Managing risk in this changing era

Managing risk in this changing era
Published: 
July 2018

"The finance industry’s narrow focus on creating shareholder value often has unintended consequences," says UQ Business School’s Professor Karen Benson. "It’s time for a new approach."

The unwelcome stories of fraud and misconduct coming out of the royal commission have shaken Australia’s banking sector like never before. As each new scandal is uncovered, it raises the question: How could the banks which helped the country to weather the Global Financial Crisis have now let down their customers so badly?

For years the banks, and the wider finance industry, have focused on maximising shareholder wealth – but at what “cost”? Unfortunately, in some instances it seems that the goal of increasing share prices has been at the expense of the customers who help to create that wealth.

Creating shareholder value is the mantra of the finance community – indeed, for all for-profit businesses. As financial managers, our job is to manage financial and other relevant risk and maximise shareholder wealth. As finance academics, we teach students to focus on the same goals. When we make investment decisions, we ask: How will it add value to the firm?

However, in its exclusive focus on shareholders, the traditional finance model does not directly consider the interests of other stakeholders – customers, suppliers, employees and the wider community – even though they can and do have an impact on the value of the firm. Arguably, appropriate consideration of all stakeholders will indeed be consistent with maximising long-term shareholder wealth. So for example, happy workers will help drive financial success, and businesses need happy customers to ensure sustained growth.

Another issue is that the traditional finance model focuses on financial risk when this is only part of the picture in the complex contemporary world. The World Economic Forum (WEF) outlines five types of interrelated risk – economic, geopolitical, environmental, technological and – at the very centre – societal risk, such as the increasing polarisation and the growth of populist movements. WEF suggests we need to “face up to the importance of identity and community”.

Clearly addressing some of these issues is beyond the scope of the average company, yet that is not to say they have no financial impact. Take climate change – as the consequences will not be felt for many years, our traditional finance model will “discount” these long-term negative cash flow effects so there is little impact on firms’ value today.

Yet these long-term risk factors do have clear impacts. For example, fossil fuel companies face reputational risk and the Paris Agreement might increase direct financial risk if countries impose emission reduction schemes or provide subsidies for cleaner energy. As renewables become more competitive, they could ‘naturally’ phase out fossil fuels and existing assets may lose value. This is not only an issue for the fossil fuel companies themselves, but also affects the banks that lend to them and industries that use fossil fuels.

The focus on shareholder wealth and financial risk can lead to us prioritising short-term goals and ignoring the wider issues. While our traditional financial models of valuation help us to understand capital markets, the global economy is changing, as is society. It is time for a new approach.

In the age of social media and with growing concern over environmental issues, reputational risk is greater than ever. Our values are changing, we are more aware of issues and less willing to let large companies dominate. Corporations are more easily ‘found out’, and it is easier to put pressure on them.

Reputation is crucial for a company’s social licence to operate. It is also increasingly becoming a factor in a firm’s valuation.

Some would argue that social capital is as important as financial capital. Recent research on trust between a firm, and its stakeholders and investors found that trust pays off when markets suffer negative shocks. Neglecting stakeholders makes no sense.

Finally, in today’s rapidly changing environment where it has become more difficult to forecast the future, survival is about capacity to adapt. We need to focus less on value and more on resilience.

So how should firms manage risk in this new era? They need to pay more attention to social capital. Corporations need to consider their impact on the world and balance the needs of critical stakeholders, not just shareholders. Business success will follow.

Managing risk also means being adaptive and responsive – to climate change, to social capital and to society’s needs. Firms who don’t manage their footprint, risk losing the right to do business and the capacity to operate.

A new approach will not only help us take a more balanced view and better avoid future banking scandals, but it will make the world a better place.

Karen Benson is a Professor of Finance at The University of Queensland Business School.