Black Swan Scenarios: Your CFO and Business Risk Management

Posted by Janis Narvas

Jun 22, 2018 10:00:00 AM

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In today’s globalised economy, events that happen in Asia can have serious repercussions to businesses in Europe. So-called ‘black swan’ events, which may be economic, political, technological, or environmental in nature, may disrupt businesses and adversely impact organisations, if not managed properly. As such, enterprise or business risk management has never been more important.

What is a black swan event?

In The Black Swan: The Impact of the Highly Improbable, author Nassim Nicholas Taleb introduced the concept of black swans, or highly improbable, large-scale events that have a significant impact, if it does occur.

Some examples of black swan events are natural calamities and political upheavals, such as the Fukushima earthquake and the Arab Spring in 2011. Various technological, socio-economic, and political developments across the globe also affect the probability of black swan events, such as the rise of automation and the Internet of Things, the risk of cyber-security breaches, populism, and terrorism.

According to Taleb, black swans can be described as follows:

  • An outlier – A black swan event is something that is unexpected and improbably, because there are no similar events in the past that can convince us of its probability.
  • Significant – Black swan events carry an extreme impact, resulting in economic, social, political, or cultural disruptions.

As for the unpredictability of the occurrence of such events, Carolyn Williams of the Institute of Risk Management says, “In retrospect, we might think that we saw them coming, but they are by their very nature unpredictable in that predictions will either be dismissed as too far-fetched or lost in the noise of the range of possible outcomes.”

An example of a black swan scenario in risk management might be the eruption of Eyjafjallajökull in Iceland back in 2010, which heavily disrupted airline operations in about 20 Northern European countries for six days, affecting approximately 10 million travellers.

 

How do we prepare for the improbable?

Given the far-reaching effects of these events, is it even possible for organisations to effectively prepare? Most probably not. In a 2009 article on the Harvard Business Review, Taleb explained that risk management should be “about lessening the impact of what we don’t understand—not a futile attempt to develop sophisticated techniques and stories that perpetuate our illusions of being able to understand and predict the social and economic environment.”

Here are some suggestions on how we can prepare for black swan scenarios:

1. Change your perspective: Hindsight is not foresight.

Not all events have precedents in the past that will prepare us for future eventualities. Owing to the massive technological developments that continue to disrupt businesses every year, our world today is not what it was five years ago. As such, predicting major changes is not as simple as before.

According to Taleb, we now have “to predict both an event and its magnitude, which is tough because impacts aren’t typical in complex systems.”

2. Prepare for eventualities rather than predict them.

Rather than try to predict and understand these events, it would be more prudent to focus on reducing our vulnerability to any eventualities resulting from extreme scenarios.

To achieve this, the enterprise risk management function may perform stress testing, scenario planning, or supply and chain analysis. Contingency plans should also be available for a major “what if” or risk scenario.

3. Map out the shape of your enterprise.

We need to have a complete picture of the shape of our company. Understanding and mapping your company’s relationships can better prepare you for critical events.

In 2011, Apple encountered a challenge in its supply of lithium-ion batteries after the March 11 earthquake in Japan. They discovered that most of their suppliers source a vital component of their batteries from a Japanese company called Kureha Corporation. This company has a 70 percent share of the global market for polyvinylidene fluoride. Thus, analysts should also be aware of second- and even third-order relationships in their supply chain.

In an article for the Strategy + Business website, Matthew Le Merle stresses the importance of this action, as it allows the business risk management team to understand where the status quo lies. This will help the other functions in the organisation to better prepare for any eventualities that may arise that could disrupt their operations.

 

It is virtually impossible to fully prepare for every black swan event in the world. Nevertheless, enterprise risk management is every organisation’s responsibility. Minimising risk, asking “what if” questions – these are some of the actions that enterprises should take. More importantly, conducting periodic stress tests and scenario planning by the risk management department will go a long way. As Taleb put it, “Any corporation that doesn’t recognize its Achilles’ heel is fated to die because of it.”

 

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Topics: Business Financial Forecasting, Business Leadership and Management, Strategic Planning

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