6 Recommendations to Maintain Effective Risk Oversight
As the financial crisis thoroughly demonstrated, an acute focus on short-term gains can be disastrous when risk proper oversight isn’t there. Protiviti’s Jim DeLoach provides six key considerations your organization can bear in mind in moving beyond myopic “short-termism” to a more broadly encompassing risk management strategy that includes longer-term interests.
While short-termism has been a topic of discussion for as long as many of us can remember, the volume has been turned up in recent years. More recently, it has been elevated further as a topic of discussion with President Trump’s request of the Securities and Exchange Commission to study whether to cease requiring companies to report quarterly earnings. In this article, we explore the implications of short-termism to the board’s and management’s risk oversight process and how the board and executive management can ensure that oversight is not compromised.
Short-termism is a contemporary topic of interest to directors, executives, investors and policymakers that can mean many things, but it typically refers to an environment in which the focus on short-term results is so myopic that it results in a neglect of important longer-term interests. For example, in a survey of more than 600 public company directors and governance professionals, 75 percent of the survey participants indicated that pressure from external sources to make short-term gains is compromising management’s focus on long-term strategic goals. This pressure can also affect risk oversight.
Short-termism manifests itself in a number of ways. These include focusing on quarterly earnings at the expense of funding long-term sustainable growth, pursuing risky M&A deals for growth’s sake without clear linkage to the overall corporate strategy, altering the timing of operating decisions to achieve earnings targets, releasing new products to market without sufficient testing, allowing cost and schedule considerations to undermine safety on significant projects (e.g., deferring maintenance or taking risky shortcuts), forgoing employee training and assuming or ignoring huge risks and/or taking on excessive leverage to pursue an activity that is generating attractive returns currently, to name a few.
Short-termism is a complex topic, because its underlying root causes reflect powerful dynamics. For example, globalization, technological developments, improved transparency and reduced transaction costs have facilitated capital flows to the point where investors can easily reallocate their assets to seek the highest yields. In addition, there is an increasing trend for hedge funds and other activist shareholders to acquire a small stake in a company with the objective of steering profits to shareholders immediately (through, say, higher dividends, stock buybacks, asset spin-offs and/or downsizing in lieu of investing to innovate products and processes to improve productivity and drive future growth).
Still another example is a compensation structure emphasizing executive pay over the near term to the detriment of long-term shareholder interests, skewing management’s decision-making toward maximizing short-term profits at all costs. To be sure, the complexities surrounding short-termism make it a tough nut to crack.
Short-termism in all its forms is not sustainable in a rapidly changing world, and it’s an issue on which boards, executives and shareholders alike should reflect. Left unabated, short-termism presents consequences for the future growth, innovation, productivity and financial performance of those companies constrained by a short-term focus, not to mention the wages of their employees and the employment rates and living standards in the communities and nations in which they operate. Having said that, in no way are we suggesting that short-term matters aren’t important. The issue is one of seeking a healthy balance between the short- and long-term interests of the organization’s stakeholders.
The financial crisis presents an object lesson on how extreme and dangerous negative consequences can be when risks are undertaken beyond an enterprise’s capacity to bear risk. Looking back, the pervasive “volume and speed” subprime lending business model that contributed to the crisis was driven by a combustible mix of factors: excessive borrowing by households enabled by historically low interest rates and lax underwriting standards that encouraged that borrowing behavior; cavalier risk-taking by Wall Street to satisfy the insatiable global demand for high-yield fixed income securities; dramatic breakdowns in corporate governance in many firms; and the inability of policymakers and regulators to address the snowballing effect of dysfunctional behavior in the financial systems they oversaw.
Dramatic growth in the shadow financial system (i.e., non-depository banks, investment banks, hedge funds, money market funds and insurers), as well as a surge of activity in the derivatives markets, helped further fuel the credit and housing price explosion. The onslaught of toxic, opaque mortgages, troubling imbalances in “Heads I win, tails you lose” compensation structures and unengaged boards exacerbated the problem, contributing to a lack of accountability for long-term shareholder interests.
As U.S. housing prices peaked and began declining in mid-2006, defaults began to escalate. The tipping point was the sheer volume of activity by mortgage brokers, lenders, mortgage insurers, investment banks, credit default issuers and institutional investors. Not enough of these market players knew when to stop. Too many of them followed the herd simply because they were making too much money, creating a housing bubble of massive proportions. When the bubble finally popped, financial institutions and investors were forced to write down the value of their subprime assets. Sad to say, for many financial institutions, the long-term risks and risk management discipline many would have expected of the industry were irrelevant.
The point is, complex forces drive the short-termism phenomenon. Directors and executives need to ensure that the organizations they govern seek a healthy balance in addressing short- and long-term interests. Our concern here is concrete steps the board and senior management can take to ensure that short-termism does not compromise risk oversight, as it did for many institutions during the financial crisis. The following are six recommendations:
1. Focus the board’s and senior management’s oversight on risks that matter.
If risk management is focused primarily on operational matters, chances are management may be moving “known knowns” around on a risk map through periodic risk assessments rather than focusing attention on the right question: Do we know what we don’t know? To face the future confidently, both management and the board need to focus the risk assessment process on (a) identifying and managing the critical enterprise risks that can impair the organization’s reputation, brand image and enterprise value and (b) recognizing emerging risks looming on the horizon on a timely basis. While the day-to-day risks of managing the business are important, they should not command the board’s risk oversight focus except on an outlier basis when issues arise.
2. Lengthen the time horizon used to assess risk.
The focus on quarterly performance, annual budgets and business plans may lead to a horizon for assessing risk of no more than, say, three years. That period of time may be too limiting because strategic opportunities and risks have a longer horizon. For example, the World Economic Forum uses a 10-year horizon in its annual risk study. Likewise, more companies are using a longer horizon to elevate their assessment process to a strategic level.
The longer the horizon, the more likely new issues will emerge – particularly those relating to industry disruption and disintermediation – and the greater the uncertainty and new plausible and extreme scenarios present themselves. Given these volatile times, directors and executives need to be satisfied that the horizon used by management is appropriate.
3. Understand and evaluate strategic assumptions.
One way to ensure that risk management is focused beyond the near term is to understand the environmental impacts that invalidate the critical assumptions underlying the strategy. Strategic assumptions are part of management’s “world view” for the duration of the strategic-planning horizon. They pertain to such attributes as the enterprise’s capabilities, competitor capabilities and actions, customer preferences, technological trends, capital availability and regulatory trends, among other things.
Directors should request that the senior executive team outline its view of the internal and external factors comprising the environment in which the extended end-to-end enterprise will operate during the planning horizon. The board can then understand and weigh in on the thinking underlying the strategy. Insights from thinking strategically about risk and opportunity in this manner can greatly enhance investor communications.
4. Integrate risk and risk management with what matters.
Short-termism can render risk to an afterthought and the formulation of strategy and risk management to a mere appendage to performance management. As a result, the strategy may be unrealistic and entail taking on excessive risk, and performance management may be overly focused on retrospective, backward-looking lagging metrics.
As risk, of necessity, entails looking forward beyond the near term, the board and executive management should ensure that the strategy-setting process considers risks arising from strategic alternatives, risks to executing the strategy and the potential for strategy to be out of alignment with the organization’s mission and values. In addition, they should insist that prospective, forward-looking lead metrics be used to complement the more traditional retrospective lag metrics.
5. Watch out for compensation imbalances.
Public companies listed on an exchange in the United States are required to disclose in the proxy statement whether the company has established a system of incentives that can lead to inappropriate decisions by employees to take unacceptable risks in the pursuit of near-term rewards. The compensation committee typically conducts a review for excessive risk-taking in conjunction with its oversight of the compensation structure.
Board concerns with respect to short-termism are a red flag for the compensation committee to sharpen its focus on potential compensation issues. For example, if one or more operating units and/or star performers are making a disproportionate amount of money and their superiors are indifferent as to how they’re doing it, directors and executive management need to ensure there is an absence of bet-the-farm behavior.
6. Pay attention to culture.
Short-termism can contribute to a dysfunctional environment that warrants vigilant board and senior management oversight. For example:
- Operating management may continue to execute the same strategy and business model regardless of whether market conditions invalidate the underlying strategic assumptions.
- The organization may be insular in its outlook, leading it to fail to reality-test its assumptions about markets and the business environment regularly.
- Unit and process owners are fixated on making artificial moves (e.g., defer investments) and manipulating processes (e.g., cut costs to the bone, accelerate customer shipments) to achieve short-term financial targets, rather than on fulfilling customer expectations by improving process effectiveness and efficiency.
- Risk management responsibility is not adequately defined or linked to the reward system or, worse, the incentive compensation program rewards unbridled risk-taking over the short term.
- Management may be reluctant to consider investments that may not pay off in the short term even though there is long-term shareholder value creation potential.
These and other red flags warrant the board’s attention, because they signal the possibility of unacceptable risk-taking or poor decision-making that needs to be addressed.
Short-termism is an area of concern on the part of many companies. Boards and senior management teams need to ensure that their risk oversight process isn’t compromised as a result of it. A strong focus on linking risk and opportunity can help overcome some of the blinds spots created by short-termism.
Questions for Executives and Boards
The following are some suggested questions senior executives and boards of directors may consider, based on the risks inherent in the entity’s operations:
- Is the board’s and executive team’s risk oversight focused on the issues that matter? Is the board satisfied that short-termism is not creating unacceptable risks that warrant immediate attention?
- Does the board insist that management adopt a long-term view to assessing risk? Is there sufficient attention given to understanding strategic assumptions and risks inherent in the strategy?
- Do the company’s compensation and rewards systems foster a short-termism mentality? Does the board ensure that key executives have “skin in the game” to take risks prudently in the pursuit of value-creating opportunities?
 “Trump Asks SEC to Study Six-Month Reporting for Public Companies,” Dave Michaels, Michael Rapoport and Jennifer Maloney, The Wall Street Journal, August 17, 2018, available at www.wsj.com/articles/trump-directs-sec-to-study-six-month-reporting-for-public-companies-1534507058.