cyber thieves from all corners of the world.

COnClUSIOnTechnology is changing the way businesses operate in exciting ways, and at breath-taking speed. yet now more than ever, companies need the counsel of their boards to help them navigate a rapidly changing environment.

Unfortunately, as our survey shows, many board members are frustrated with their ability to oversee IT risk. Whether it’s due to a lack of technical expertise, insuf-ficient information coming from management, or that old chestnut, lack of time, many boards don’t offer the same sort of guidance and pushback that they do in other areas of corporate performance.

That has to change. boards must begin demanding the information they need, and management must start presenting a picture of IT that is integrated with their view of their business. by using a common framework to think about IT risk, board members will have a shared lens through which to assess their position and a solid platform from which to take actions that benefit the corpo-rations and shareholders they serve.

Jonathan Cohn is a partner in the Strategic IT

& Operations Practice and mark Robson is a

partner in the Global Risk & Trading Practice

The primary reason is a timing mismatch: To be successful, a business has to react quickly to changes in market structure, competition and client needs. In many cases, it must make sizable course corrections from quarter to quarter. Most IT organizations, by contrast, work on an annual cycle. They aren’t equipped to shift course quickly. As a result, despite their best efforts, IT solutions fall further and further behind the business each quarter.

Consider, for example, the all-too-common problem of IT projects getting rolled out much later than expected. It’s not that IT is lackadaisical about deadlines, or the project manager is subpar. It happens because companies shift

WHy do It organIzatIons Have sucH a dIffIcult

tIme supportIng rapIdly cHangIng busInesses?

and WHy does tHe problem seem to be gettIng

Worse, not better?

tHe ViCiOus CyCle In It

Time

REL

ATI

VE

LEV

EL O

F C

HA

NG

E IN

BU

SIN

ESS

NEE

DS

AN

D D

IREC

TIO

N

BUSINESS NEEDS DELIVERY OF REQUIRED IT CAPABILITY

A

Example AC here represents one IT project – this problem is replicated hundreds or thousands of times throughout a given corporation

Significant gap in meeting business needs impacting revenue and competitive

positioning

B B

Manageable gap in meeting business needs

A A

Untenable gap in meeting business needs impacting revenue, margins and new

product introduction. That can force a business to build “shadow

IT” solutions without su�cient security or compliance controls

CC

CHAnGE In IT bUSInESS nEEdS OVER TIME

Source: Jonathan Cohn,

Oliver Wyman

plans for their product, market and trading strategies at lightning speed as the environment alters. And every time a company changes direction, the gap between what it needs as an IT solution and what IT has been working to deliver grows disproportionately larger. (Exhibit below.)

IT teams find that they’ve been investing time trying to provide solutions to needs that have already changed. Making minor changes to projects becomes more difficult as other altered or unfinished IT initiatives pile up behind them. Worse, some IT endeavors may never get under way, potentially forcing businesses to miss critical opportunities.

This timing problem has two other insidious effects: First, bowing to the pressure to deliver, IT groups will stop adhering to standard solutions and/or architectures, increasing the risk and support costs of a project. Second, business managers become so frustrated that they bring in “shadow IT” solutions that then must be integrated into and supported by the

larger corporate IT environment.

Understanding this vicious cycle is the first step toward avoiding it. boards should be alert to the presence of these issues within the corporations they govern. Asking tough questions of IT and business management ensures they are developing more nimble methods of designing and delivering solutions.

67Risk JOuRnal


dynamiC RISk MAnAGEMEnT

John larew mark robson

THE “MISSInG lInk” In InFRASTRUCTURE FInAnCE

68 Risk JOuRnal

69Risk JOuRnal

there is a paradox at the heart of investing in infra-structure. On the one hand, investors are typically attracted to infrastructure assets because they are seeking stable cash flows over long time horizons.

On the other hand, greenfield infrastructure projects represent huge and often risky bets—bets that can go spectacularly bad.

It’s no wonder, then, that infrastructure funds in recent years have found it easier to come across interested investors than to unearth investments that suit their investment strategies —even as global infrastructure needs continue to outstrip the capacity of public sources to fund them.

Today, more than ever, infrastructure investors need tools to bridge the gap between their risk appetite and the actual level of inherent risks of projects requiring massive capital outlays against time-distant revenue streams. In Oliver Wyman’s work with large infrastructure projects, we have found that there are a number of tools for dynamic risk modeling that are often underused, but that can be a valuable resource for project sponsors, lenders and equity investors alike.

THE UnTAPPEd POTEnTIAl OF RISk MAnAGEMEnTInfrastructure projects, be they roads or rail lines, ports or airports, power lines or waterworks, all share certain characteristic features. These typically include:

f High upfront investment requirements

f “Chunky” capacity, with significant scale economies

f building ahead of demand (often uncertain or speculative demand)

f Uncertain cost to create capacity

f Uncertain timing of revenue

f High leverage (typically 60-80 percent gearing)

f Extraordinarily high sensitivity to financing costs

MAnAGEMEnT

mIsmanaged large proJects

70 Risk JOuRnal

numerous academic studies have come to the conclusion that greenfield infrastructure projects systematically disappoint their backers: cost overruns, schedule delays and revenue overestimates seem to be the norm more than the exception. It is no exaggeration to say that mastering risk—understanding, quantifying and managing it—is the key capability in successful infra-structure investment.

In this environment, sophisticated investors have learned to appreciate the value of dynamic financial modeling (e.g., Monte Carlo simulation) in assessing the likely performance of prospective investments. Unlike traditional static financial modeling, a stochastic risk model recognizes that key drivers of financial results (capital costs, operating costs, volumes, prices, timing of cash flows, etc.) are inherently uncertain and can interact in unexpected ways. Instead of assigning a discrete value to these variables in a

exhiBit 1: CASH FlOW/

EARnInGS And THE IMPACT

OF RISk

Oliver Wyman analysis

spreadsheet, the Monte Carlo method models key variables in the form of a probability distribution function. This can be further extended to include the dynamic interactions between simulated outcomes of risks.

The output of such an analysis is a much richer view of the financial prospects of the investment. Instead of looking at, say, the results of three or four scenarios, a decision maker can see the consolidated results of thousands or tens of thousands of simulation runs. And while a traditional financial model might answer the question, “What is the sensitivity of cash flows to a 1 percent change in interest rates?”, it cannot reliably answer questions such as, “What is the probability that this project will meet its IRR target?” or “What is the probability that the project will remain in compliance with all its financial covenants?” The stochastic risk modeling approach, however, can answer those questions, which is one reason it has become the acknowledged gold standard for financial analysis of infrastructure investments.

In our experience, however, many project sponsors and investors do not capture the

mastering risk—understanding, quantifying and managing it—is

the key capability in successful infrastructure investment

DISTRIBUTION OF CASH FLOW/EARNINGS IMPACT OF DIFFERENT RISKS ON CASH FLOW

Financial Asset integration

Facility disruption

CompetitionCounter-party

0%

50%

40%

30%

20%

10%

0%

50%

40%

30%

20%

10%

71Risk JOuRnal

exhiBit 2: UnCORRElATEd VERSUS CORRElATEd RISkS

Oliver Wyman analysis

full value that stochastic risk modeling offers. Value is typically left on the table in two ways: the risk model itself may be faulty or incomplete, or the risk model is too often abandoned after the initial investment decision has been made.

The first major pitfall in dynamic risk management is getting the model wrong. When it comes to stochastic risk modeling, there is wisdom in the old adage that a little knowledge is a dangerous thing. The very precision of the outputs (“In 95 percent of the cases, the project will meet its IRR target”) can lead to a false sense of confidence if the appropriate care has not been taken in constructing the underlying model. The recent proliferation of easy-to-use spreadsheet add-ons such as Crystal ball and @Risk may have encouraged a tendency toward overreliance on unreliable models.

There are many ways to go wrong in modeling risk (just ask anyone who invested in collateralized mortgage obligations), but one example serves to illustrate this point. Imagine a project in which the net present value is sensitive to two variables: the price of crude oil and the

dollar exchange rate. With the help of a spreadsheet add-on and a few databases, it’s a simple exercise to generate a proba-bility distribution function for both variables based on historical ranges. After running a Monte Carlo simulation of the project, the expected nPV of the project might look like the figure on the left in Exhibit 2 below.

but this analysis implicitly assumed that the oil price and dollar exchange rate are independent of one another, when in fact they are correlated. After modifying our model to account for the correlation between the two variables, our expected nPV might look more like the figure on the right. What once appeared to be a sure thing is revealed to have a nontrivial chance of failure. Across many projects in diverse industries, Oliver Wyman has seen our belief confirmed that there is no substitute for a disciplined modeling approach, rigorously applied by skilled practitioners.

The second major pitfall in dynamic risk management is getting the model right, but not doing the right things with it. A common shortcoming is the disjunction between the risk analysis that goes into


UNCORRELATED RISKS CORRELATED RISKS

NEGATIVE NPV

POSITIVE NPV

NEGATIVE NPV

POSITIVE NPV

72 RISK JOURNAL

the concept, design, and finance phases and the risk management approach that guides the engineering, procurement, construction and operating phases.

Oliver Wyman’s approach to risk analytics looks at the variability of cash flow versus plan (“cash flow at risk”) as the primary metric. While this metric usually makes intuitive sense to project sponsors and investors, it stands in contrast to the engineering-driven approach to risk analytics that often prevails in a contracting and construction environment. To be sure, there can be value in the tools used in engineering-driven risk management, such as comprehensive risk registers, heat maps and the like. but this approach falls short of the needs of senior management. While notionally comprehensive, it fails to distinguish the merely important from the absolutely critical. And it leaves senior decision makers without the tools to understand potential trade-offs in risk and reward.

dynAMIC RISk MAnAGEMEnT: FEWER RISkS, MORE REWARdSOur experience has shown that investors and sponsors who incorporate a dynamic risk management approach can avoid these pitfalls and extract substantial additional value from their investment.

The benefits of a more robust risk management approach are numerous, and accrue to infrastructure funders, operators and users alike.

Focuses on the right risks. The dynamic risk management framework gives management visibility into the impact of risks on the bottom line. In one recent engagement, the project sponsor intuited that the major risk to cash flow was demand risk, and was prepared to sacrifice substantial revenues to mitigate that risk through take-off agreements. Oliver Wyman’s risk analytics showed that risks related to internal execution were far more important, leading the client to devote more resources to those risks.

Supports a wide range of management decisions. Armed with the right analytical tools, management can compare and contrast the value created by investing in different risk mitigation measures for different risks. Funding strategies, hedging strategies, sourcing strategies and technology choices are among the tools that become more effective with a reliable understanding of cash flow at risk. In one recent example, we used a stochastic risk model to quantify a heretofore underappreciated supply risk. The client subsequently modified its technology strategy to focus on a more expensive, but more secure source of raw material.

Supports efficient allocation of risk. Infrastructure projects increasingly involve multiple investors and stakeholders, for example, through public-private partnerships and customer-supplier co-investment. Efficient allocation of risk can be a significant lever of value creation,

the benefits of a more robust risk management approach are numerous,

and accrue to infrastructure funders, operators and users alike

73RISK JOURNAL

not to mention a vehicle for making deals possible that might otherwise founder on stakeholder resistance. In a recent deal involving a major expansion to a transpor-tation asset, risk analytics revealed that the infrastructure developer faced substantial exposure to steel price inflation—an exposure that could not be conveniently hedged. Faced with the prospect of paying for the steel risk through a price premium, the infra-structure users found it more efficient to accept the risk themselves, as they had some upside risk exposure to steel prices. The natural hedge was a win-win for the developer and the users.

Prioritizes value improvement opportu-nities. dynamic risk management is not just about avoiding downside risks, but also enabling upside opportunities. by comparing multiple investments across the dimensions of risk and return, companies often can find “free lunch” opportunities: higher return for the same level of risk.

lowers financing cost. dynamic risk management is ultimately about making risk transparent—to sponsors, operators and investors. bank regulators, following the capital adequacy standards in the basel II and basel III accords, are pushing lenders in the direction of greater reliance on dynamic risk evaluation. Project sponsors increasingly find that they need to have access to dynamic risk models to access the widest possible capital pool.

based on concrete project experience, Oliver Wyman has identified a set of factors that underpin the success of risk management in infrastructure projects or, indeed, any large capital project:

f Adopt a cash flow at-risk framework, and apply it consistently throughout the project life cycle.

f Get the model right. Take a rigorous approach to constructing a pyramid of risks that describes the network of interrelated risk drivers.

f Calibrate the model carefully. Pay attention to the choice of statistical distributions, to the impact of “tail risks,” and the correlation of risks.

f Anchor the responsibility for risk management in the organization. decision making processes and governance should adhere to the risk framework.

The universe of infrastructure investment opportunities grows larger every day. but comparatively few opportunities have the “ideal” risk profile investors seek. If every infrastructure investment had known capital costs, predictable revenues and stable margins, there would be no need for sophisticated risk management techniques. Until then, savvy sponsors and investors will need the best tools at their disposal to master risk.

John larew is an associate partner in the

Corporate Finance & Restructuring Practice

and mark Robson is a partner in the Global

Risk & Trading Practice


74 Risk JOuRnal

James mackintoshpaul mee

data Quality: THE TRUTH ISn’T OUT THERE

WHy do banks stIll struggle to acHIeve

tHeIr fInancIal goals? tHe data on WHIcH tHey

base decIsIons Is serIously flaWed

This is not an uplifting article. it makes a dismal claim about a dull topic: namely, that the information on which banks base their decisions—information about exposures, risks and customers—suffers from

serious shortcomings. the humdrum matter of poor data explains many of the problems banks experience in achieving their goals, including avoiding insolvency.

Crisis commentary has focused on fundamentals of morality and common sense that were allegedly discarded during the pre-crisis boom. bankers were consumed by greed; investors were fooled by leverage; regulators were blinded by complexity. you know the story. However, one fundamental has been ignored. banks can only make good decisions if they have collated data and translate it into useful information. Good managerial decisions require a foundation of accurate information. It is well-documented that, pre-crisis, big decisions were made on little information. but it is less widely understood that this was often because the infor-mation was unavailable.

RISk MAnAGEMEnT IS bUIlT On THREE bASIC CAPAbIlITIES, EACH OF WHICH IS A nECESSARy PRECURSOR TO THE nExT:

1. Information: knowing current positions or “exposures”

2. Measurement and forecasting: Understanding how and why the bank’s exposures and earnings might change

3. Management: Processes to bring exposures in line with an agreed risk appetite or tolerance

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Post-crisis there has been much discussion of risk measurement and management but remarkably little of the data on which they depend. This is perverse. If, as we claim, the data on which risk measurement and management are based is seriously flawed, the material progress in these two areas is next to impossible.

Indeed, poor data can undermine not only risk management but most of the actions a bank takes. be it a group-level strategy decision or something as specific as setting prices for consumer loans, the story is the same; the quality of any decision depends on both the skill of individuals involved and the information they rely on. If data quality is poor, the information will be poor and only luck can stop the decisions from being poor.

What is good data quality? Its hallmarks include accuracy at the point of entry, completeness of fields, congruency as it flows through the institution, consistency of interpretation and a stable approach to storage over time. Most importantly, high-quality infor-mation is well-structured to support business uses. For example, data processing systems often have no place for information that is relevant to the economics of transactions, such as the term of a collateral pledge. Even if the data is collected, it is not stored with the other relevant information, gets “lost in the system,” leading to errors in the bank’s understanding of its exposures.

So, how bad is the information on which banks base their decisions? We cannot prove definitively it is not fit for purpose, but we are prepared to state that there are serious problems at most institutions.

Prior to the crisis, institutions unwittingly generated concentrations, partly because different internal businesses ran separate systems that failed to identify where risk drivers were shared (e.g. exposures to the same counterparty, different risks to the same counterparty and so on). When executives ask how much exposure they have to an asset class, they normally receive a range of very different answers and no single conclusion is ever quite reached. data paucity at some institutions is as simple as the inability to differentiate between OECd government debt (system identifier: “AAA bond”) and structured products (system identifier: “AAA bond”).

Compounding such structural data problems is the plethora of data errors or omissions. In our work with clients and their databases, we often encounter individual missing fields with direct financial implications exceeding $10,000. Consider a simple but common example: the omission of information about the term of a collateral pledge. This exposes banks to the risk that an apparently collateralized loan is in reality unsecured. In the event of a default, such an omission could cost the bank millions. This is but one of countless apparently trivial but cumulatively expensive and dramatic shortcomings in data quality.

Many executives were surprised by their exposures as the crisis unfolded. yet the underlying problem is still to be solved. Most banks still devote considerable effort

poor data can undermine most of the actions a bank takes…

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to manual “workarounds” or “clean ups” during their regular reporting cycles. Rational executives at most banks remain skeptical of the data presented to them. Strategic thinkers will ask themselves about the opportunity cost of lost customer insights or economic understanding. little imagination is needed to see that radically different customer service propositions and operating models would be possible if data were of higher quality.

Given the centrality of information to banking, it may seem surprising that data quality at most banks remains poor. However, a brief examination of stake-holders’ incentives makes it less surprising:

f Executives Fixing data quality is difficult, expensive and time consuming. Given the time horizon of most senior executives, other uses of capital and staff attention are likely to be more rewarding. nor are data issues likely to be those that naturally concern such men and women. It is not a topic that one immediately associates with “Titans of Finance.”

f Regulators Given that banks struggle to assess data quality internally, third parties may find it impossible. Moreover, the existence of poor data undermines the regulatory measures that underlie prudential supervision. If information quality is an issue, regulators themselves have some tough questions to answer.

f CIOs cannot be directly accountable for data quality. Technology functions take the data provided, collate it, transform it according to models provided by other functions (such as

Risk, Finance and the business lines) and then funnel the outputs to their users. It is a “plumbing” job that cannot in itself improve the quality of the base data provided or the design of the models that transform the data into information. The CIO can (fairly) protest that he and his staff were “only following orders.”

f Risk Managers have an incentive to ensure that the data is accurate as this will improve the quality of their decisions. However, two facts about modern risk management blur this incentive. The first is that the performance of risk managers is unobservable over any reasonable time frame. Their primary job is estimating “tail risk”—e.g. the size of annual losses with extremely low probabilities. Since annual losses with very low probability do not happen often, there is no way of measuring the accuracy of risk managers’ estimates, and thus the whole incentive area is a difficult one. From a different angle, many modern risk managers have committed themselves to mathematical techniques that are heavily reliant on data accuracy. If they become vocal about the poverty of the data with which they are working, what does that say about the value of what they do? A “quant” who values his or her role cannot be a fierce critic of the bank’s data quality.

f Investors and analysts cannot touch or feel the internal data of institutions to get a handle on what is really going on. Agreeing that basic data is flawed does not fit well with their avowed, information-based strategies for delivering alpha.

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f Politicians, the press and public opinion are unlikely to recognize something as mundane as data quality as being a crisis cause. Greedy bankers make more emotionally satisfying culprits.

What can be done? data quality programs start (and often end) with a framework consisting of measurement, governance, ownership, processes and organization. While these are undeniably important, implementing such frameworks has failed to improve information at many banks. It is striking that these “solutions” do not even attempt to address the incentive problems described above. The problem of collective myopia and incentives is replaced with a more tractable set of process-type issues. We wonder how many times the “tried and tested” approach must fail before more creative approaches are considered.

ensure that the “life or death” influence that data quality has on strategy and operations is recognized. Progress is seen from the few banks that have grasped the nettle, understood the extent of the problem and dedicated resource and mind space from across the organization.

Metaphors aside, what can executives actually “do” differently? The following are critical:

f build a case for action: Quantifying the cost and/or opportunity of data to underline the importance of the issue. FTE costs of manual data review will likely be visible to some degree; the potential benefit of better customer service or more precise credit decisions may not be.

f Embrace the challenge: Critical issues pervasive to organizations are governed day-to-day by the executive, and data quality should be no exception. If group-wide financial planning is worthy of ongoing executive attention, then so is data quality.

f Tackle incentives head on: data quality is an incentives problem—for individuals that impact data quality (e.g. most executives and a majority of staff members) data quality should appear in incentive schemes, job descriptions and performance evaluation.

f Articulate what good looks like: Most organizations have several data quality definitions, occupying dusty

Information quality has become a ceo agenda item at some

forward-thinking institutions

building data quality into the dnA of an organization is not a short-term project that can be undertaken in any given operating function. Instead, radical changes to the culture, priorities and incentives of the top-level executive through to branch staff are required. Graveyards packed with failed or aborted data quality projects demonstrate that bottom-up IT-led solutions are likely to prove costly, time-consuming and poten-tially futile diversions. buy-in from the Executive Committee is necessary to

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drawers. Internal marketing of a business-relevant definition helps to ‘sell’ the issue and lays the groundwork for other initiatives.

f Instill discipline over “proprietary” data: In a data quality vacuum, many functions in a bank will have their own “proprietary” version of the truth, undermining transparency and access to information. Phasing out “proprietary” data has to be done carefully (it was created for a reason), but the executive should set and stick to hard standards for data sources to meet, and these should include a single version of the truth.

f Win something (for a change): Steps in a typical data program life cycle include “scope creep”, “overwhelmed” and “capitulation.” Maintaining focus on a small set of business critical decisions, and proving that success is possible, helps to break the failure cycle.

Pessimists who propose that data quality cannot be improved face a stark choice. They must either continue “as is” or simplify the organization’s operations to reflect the poverty of their data. Choosing between “flying blind” and severely constraining your ambition is an ugly choice—and reason to resist the pessimistic view about the possibility of improving data quality.

The first step of treatment is recognizing you have a problem. It is not clear that a majority of stakeholders in banks have reached this stage yet. but information quality has become a CEO agenda item at some forward-thinking institutions. Will data quality be a differentiator of future performance? Alas, we do not have the data.

James mackintosh is a partner in the Finance

& Risk Practice and Paul mee is a partner and

head of the EMEA Strategic IT & Operations

Practice

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For more information, please contact:

Roland Rechtsteiner

Managing Partner


Phone: +41 445-533-405

Email: [email protected]

emily thornton

director of Research


Phone: +1 646-364-8279

Email: [email protected]

about Oliver Wyman’s global Risk & trading Practice

Oliver Wyman’s Global Risk & Trading practice enables the world’s top industrial

corporations and commodity trading organizations to gain competitive

advantages by assisting them with managing risk across their businesses more

effectively. by working with global leaders in a broad range of industries, our

practice has developed unique capabilities that help industrial corporations and

commodity trading organizations create value and maximize their performance

by making risk-adjusted strategy, investment and capital allocation decisions.

about Oliver Wyman

With offices in 50+ cities across 25 countries, Oliver Wyman is a leading global

management consulting firm that combines deep industry knowledge with

specialized expertise in strategy, operations, risk management, organizational

transformation and leadership development. The firm’s 3,000 professionals help

clients optimize their businesses, improve their operations and risk profile and

accelerate their organizational performance to seize the most attractive

opportunities. Oliver Wyman is part of Marsh & Mclennan Companies [nySE:

MMC]. For more information, visit www.oliverwyman.com.

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