Running with Risk

 

Companies must also provide education and training in risk management, which for many managers is quite unfamiliar, and establish effective incentives to encourage the right risk-return decisions at the front line. Judging the performance of business-unit heads on net income alone, for instance, could encourage excessive risk taking; risk-adjusted performance should be assessed, too. Ultimately, people must be held accountable for their behavior. Good risk behavior should be acknowledged and rewarded and clear penalties handed out to anyone who violates risk policy and processes.

Finally, to convey the message that the potential downside of every decision must be considered as carefully as the potential rewards, CEOs should be heard talking about risk as often as they talk about markets or customers. The CEO's open recognition of the importance of good risk management will influence the entire company.

Even world-class risk management won't eliminate unforeseen risks, but companies that successfully put the four best-practice elements in place are likely to encounter fewer and smaller unwelcome surprises. Moreover, these companies will be better equipped to run the risks needed to enhance the returns and growth of their businesses. Without adequate risk-management programs, companies may inadvertently take on levels of risk that leave them vulnerable to the next risk-management disaster, or, alternatively, they may pursue "recklessly conservative" strategies, forgoing attractive opportunities that their competitors can take. Either approach will surely be penalized by investors.

Sidebar: Board oversight of risk management

A company's board of directors should understand and oversee the major risks it takes and ensure that its executives have a robust risk-management capability in place. To assure appropriate oversight, the board must address a few key issues.

Board structures. The board must decide whether risk oversight should be vested in an existing committee (such as the audit or finance committee), in a new committee, or divided among a number of committees. The audit committee might seem the natural choice, but as it already faces expanded responsibility to ensure the accuracy of financial reporting, it might not be able to cope with a further expansion of its charter.

Board risk reporting. Reports to the board and its committees must go beyond raw data by setting out, for example, what the key risk-return trade-offs might be. Data alone probably won't reveal the real issues or promote proper debate.

Education and expertise. Training programs might be needed for current and new board members. Boards should also look at whether they need new members with risk-management expertise.

Board processes. Boards need to review the effectiveness of their own risk-management processes periodically. They should look at committee structures and charters, how well board members understand risk policies, and the value of their interactions with management on risk. Some companies use a formal self-assessment tool that allows directors to rate the effectiveness of board-level risk-management processes in areas such as risk transparency and reporting, committee meetings, and risk expertise. Reviews should take place about once a year.

Return to reference


Notes:

Kevin Buehler is a principal and Gunnar Pritsch is an associate principal in McKinsey's New York office.

1For this analysis, we defined financial distress as a bankruptcy filing, a ratings-agency downgrade of two or more notches, a sharp decline in earnings (50 percent or more below analysts' consensus estimates six months earlier), or a sharp decline in total returns to shareholders (at least 20 percent worse than the overall market in any one month).

2Measures of risk-adjusted performance revise accounting earnings to take into consideration the level of risk a company assumed to generate them.

3Financial Times, July 24, 2003.

Copyright © 1992-2003 McKinsey & Company, Inc.

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