Magazine article

Boards could learn a lot from Tilly Smith, the 10-year-old who saved more than 100 people during the 2004 Boxing Day tsunami in Thailand. Drawing on her geography lessons, the British student recognised a giant killer wave was on the way and alerted beachgoers.

Tilly noticed the sea was “fizzing”. Waves came in, not out. A log spun in the water. Her parents, upon being alerted by Tilly, said it was just bad weather. Undeterred, she shouted “tsunami” and convinced her parents and other beachgoers to move to higher ground.

Tilly recognised a pattern of unusual events and drew on her experience of watching a video of a Hawaiian tsunami in class. She acted quickly on the data, had conviction in her beliefs and persuaded others to accept the risk of a rare event.

Fast-forward 12 years and it is obvious that boards could do with a few more Tilly Smiths: directors who are curious, information hungry and able to join the dots from disparate data. Directors who see early warning signs and influence others to respond.

Identifying “grey” swans

As global business becomes more unpredictable and volatile, boards will need to assess their capability to foresee unexpected events and ensure their organisation can adapt. If not for “black swan” events, which by definition are hard to predict, then for so-called “grey swans”: high-impact events that can be anticipated but are unlikely to occur.

This could involve boards challenging their role and relationship with management, using big-data software to identify patterns, and upgrading their scenario-planning skills, particularly in overseas expansion strategies. Governing for unexpected events could also force boards to challenge like never before their composition, decision-making biases, information sources and openness to new ideas.

Moreover, it could lead to boards having more unstructured conversations about “outlier” events and creating conditions where directors feel confident to think and speak at tangents to the group view. Ensuring the organisation’s culture is sufficiently open, agile and adaptive to deal with unexpected events should be a high board priority.

“The competitive landscape in global business is rapidly changing,” says Dr Nora Scheinkestel FAICD, chairman of Macquarie Atlas Roads and a non-executive director of Telstra Corporation and Stockland Corporation. “But company risk-management systems tend to focus on specific risks and mitigants, whereas so-called black swan events usually have many ‘mothers and fathers’ and are multi-factorial.”

Scheinkestel adds: “The first question is: are these shocks really black swan events or would they have been evident beforehand if the ‘dots had been joined together’? Boards and management teams must be looking beyond specific issues or sometimes even their own industry and sectors to identify trends or patterns that have the potential to materialise into large problems.”

Bank of Queensland (BOQ) chief risk officer Peter Deans GAICD, says: “In an increasingly interconnected world, shocks are transmitted rapidly through financial markets and the economy. It is imperative that boards are alert to emerging risks in Australia and offshore, but equally do not overreact to them as financial markets often overshoot with shocks.”

That is a rare skill. For all their collective wisdom, the majority of boards worldwide missed the 2008-09 global financial crisis. They failed to see the 2001 dotcom bubble and 1997 Asian Financial Crisis – events that sparked huge wealth destruction and corporate chaos in some sectors.

Boards were hardly alone. Most in business and government missed, underestimated or ignored these events, even though they could be rationalised in hindsight. Viewers of the film The Big Short, which chronicled the 2008 US housing bubble, might ask how boards were so blind.

Today, the rise of US presidential candidate Donald Trump, quickly dismissed as a serious contender early in his campaign, shocked business. As did Britain’s decision in June to leave the European Union when polls suggested it would stay. “Brexit” sent a short-lived tremor through global financial markets and hurt Australian companies with UK operations. Global equity markets slumped on the news, only to soon recover their losses as it became clear that investors had overreacted.

Other potential black swan events could be brewing under the nose of boardrooms: war between Russia and Turkey; a hard landing for China’s economy; a global stockmarket crash as US interest rates rise faster than expected; a cyberwar initiated by rogue nations or terrorists; or a collapse in overheated Australian house prices, to name a few. Climate change, too, could set off a bevy of black swans in coming years, its catastrophic risks appearing obvious in hindsight.

Although the media characterises black swans as one-off events, their fallout can affect business and boards for years as governments worldwide respond with greater regulation.

Philip Armstrong, director of governance at Gavi in Switzerland, told Company Director earlier this year: “Financial crises will continue to be seen as much a political as an economic issue and governments will need to be seen to respond with tougher laws. The big challenge for boards over the coming 10 to 15 years is that governance will be seen as a parallel form of regulation.”

That trend is playing out in the UK. In July, British Prime Minister Theresa May promised to tackle excessive boardroom pay and broaden the pool of potential non-executive directors by proposing that consumers and employees are represented on company boards – a two-tier supervisory governance model that is gaining momentum in Europe.

May’s reforms are expected to require more transparency on executive pay and to make shareholder votes on pay binding, not only advisory. She has spoken about toughening UK competition laws and reducing tax avoidance and evasion – moves viewed as a response to a divided Brexit vote and growing community disenchantment with big business.

Offshore risks

Boards of Australian organisations with global ambition must pay greater attention to offshore regulatory risks. The potential for financial shocks and the ensuing extra regulation, as well as a growing backlash in developed nations against globalisation and a potential shift towards more isolationist economic policies, are rising business challenges.

These risks are so complex and multi-faceted that boards could argue they should not waste time on “unknown unknowns” and instead focus on higher-probability events. However, leading company directors and governance experts argue that boards, particularly those with global operations, must factor the potential for shocks into risk-management planning.

Scheinkestel says a key issue is board and management diversity. “There’s been a lot of talk about diversity almost as a social justice issue, but it’s a key risk-management tool. It’s by having a group of people around the table who have truly different perspectives, knowledge, skills, industry and life experience and insights that you harness the power of diversity. Diversity helps boards challenge longstanding assumptions, avoid groupthink and recognise decision-making biases – critical skills for boards to identify, assess and then build immunity against the realisation of key risks or shocks.”

The potential for black swan events strengthens the case for directors with experience, says Scheinkestel. “You need directors with a breadth of experience and some battle scars; people who have been involved in businesses or governed through several cycles and can ‘join the dots’ across industries before, during and after shocks. The ability to recognise patterns before others, and understand how shocks might play out should they emerge, comes with experience. And while experience usually comes with years, there are also younger leaders who are accumulating great experience that will add to the strength of diverse teams”.

Scheinkestel says it is critical that directors spend time out of the boardroom to broaden their information sources. “Management is often so immersed in day-to-day business challenges that they may have limited time to get out and listen to a range of voices. By talking to staff, customers, suppliers and investors, as well as being involved in the broader economy, directors can bring that external perspective to management, and use it to frame discussions about potential risks to the organisation.”

Site visits

Scheinkestel says site visits and discussions with frontline staff can also give directors a sense of the organisation’s culture and adaptability to market shocks. “It’s incredibly illuminating when directors get out and talk to a range of stakeholders. You get a first-hand view of whether the organisation embraces change, has a lifelong learning culture and is agile and capable of responding to shocks.”

Leading company director Diane Smith-Gander FAICD, believes cultural diversity on boards is important when assessing global business risks. “How would Australian companies recognise if a black swan event is building in Asia when there are so few Asian-born directors on our boards and senior executive teams?” she asks. Smith-Gander, a former McKinsey & Co partner, chairs Broadspectrum, is a non-executive director of Wesfarmers and law firm Henry Davis York, and president of Chief Executive Women.

She says boards can and should have a larger role in risk identification. “Boards can become more expansive in how they define their scope. Directors usually take a great deal of care not to cut into the role of management, but they can carve out a more active role in long-term risk analysis. That is where the benefit of having directors who have worked across different industries and had diverse collective experience comes to the fore.”

Smith-Gander says boards can work more independently of management with risk analysis. She favours a McKinsey technique where a board identifies possible shocks and management separately does the same. The two perspectives are compared and the gap between the board and management views of potential risks is discussed together. “You have that valuable conversation where boards and management explore their differing views on risk.”

The process helps boards identify which risks to focus on and where to make episodic interventions to gather data. “It’s about probabilities,” says Smith-Gander. “Boards might identify a small number of high-impact risks, understand the leading indicators that would alert them to the event, and then consider information needed to confirm those indicators.”

She says boards should use data-mining software to test leading indicators and identify patterns that are potential precursors to market shocks. “It would be foolish not to use software robotics to mine data for risk and other emerging scenarios. Outputs from data mining can help boards determine if their assumptions in risk-management identification are true or false.”

Boards, says Smith-Gander, should consider how they can help directors gain extra insights into identified risks.

“Directors should have access to a range of different experiences that help them join the dots. At an individual level, most senior company directors have their own professional development program, are attending industry conferences or key business lunches, or are doing short courses at overseas universities. It’s about directors proactively building their industry knowledge and scanning their company’s environment, domestically and overseas.”

Nothing beats director curiosity when it comes to understanding the organisation’s key risks and how it would respond should any eventuate, says Smith-Gander. “It has been said that good directors are always smelling for smoke in the organisation. When they sense it, they keep peeling back the problem, layer by layer, until they are satisfied the issue is being addressed.”

Balancing act

BOQ’s Deans, the country’s top chief risk officer for three consecutive years at the Australian Banking & Finance Magazine awards, says boards should not spend excessive time worrying about black swan events.

“It’s a balancing act. Boards should think about geopolitical, regulatory or technology risks over the horizon, but often the real shocks that damage an organisation are happening now. It could be changing consumer preferences or evolving product markets that do most damage; not a possible black swan event that could be years away.”

Deans recommends boards do an annual deep dive into the organisation’s three-to-five-year strategic risks. He says Australian companies operating in politically riskier countries need to understand their risk appetite.

“Having approved an investment in a developing country, the board should work with management to understand how sovereign or economic risks can be mitigated. Directors need to know the organisation is not exposed to excessive risk if a shock occurs.”

Deans says scenario analysis can help boards and management understand different outcomes from potential shocks, but adds that these tools are underdeveloped in Australia. “US and European companies and boards tend to have more sophisticated scenario-planning tools. There’s an opportunity for our companies to strengthen their scenario-analysis capability.”

Strategy consultant John Barrington FAICD, says an open boardroom culture and the right governance processes can help directors identify potential market and business shocks.

“Boards need an environment where directors feel confident to discuss what seem like low-probability events at the time. It can be hard for directors or executives to bring up implausible risks. Nobody wants to go out on a limb, even though that type of thinking is usually required with black swan events. This is more than just a time-management issue; it can be an indication of a lack of an open and enquiring mindset within the board or the executive, or both.”

Probing discussions

Barrington, chair of the Perth International Arts Festival and Anglicare WA, says boards should hold unstructured conversations about high-impact risks, where there are no meeting agendas or measurable goals. “We’re all so busy moving from meeting to meeting and getting things done that we don’t stop to have unstructured conversations with our fellow directors. Conversations where directors are open-minded about future strategic risks and probe and explore issues.”

Boards, says Barrington, should have a session for unstructured conversation before some meetings. Directors must still prepare and contribute to the topic and an industry expert who can challenge organisation thinking should facilitate the conversation. “These discussions help the board develop an enquiring mind and collectively become more intuitive over time,” he says. “It also helps the board’s relationship with management because they are working together to explore issues where there are no known answers.”

Boards should allocate the first 30–50 per cent of the formal meeting to strategic dialogue, leaving compliance matters to the second half, recommends Barrington. “Boards need a process where directors can discuss current and future strategic threats and opportunities in the first half of the meeting. But they often get bogged down in conformance rather than performance issues, and don’t have the scope or the urgency to take deep dives into potential black swan events.”

Tilly Smith had ample motivation to reduce risk as the tsunami roared toward Phuket. Her open mind, knack for pattern recognition and courage saved many lives. As companies face their own tsunami of digital disruption and geopolitical risk, boards must get better at recognising patterns and alerting management to risks that seem far-fetched at the time.