The corporate executive must face a paradigm in their role to transform

CORPORATE FINANCE AND STRATEGY EXPERTS

INTRODUCTION

Since the turmoil in the global market is not appearing to subside soon, it is accepted as a new normal. Industry experts focusing on corporate development and finance continue to partner with leading companies to arrive at solutions in portfolio strategy and capital allocation, value creation strategy, value-based processes and culture, and more. As the prevalent market conditions, volatility, and fear of recession are on the horizon, the aftermath of Covid 19 and Russia's invasion of Ukraine on 24.2.2022. The supply chain is being recalibrated. Sri Lanka and Pakistan collapsed their national economy and sovereign defaults. Russia Ukraine's belligerent stand may lead to nuclear war. Sanction and ant sanctions are now a regular phenomenon. Everywhere lack of trust. Amidst all the challenges These are some selected critical our global and regional leaders on this top three as under: Innovation Strategy and Delivery, International Business, Pricing and Revenue Management, Consumer Products Industry, Building Materials Industry, and so on Forest Products, Paper, and Packaging, Technology, Media, and Telecommunications, Media Industry, Health Care Industry, Biopharma, Business Transformation, Corporate Finance, and Strategy, Mergers, and Acquisitions, Corporate Strategy for monitoring, Value Creation Strategy, and Shareholder Activism Defense, Business Strategy

Tim Koller on the timeless truths of corporate finance wrote?a book on corporate finance as coauthor of the best-selling?Valuation, now in its seventh edition. After all,?Valuation?came out in 1990, and the core messages are the same: that value creation comes from revenue growth and return on capital, which drives cash flows. Now change occurred in more subtle things. For example, we experienced a bit of a bubble in tech stocks in 1999 and 2021, and less confident about the short-term alignment of share prices and economic fundamentals. Even if companies develop strategies based on growth and return on capital, they don’t always follow through. Let’s go back further still. We are in a period of high inflation, low growth, and geopolitical tension—it’s 1972. The situation today is different than what we experienced in the 1970s, which was a period of high inflation and unemployment that lasted a decade. While there is a lot of uncertainty, today is very different. In past is very dependent on the company’s situation. Various sectors respond dissimilarly to different forces. For example, innovation-driven sectors, such as technology and pharmaceuticals, continue to grow as long as they innovate, so a tech or pharma CFO was advised to continue to invest in innovation and the same to a consumer-packaged goods company, People still needed breakfast cereals and laundry detergent, and those companies could raise prices with inflation and maintain fairly good results. To a cyclical manufacturer or an auto company, “Be more cautious, because demand will be low, so you don’t want to over-expand.”

?We know some things that will shape our future: the net-zero imperative, AI and ML, and prominent demographic trends, for example. We face an unprecedented macroeconomic situation. We’ve had a very loose monetary policy for more than ten years. The Federal Reserve was buying bonds, forcing down interest rates to very low levels, and that’s not sustainable. That’s why, even before the recent inflation numbers, economists were concerned about inflation, especially with a strong economy. Simultaneously, we are facing massive supply shocks that are pushing up prices. We also have labor shortages, with people not returning to work despite job availability.

If the Fed sticks to getting interest rates back to normal and letting the economy fix itself, we can get through this period in a year or two without too much difficulty. If the government acts as it did in the 1970s, introducing wage and price controls, gas rationing, and other economic interventions that dispirited investment, we could end up with a longer period of high inflation and a deeper recession. What parts of the market are overvalued, during almost every 20-year period stock will outperform any other investments because they are linked to economic growth and profitability.?They are in their 20s and by the time they are 50 or 60, they will have ridden the ups and the downs and will be much better off. It is not a coincidence that stocks earn 6.5 to 7 % real returns over longer periods of time. It’s due to corporate growth and returns on capital. As long as companies grow along with the economy and continue to earn similar returns on capital as they have, we will be able to earn similar returns on stocks. Most American households hold stocks directly or through mutual funds, but a sizable segment does not. We need to separate direct effects from indirect effects. The direct effects, the immediate returns only accrue to people who can own shares. But what’s more important is the indirect effect, which is that stock market returns encourage people to invest in building new factories, innovation, or medical research. The market enables the creation of wealth for the whole economy. Less than 100 years ago, about 40 % of the population was involved in feeding the country. Now that number is around 3 % and others have moved to different jobs, improving the general standard of living. Even those who don’t own stocks typically have air conditioning, iPhones, and reliable automobiles, and we don’t think that would have come about without the stock market as a facilitator. While the market encourages innovation, it also encourages competition. It enables me to raise capital to compete with you. As a result, prices are much lower than they were 50 or 80 years ago in many categories. Prices are highest in areas not subject to competition or much innovation. For example, there has been relatively little innovation in education, and we spend a lot more on education than we used to.

Markets face increased regulations. Many large companies are too large to go private. Once they get above a certain size, they cannot get sufficient capital without access to public markets. You do see medium-sized companies go private from time to time, but they often go public later because investors need to cash out at some point, creating a cycle. Despite the regulatory burdens, there are many reasons why the bulk of corporate market capitalization is in listed companies. One reason for going public, especially for young companies, is to attract talent.?We should separate companies’ internal dynamics from external forces. Many perceive the markets as short-term oriented, forcing management to worry only about quarterly earnings. Our research shows that successful companies are typically those with longer-term horizons. There are plenty of investors who have long-term horizons as well, but they generally need to talk to a company only once or twice a year to make their decisions. Short-term investors are noisier. They probably drive the short-term market volatility, but it’s longer-term investors that drive the share price over time. In a typical large US or European company, long-term institutional and retail investors comprise about 75 % of the shareholder base. We encourage our clients to spend more time on communicating with and getting to know those investors. And it’s interesting: if we start a conversation with clients on the long-term, we often end up talking about innovation, and if we start on innovation, we end up talking about being long-term-oriented. Those two go hand in hand.

As for the internal dynamics, public companies are often not set up for innovation, partly because their compensation systems tend to be short-term-oriented and because the boards aren’t deep enough involved in innovation. In a recent survey, more than 60 % of executives told us their companies are not investing enough in growth and not taking enough risk. We’ve seen a tremendous amount of innovation in the past 20 years, but a lot of it has come from younger, newer companies. Despite all the talent, capital, and customer knowledge established corporations have, there do seem to be barriers. How to rid fears surrounding innovation. We have to put in place mechanisms to encourage people to bring forward ideas that could be risky without fearing that if circumstances outside the company’s control make the projects unsuccessful, their careers will be damaged. From an economy-wide perspective, it doesn’t matter where innovation comes from, but from a shareholder perspective, you could argue that the shareholders of some larger companies are missing out because of those barriers. Companies respond to self-imposed short-term pressures created by their compensation systems, so I wouldn’t blame it on the stock market.

We spent most of my career focusing on the analytic side of things, but when we start learning about cognitive biases in decision-making, Companies were not following through on their strategies partly due to those biases. Psychologists have identified more than 60 cognitive biases that affect how people make decisions. We boiled them down into four groups: group thinks; confirmation bias; loss aversion, which leads us to put more weight on losses than gains; and anchoring or inertia—anchoring decisions in what we did in the past. I see that last one all the time: companies allocate capital based on last year’s allocation plus or minus a little bit, instead of starting from scratch based on where current opportunities are. They should put resources where the strategy says those resources should go, whether it’s dollars or people. It seems like an enormous opportunity that hasn’t been addressed.?A lot of it relates to governance. One executive at a company with three divisions told, “We allocate resources to the three division heads and hope they make the right decisions.” But those division heads have a much shorter-term incentive structure than the enterprise leaders like the CEO and CFO, and resource allocation is one of the most important things a company does. We encourage CEOs and CFOs to play much more formal roles at a granular level. They should be looking at the top ten to 30 strategic initiatives to make sure those are fully funded and translated into concrete initiatives. Another way to improve decisions is by separating debate from decision-making. Social science suggests that rigorous debate leads to better decisions, so when you are evaluating initiatives, you should include everyone who has a stake in the outcome of the debate, even going so far as to appoint someone to take a contrarian point of view. But we can’t have 15 people making decisions through consensus because we end up with the lowest common denominator. We need to have a rigorous debate in one forum, then the top leaders separately make the hard decisions. New companies typically have strong debate cultures, but some companies get so big that debate and dissent become difficult.

We can see three big challenges facing corporations in the coming years. One is innovation, and the second is taking good ideas too far, which has been behind many of the systemic failures we saw through the decades. When good ideas are taken too far, they lead to the misallocation of resources in the economy, which eventually has to be corrected. Since, fortunately, the global economy and most national economies are not centrally directed, there’s not much we can do to stop that misallocation broadly. At the company level, what matters is having an independent perspective. In the wake of the financial crisis, some banks emerged stronger than others, and those were often the ones that went against the grain. They had done their own analysis, decided the housing market was overheated and were cautious about their exposure. One of the big challenges for companies and investors is avoiding going along with the herd.

?It is astonishing that how much capital is available for investments in the energy transition—from venture capitalists, pension funds, and other sources. As a result, capital is not at all a competitive advantage. So, what would differentiate a company? Just because we have cash flows coming in doesn’t mean we should be investing them into the energy transition if we can’t create value. I’m better off letting people who have not just capital but the right skills do that. Building a wind farm, for example, requires skills like identifying appropriate sites and negotiating with landowners, local governments, and utilities. The skill set is very different from what most large companies have. Business leaders need to figure out what their companies can offer that’s unique and better than someone else. That’s not just best for shareholders but for the economy as a whole. The transition for an automobile company from manufacturing cars with internal combustion engines to making electric vehicles is a much different challenge than what an oil and gas business faces. Automakers have many advantages over start-ups in the electric-vehicle space and may perform better in the long run because they have dealer networks and know how to manufacture with high quality. The transition will be difficult, but their core business likely won’t go away, or at least not for a long time. Oppositely if we eliminate our reliance on oil—and, to a lesser extent, gas—oil production and refining will go away. Companies will need to figure out how to manage the decline, but from an economy-wide perspective, we don’t want everyone to shut down oil production tomorrow because that would be disastrous. ??The answer is simple. If we can figure out a way to create value—if we have skills, for example, in building platforms in the deep waters of the North Sea—we could potentially apply those skills to building wind farms. If we don’t have the capabilities to create value, then we would be better off returning that cash to shareholders. It’s not like that money will not get invested in the green economy; it will just be invested by a business that may do a better job.

CFOs need to develop strong teams behind them that can handle more tactical, less strategic tasks. In today’s environment, CFOs play a key role in strategy, educating the rest of the management team, and making the hard decisions, serving as CEOs’ right hands on these matters. To do that, they need controllers, tax people, and other specialists they trust who can operate pretty independently. ?The world doesn’t change that quickly in finance—the principles don’t change.

Sustainable, inclusive growth?is the?sine qua non?of free markets. Our economy, and society, can thrive only if more people take part: cooperate, invest, create, and solve to provide solutions, in a responsible way, that other people value. Revolutionary innovations, brilliant ideas, and climate imperatives will change everything—except the fundamentals of finance and economics. How is value created—and destroyed? A closer look at corporate finance, its bond with strategy, and the benefits of value creation. A long-term perspective is essential for value creation—all the more so when the challenges and consequences of externalities are increasingly top-of-mind.

CFOs and the evolving finance function. Building a leading-edge, digital-first, and strategy-minded finance function takes a lot more than delivering quarterly and annual reports. For decades, we’ve been exploring how leaders can push their organizations to unbias decisions, particularly on resource allocation and strategy. Stock markets can be volatile, and in some years they decline. But the ups far outnumber the downs—and returns are in line with two centuries of performance.

?AWS REINVENT 2022

One year ago, we asked global journalists, media executives, columnists, commentators, and media critics, from the US and around the world, for their perspectives on what will make—and what should make—news headlines in 2023. In the same way, athletes can’t compete effectively without taking adequate time to rest after a sporting event, employees can’t perform without taking adequate time to recharge their batteries. Black Friday is back. And despite continued challenges for both retailers and consumers, people are generally optimistic about holiday shopping this season. As many take to the roads and the skies on one of the most traveled days of the year, food and fellowship are top of mind. Yet rising inflation, global supply chain challenges, food loss, and climate change have had tremendous impacts on the path of food from farm to table. The role of a leader isn’t just to give orders—it’s to make their team better as they go. Those who lead with purpose prioritize taking care of their people, their customers, and their community while manipulating the demands facing their organization. The world is more turbulent and volatile than ever. To be prepared to meet the next challenge, leaders and organizations need one tool above all: adaptability. But the human brain isn’t wired to be adaptable in uncertain situations; it’s a skill that needs to be learned. Think about how to handle a crisis that is outdated, ??The same is true in the workplace: It’s important that individuals work together toward a common goal, especially when the business environment is volatile and uncertain.

Reflections on COP27

?The 27th annual UN Climate Summit—known as COP27—concluded in Sharm el-Sheikh, Egypt. World leaders converged on the Red Sea resort to discuss increasingly dire natural disasters, the war in Ukraine, climate reparations, and how best to accelerate the transition to net zero. As millions prepare to travel during the holiday season, the airline industry faces growing pressure to accelerate its sustainability efforts from environmentally minded passengers. While many organizations have committed to reaching net zero, obstacles stand in the way. Technology alone can’t achieve sustainability targets, but advanced technologies will be critical to mitigating the worst effects of climate change.

Taking stock as the world population hits 8 billion

?Projections show the global population will surpass 8 billion people on November 15, and in 2023, India is expected to surpass China to become the world’s most populous nation. It was only 11 years ago that the world reached the last billion; these milestones generate considerations of resource allocation. A survey of financial institutions?shows that firms have made significant progress during the past several years in using new data and techniques for credit portfolio management, but also demonstrates that challenges remain around technology, talent, and integration of new use cases like climate and environmental, social, and governance (ESG) risk. In recent years, many financial institutions have increased their adoption of data and new technologies to manage credit portfolios. After surveying 44 financial institutions globally on the latest developments in data and analytics for credit portfolio management. The objectives of the survey were to understand the use of traditional and alternative data sources for credit risk information, to determine how financial institutions use analytical approaches across portfolio segments, and to inform the path forward to incorporate next-generation data and analytics across the corporate and commercial real estate (CRE) portfolios of small and medium-sized enterprises (SMEs). More than 60 % of respondents said that they have increased, over the past two years, their use of new types of data and deployment of advanced analytical techniques, like machine learning, for advanced credit portfolio management. An even larger portion of respondents (more than 75 %) expect these trends to continue over the next two years. Over the past several years, financial institutions have made significant progress in using new data and techniques for credit portfolio management.

As they look to deploy new analytics, companies are obtaining data from sources like automated client financials; internal credit behavior data and cross-product data from internal sources; and credit bureaus, economic forecasts, and news data from external providers. This includes alternative data as well; for example, in the corporate portfolio, more than half of respondents are currently using, piloting, or considering news media, social media, or third-party account data. Relatively fewer banks are using internal cross-portfolio data on consumer-to-wholesale crossover accounts, with 44 % of banks evaluating whether to use this data for their corporate portfolio and 38 % for their SME portfolio. Given segment characteristics, the implementation of new, data-intensive techniques like machine learning is focused on specific asset classes and specific use cases. Adoption of machine learning models is higher in SME segments than in large corporates for a good reason. In SME portfolios, these models have found their use in credit scoring, early-warning-signal development, and credit pricing. In corporate asset classes, however, their usage is largely confined to early-warning-indicator development. Banks that have fully automated decisions for a majority of the portfolio (more than 50 %) are still relatively rare (about 11 % for SME portfolios and about 4 % for midmarket). However, for SME portfolios specifically, about 30 % of respondents reported that they have automated more than 30 % of their decisions. In addition, in the SME space, respondents report a significant benefit in turnaround time, with 37 % of participants reporting a more than 10 % decrease.

The benefits of new data and analytics in the midmarket, corporate, and CRE spaces have not translated to a reduction in turnaround time to such an extent: only 13 %, 3 %, and 12 % of banks that have automated some of their credit decisions across midmarket, corporate, and CRE portfolios, respectively, have seen more than a 10 % decrease in turnaround time. At the same time, the deployment of ML and other analytical techniques has brought several challenges to the forefront. Survey respondents noted various barriers to increased adoption of innovative data solutions and advanced analytical methods in credit portfolio management. This includes data quality assessment, talent availability, and difficulty in validating and explaining new techniques.

Climate and ESG risks are emerging as the next biggest challenges for credit portfolio management

Every survey participant was asked about the biggest challenges facing credit risk and portfolio management analytics in the next two to three years. Notable challenges included capital, provisioning, and regulatory requirements for stress-testing models (58 %), challenges posed by model uncertainties after the COVID-19 pandemic (51%), and the incorporation of machine learning models within regulatory and risk constraints (42 %). However, an overwhelming majority (86 %) cited climate risk and ESG as the next big challenge. ESG risks are composed of environmental risks arising from operations and consumption of the output (that is, services and products) of the organization; social risks arising from how the organization treats people, including employees, customers, and the communities in which it operates; and governance risks arising from poor practices in the organization’s interactions with its shareholders, board, and management. These risk factors may have a positive or negative impact on the financial performance or solvency of an entity, sovereign, or individual. Within this overall taxonomy, climate risk falls within the category of environmental risk and is connected to both the direct and indirect effects of physical hazards associated with climate change. (Direct damages are caused by, for example, hazards like floods, wildfires, and hurricanes; indirect damages are consequences such as potential increases in insurance premiums and the effect on at-risk communities’ living standards.) It is also connected to transition risk: the policy, technology, and regulatory risk inherent in transitioning away from an economy overly reliant on activities that produce greenhouse gases. Many financial institutions are now assessing their portfolio’s exposure to climate risk, either due to regulatory requirements, or to test the hypotheses that hurricanes, floods, blizzards, tornadoes, wildfires, and other natural hazards can inflict billions in damages across loan portfolios in any given year.

Banks that have started climate stress testing are now considering whether to build new credit models or to tailor existing ones for stress testing. Respondents were evenly split into thirds, saying they are developing new loss models, using current models, or are not yet exploring. In addition, analyses on loss scenarios due to climate stress were more concentrated on the midmarket, corporate, and CRE portfolios (more than 50 % of banks for each), with fewer banks (less than 40 %) conducting these analyses on SME portfolios. The majority of institutions in Europe, the Middle East, and Africa are developing models internally or subscribing to vendor models to assess climate risk. Institutions in the Asia–Pacific region are the least advanced, and North American institutions fall somewhere in the middle.

Addressing climate risk will require a coherent framework

Our survey indicates that portfolio managers have only recently started to consider how climate and ESG risks affect risk identification and risk measurement, including obligor credit ratings. They now need new tools and processes to analyze climate stress loss and climate scenarios; they must also evaluate how climate risk assessment can be integrated with existing credit processes. We have identified, based on discussions with survey participants, as well as our extensive work with banks, several important factors to consider about the material impacts of climate risk on credit: Climate risk is typically concentrated in ‘pockets.’ We found both physical and transition risks lie in very targeted areas of the portfolio. To identify the pockets with a high concentration of climate risk impact, financial institutions need to perform a detailed heat mapping to focus their efforts on prioritized hazards for each of the high-risk portfolios. For example, it is commonly observed that most of the credit impact (around 70 to 80 % of incremental impact) for real-estate-related asset classes comes from 10 to 20 % of the obligors in the portfolio. This understanding is also reflected in the priorities identified by survey respondents.

The average credit impact can be moderate in the near term, but there is likely to be a high degree of obligor-level variability. We found that even in industries exposed to high physical and transition risk, the aggregate/average impact to the portfolio can be moderate. For example, in a portfolio of upstream oil and gas companies, the median impact might be about a 7 % reduction in EBITDA. However, the difference between borrowers with maximum and minimum impact can be stark. In this example of the upstream oil and gas industry, there are several companies with up to a 40 % negative impact on EBITDA, while others experience a positive impact on EBITDA in some scenarios due to the reallocation of oil and gas demand. Financial institutions have started evaluating these impacts and plan to explore them further, indicating there is still a long way to go. For industries exposed to physical hazards, most risk is in knock-on impacts, not direct damages. The near-term credit impact of direct damages is typically covered through insurance in industries like real estate (both commercial and retail). However, the knock-on effects can dwarf direct impacts, and any assessment of material risk drivers would include higher insurance payments and the deterioration in living standards in a community, even though the property itself might not be damaged.

Unmanaged climate risk can have a tangible impact on returns and economic profit.?Comprehensive capital analysis and review (CCAR), stress tests mandated by the European Central Bank (ECB), or methodologies driven by regulatory capital might not be appropriate for climate risk assessment. These are focused on capital risks and can underestimate the credit impact on single obligors. Climate risk assessment requires understanding returns from new climate-oriented businesses and obligor-specific scenario analyses. If these are not done well, the impact can be significant. At one North American bank, we identified a 35 % potential erosion of profits by 2030 in the absence of action on key pockets of climate risk exposure.

Before addressing and mitigating climate risk, financial institutions must address several barriers related to capabilities, data, and analytics.?First, financial institutions need internal alignment on their climate ambitions and aspirations to gain stakeholders’ buy-in and to ensure collaboration with relevant board committees. Financial institutions must also acquire technical capabilities and educate themselves by getting familiar with topics related to climate science, risk-assessment methodologies, and the complex design choices related to net-zero targets and their impact on credit assessment. As many existing risk-assessment tools were not built for the requirements of climate assessment, financial institutions will need an open architecture that can support new methodologies for data quality, standardization, and collection. Finally, to capture and address the holistic impact of climate risk on the portfolio, financial institutions need to increase their focus on interdisciplinary skills and mobilization across credit, front-line, and model risk management. Before addressing and mitigating climate risk, financial institutions must address several barriers related to capabilities, data, and analytics. To overcome these barriers, financial institutions need to make significant progress in two important approaches to climate risk assessment: climate scenario analyses and integration of climate into credit processes. Evaluation of data sources that can be used in scenario analyses and credit assessment, as well as analytics that help provide transparency on the effects of potential climate risk, will also help financial institutions understand the evolving data and vendor landscape.

Scenario analyses to start the climate-risk-assessment journey

Scenario analyses help financial institutions understand and quantify pockets of climate risk exposure. Results from scenario analyses can include a portfolio’s expected loss range under different transition- and physical-risk climate scenarios in the short, medium, and long term. Typically, they would also bolster the financial institution’s understanding of climate drivers and transmission channels and how they interact with obligor-level credit risk factors.

Scenario analyses consist of three major steps. Identify risks across portfolios.?The first phase is to identify the hazards, such as floods, hurricanes, or wildfires, that are most relevant to the portfolio. In addition to physical hazards, the potential macroeconomic impact on different regions (for example, the loss of economic output in counties with high fossil-fuel dependencies), and regional exposure can also feed into the risk-identification process. One of the best ways to illustrate this risk is by using a “climate risk heat map” or an “exposure at risk” metric to understand how much of a portfolio is exposed to climate-related vulnerabilities. For example, a financial institution might determine through this exercise that it is exposed to wildfire and coastal flooding due to its geographical concentration in California. Assess the impact on obligor financials.?The next phase is to connect these risks to how they can affect financial ratios (for example, net operating income or property values for a CRE portfolio) or additional drivers of creditworthiness (for example, additional sponsor risk for CRE). At this point, it is important to begin testing detailed scenario analyses for each portfolio while understanding different climate scenarios and their effect on hazards and macroeconomic factors. The transmission mechanism of translating this impact to obligor financials can be complex and must factor in, among other things, uninsured damages, business interruption, and increased insurance costs. As empirical validations may not be possible at this stage, financial institutions may also want to leave ample room for sensitivity analyses of assumptions. Quantify the effect of change in obligor financials on the portfolio.?The final phase integrates obligor-level analysis into credit loss assessment for portfolios. It is important to develop a transparent framework to link changes in obligor financials to changes in a credit rating or probability-of-default (PD) and loss-given-default (LGD) parameters. We have found that banks in particular can use existing underwriting or loss-forecasting models (for example, CCAR, FASB’s current expected credit loss model; International Financial Reporting Standards 9; and ECB stress tests) with some modifications to inform this phase.

Integration of climate with the credit assessment process

As financial institutions develop their climate-risk-assessment capability through risk identification and climate scenario analyses, the next step includes developing an approach to credit decision-making that ensures climate risks are appropriately and sufficiently considered in credit portfolio construction and management. To achieve this, process changes must be implemented and methodology gaps closed to incorporate climate risk quantitative analysis into the credit adjudication process. We believe that designing and piloting a “climate risk scorecard” that uses knowledge gathered during the risk identification and scenario analyses phase will be critical to this effort. For example, a climate risk scorecard for a high-priority portfolio like CRE would have the following modules:

Module 1: Prescreening filter. This is an initial heuristic-based assessment of an area’s vulnerability to climate events to identify properties that require further assessment. Metrics to assess physical and transition risk include flood inundation depth (property level), fire risk zone (property level), and the % of oil and gas and utilities-related sectors in local GDP (for example, at the county level in the United States). Properties are sorted into high, medium, and low risk, and only properties identified as highly vulnerable go through the next two modules.

Module 2: Scenario analysis tool. This tool provides a quantitative estimate of the change in credit risk under different climate scenarios for obligors that have been flagged as high risk in the previous prescreening module. The change in credit risk parameters can be reflected in a separate “climate score.”

Module 3: Property-level climate scorecard. In this module, a detailed client questionnaire, designed for each sector, enables the qualitative assessment of factors not captured in module two to adjust the climate score (through a client questionnaire and a first- and second-line assessment). A detailed client questionnaire is designed for each sector with graded response options and a potential source of information. The output is the adjusted climate risk score.

While practices in climate risk assessment are still very much evolving, we believe it will track the methodology laid out. The research summarized in this article highlights the benefits and challenges of incorporating new data sources and analytical techniques into the various aspects of credit risk and credit portfolio management. The potential upside should motivate institutions to maintain and intensify their efforts, as most expect to do in the near term. Institutions are rapidly implementing methodologies to assess the credit implications of climate risk. This article describes the benefits of developing a detailed, use-case-driven understanding of the necessary climate data, the technology infrastructure requirements for storage and processing, the reporting requirement for risk assessment, and the best orchestration model across functions. It also outlines the three immediate steps those institutions should take. The lessons learned in implementing data- and analytics-driven approaches to address credit risk assessment, as captured in this survey, inform what credit institutions must do to meet the challenges of today’s risk landscape.

?DESIGNING NEXT-GENERATION CREDIT-DECISION MODELS

?Using analytics to address inflation risks and strengthen competitive positioning

?Using analytics to address inflation risks and strengthen competitive positioning. In the new inflationary environment, company leaders can protect their businesses and gain a competitive advantage by deploying analytics-aided strategies. During 2021 and 2022,?consumer inflation accelerated in most developed and emerging economies. In the United States, the consumer price index (CPI) rose from 2.6 % in March 2021 to 8.5 % in March of this year. In June, the pace reached 9.1 %, the fastest in 40 years, while producer prices have increased faster still. In the eurozone, consumer inflation reached 8.6 % in June 2022, its highest-ever level. Two-line charts show the year-on-year change, by month, of the consumer price index (CPI) and the producer price index (PPI) in the United States and the eurozone from 2019 to June 2022. Both the CPI and PPI stood under 2 % in January 2021. Since then, the CPI has risen by almost 10 % in both the United States and the eurozone. PPI data have climbed even higher: the United States is at 16 % and the eurozone at 37 %. Investors, economists, and forecasting institutions?expect inflation to ease, but only gradually. (July measurements were somewhat lower in the United States but higher still in the eurozone.) The return of inflation is linked to the pandemic—the public-health measures taken to contain the spread of the virus and the economic and fiscal measures taken to mitigate the disruption this caused. The Russian invasion of Ukraine is exacerbating the inflationary dynamics.

?Inflation accelerated in an environment of strong consumer demand inflation environment, supply shortages, production shortfalls, and rising energy prices. The main inflation driver, energy prices, increased in Europe by 38 % in April and by 45 % in March. In June, the core inflation rate in the eurozone (inflation excluding energy, food, alcohol, and tobacco) was 4.2 %, a record level but one that underscores the lopsided composition of the overall rate. For many companies, a high-inflation environment is an unstable and insecure one to operate in. Responding to inflation is of paramount importance now, but responses must carefully account for future inflation, its impact on the company's business model, and the time lags for any response to manifest. Analytics can be used to improve decision-making in a?high-, with the level of analytics sophistication determined by the business requirements. In sectors where businesses are highly specialized and margins are thin—such as consumer packaged goods—analytics will need to be more precise to aid in developing a nuanced understanding of exposures. On the other hand, high-margin enterprises (software development or luxury goods, for example) can benefit from a more conceptual approach, without building deep analytics. Inflation forecasting is a separate and complex topic of its own, and in developing inflation responses, most organizations use forecasts and scenarios developed externally. Analytics for decision-making, on the other hand, cannot be outsourced. Without resorting to direct inflation forecasting, companies can use a flexible, analytically sophisticated method to help determine how and when to react. The approach includes assessing the extent of exposure and breaking down the types of exposures.

Assessing the extent of inflation exposure with simulations and scenarios

Analytics can help companies estimate their exposure to inflation. Mitigation strategies can then be prioritized based on the estimates. To assess exposure, companies can associate drivers of cost—such as commodity prices, foreign exchange rates, and labor costs—with actual costs. The association can be made in detail, potentially down to the sub-product level. A variety of analytical methods can produce simulations and scenarios for the drivers of costs. The estimates should be historically accurate as well as forward-looking. The estimates should maintain consistency across factors: for example, the prices of construction commodities such as steel and copper tend to be correlated. Once companies have assessed their exposure, they can prioritize risk factors with the largest exposure and then overlay and select potential mitigation strategies. Proper exposure assessment requires capabilities for scenario analysis, stochastic simulations, predictive modeling, and well-established, repeatable analytical methods.

Decomposing exposure: Pure inflation, relative price inflation, and idiosyncratic inflation

Companies are exposed to different types of inflation; analytics can be used to establish the levels of exposure to pure, relative price, and idiosyncratic inflation.?Their exposure profiles provide a basis for tailoring mitigating actions to manage a business in inflationary conditions. A number of robust methods can be employed to estimate the inflation breakdown repeatedly and accurately. Economists sometimes use a two-step method, for example, first separating out exposures to idiosyncratic inflation and then separating pure inflation from what remains.

Matching strategies to inflation types

Depending on exposure and inflation decomposition, companies can use analytics to size and prioritize the various risk factors for inflation. Strategies can then be selected according to their efficacy in addressing the risk factors that lead to the greatest company exposure. Among others, potential strategies include hedging to reduce price volatility, vertical integration up the value chain, and pass-through pricing. The following discussions of hedging and pass-through pricing demonstrate how strategy choices depend on company position and inflation decomposition.

Volatility reduction through hedging: A response to relative price changes

Companies have long used hedging strategies to mitigate and manage the risk of price fluctuations for their businesses. To manage hedging risks, companies can involve different parts of the organization, actively managing inventory price risks and commercial contracts, building analytics capabilities such as scenario testing, and developing governance and policies for oversight. The hedging option will require the strongest analytical capabilities, including forecasting and optimization. It can often mitigate the risks of price fluctuations for feedstock, which mostly relate to relative price changes. For example, a chemical company executed a financial hedge to lock in natural gas prices, resulting in a significant reduction in risk from rising prices. This lever comes with risk and requires careful consideration. The danger is that organizations can lock themselves into higher prices or significant margin calls. External early-warning signals (such as a steel price threshold) should be in place and periodically refreshed.

Pass-through pricing: A response to pure inflation

Dynamic pricing levers are an alternative to cost reduction levers. Companies can respond to increases in input costs and price volatility by adopting a?dynamic pricing strategy . They can often derive more value from pricing by setting the right price, optimizing discounts and rebates, and managing margin leakage. This option requires strong analytical capabilities, including sophisticated market segmentation and assessment of pricing impact. The dynamic pricing response to input cost increases and volatility is a strategy that is relevant for pure inflation. However, a partial price pass-through may be a component of an optimal response to all types of inflation. A manufacturing company, for example, managed granular price increases across thousands of products through customer pattern analysis and ended up with hardly a complaint; by contrast, a packaging company that had not prepared its sales force for price changes experienced double-digit market share losses.

Analytics, implementation, and continuous testing: An example sequence Accelerating your company’s analytics journey

?Companies will begin with different levels of analytics sophistication. Some have had experience in implementing analytics solutions while others have not (see sidebar, “Analytics, implementation, and continuous testing: An example sequence”). For the application of inflation analytics, a few guideposts will help companies get up to speed: Start small.?Start with a single product, business unit, or geography. Most of these analyses are accretive and need not be completed together. Start simple.?Break down the income statement to drivers of margin. “Stress” these drivers with your view of inflation impact. Not all drivers will be affected by inflation, so they will not need complex analytics solutions. Start now.?Experience shows that capabilities, data, and know-how are always work in progress. The benefits of starting now always outweigh the impact of better resources.

Business building: The path to resilience in uncertain times

In an uncertain economy, executives’ first instinct might be to cut costs and shore up established holdings. A better way is to build new businesses. In stable times,?the business building is a powerful way to extend into new and higher growth areas. In times of great disruption and uncertainty, however, building new businesses becomes a critical path to improving an organization’s ability to survive and thrive. Many leaders are bracing for a rough economic ride—they’re girding their companies against a series of acute global risks. In addition to geopolitical instability, volatile commodity markets, and rising inflation, they anticipate continued waves of global health crises, more frequent and severe climate hazards, and major shifts in consumer and industrial demand. These developments, they feel, could put long-term pressure on their business models—thus heightening the need for resilience. The new reality is that crisis and disruption are here to stay, and conventional approaches won’t work the way they did in the past. Business building, by contrast, is a way to diversify, shore up, protect, and expand when others are contracting. Committing resources to a new business, however, is only part of a winning strategy. Incumbents need a tool kit: a road map, a sense of urgency, and an entrepreneurial mindset using their advantages—resources, and talent—and eliminating disadvantages, such as barriers to innovation and systems that don’t support new initiatives and growth. Traditionally, resilience meant cutting costs and preserving capital. While belt-tightening shouldn’t be ignored, the cost focus alone has never been sufficient—and certainly isn’t in today’s market. Business is not facing just a momentary inflection but a state of volatility and long-term change that is becoming the new normal. In an extended volatile environment, companies must create optionality to enhance their risk profiles—not only their exposure to markets or geographies but also their exposure to system-level changes. New businesses can be the best way for incumbents to grow now—and in future evolutions of the world’s current era of volatility. Established companies have many advantages in building new businesses: infrastructure, talent, facilities, and brand. Incumbents may, of course, face challenges with innovations, processes, and cultures that don’t lend themselves to internal entrepreneurship—but these are all execution-driven challenges, and none are insurmountable. Companies can diversify in a few ways, but building new businesses constitutes an especially powerful approach. For example, our research suggests business building helped companies weather pandemic disruptions: 34 % of?companies that prioritized business building?kept their revenues from shrinking during the pandemic, compared with 26 % of companies that prioritized other organic-growth strategies.?The business building provides both financial as well as operational diversification that is broader than typical cost-saving measures.

At a basic level, newly built businesses help established companies form new customer relationships and accelerate growth. Organic growth typically generates more value, and it spares companies from paying a take-over premium on top of the stand-alone value of the acquired business.?Because new businesses don’t have legacy costs, they can yield higher profit margins and be less exposed to cash flow pressures. And when new businesses have offerings and operating models that differ substantially from those of existing holdings, they help insulate an organization against inflation, supply chain disruption, and economic down cycles. Achieving these benefits involves focusing on businesses that foster resilience and growth.

New businesses that build resilience

Considering the challenges facing companies today, four types of new-business builds are particularly well suited to resilience. Many of these can be started rapidly and begin generating earnings within 24 months—enabling success in the early stages and beyond.

The counter-cyclical businesses

Catering to markets or customers with relatively inelastic (and growing) demand allows established companies to better counter-cyclical swings. For example, data sales related to transaction processing are less directly correlated to consumer spending than swipe fees, which tend to go up and down with the economy and consumer confidence. 50% of all revenue during the next 5 years is expected to come from new businesses, products, and services. There are several approaches to building ventures that help organizations diversify away from exposure to inflation. For example, some service businesses generate more stable revenues than comparable product or capital-goods businesses, because they can supplement their sales of larger-ticket items such as elevators or automobiles with services that are smaller but longer touch. In such cases, companies can shift their sales model to accommodate cash-strapped customers and move from a “sell the air compressor” model to a “sell the tire refill” model. At times, even more, straightforward approaches to inflation mitigation (for example, cost pass-throughs) are more palatable to customers if accompanied by updated business models (for example, where sales are linked to outcomes). In consumer products, for example, the notion of the “Lipstick Index” was coined to describe how certain, more accessible products (small “affordable luxuries”) can become popular during times of economic difficulty when larger purchases need to be put on hold. Finding these pockets of growth within whatever business you’re in (and even scaling to new businesses through novel delivery platforms, for instance) can be critical to survival and future growth but won’t happen if an organization is narrowly focused on cost.

Resource-light businesses

When interest rates rise and cash flow dwindles, new ventures that can scale without proportional additions of equipment or workers can reinforce the bottom line of a company whose other divisions require substantial capital assets and headcount. These commonly take the form of marketplace convenors. Uber and Airbnb, for example, famously created e-commerce versions of these models. More recent examples are companies that have provided platforms for services that others provide, such as Verbing, which connects language tutors to students, and Bosch-owned Azena, which created an Internet of Things ecosystem for security devices. Companies such as these, with existing relationships and access to users or providers, are in a privileged position to scale these businesses rapidly with little capital of their own at risk. Similarly, we are seeing new businesses built by “asset owners” take on more business functions that used to be done later in the value chain. Residential real-estate companies such as RXR?built businesses during the 2008–09 financial crisis?that enabled them to offer new end-to-end customer experiences—for example, move-in assistance or digital concierges for housekeeping or grocery delivery. This isn’t limited to residential real estate: commercial warehouse providers now offer logistical services beyond the four walls, workforce training, and more. If your organization might not be the best owner of the asset or function, it can still be the best connector of whatever the asset is to whomever needs to use it, depending on your business context.

Consolidated or robust supply-chain-driven businesses

A McKinsey survey in 2020 found that industries experienced supply chain disruptions lasting for a month or longer every 3.7 years. And this was before COVID-19 lockdowns, trade tensions, the war in Ukraine, disruptive weather, and other difficulties snarled global supply chains. This year brought sharp increases in the prices of commodities such as fertilizer, aluminum, coal, and steel. While supply chains and commodities tend to correct in the long term, midterm disruptions abound and highlight the comparative resilience of businesses that operate with light exposure to global logistics and overseas production. These patterns are generating a lot of interest in circular business models,?which reclaim the initial product for its raw materials to be used in future production. Such models are meeting new needs from a supply chain perspective but also from an environmental standpoint. One example that is being highlighted as a success is EMMA Safety Footwear. The company created the first safety shoe that had a fully circular business model back in 2017 but couldn’t scale it enough to be profitable. It then engaged with industry competitors to create a bigger ecosystem that has the scale to be fully profitable and significantly less vulnerable to shocks that affect access to raw materials and overseas supply chain disruptions. Similarly, successful businesses have been built based on providing insights that reduce input costs by increasing yield. Such businesses have thrived in disparate sectors such as semiconductor manufacturing (by increasing chip yields) and agricultural production (by increasing crop yields while reducing input costs such as fertilizer or pesticides).

Adjacent businesses facing less (or at least different) headwinds

Often, value pools adjacent to a company’s core can be unequally affected by headwinds. The adjacencies—commonly value-chain or market-segment adjacencies—can be value areas to enter, as some incumbent advantages may be transferrable. Our research suggests companies that master moving into adjacencies can deliver 3 % more TSR over time. News Corporation was a traditional print-media conglomerate that found itself needing to radically pivot in order to survive. Digital-heavy investment has transformed News Corporation into a market leader in the online real-estate, streaming, and information aggregation sectors. It didn’t just move its news from print to online (though it did that as well). It executed M&A-led entries into digital brands such as REA in Australia and Move in the United States and built out adjacent services such as mortgage brokering through the same platforms. It also purchased complementary data businesses that could plug into existing services and aggregated intellectual property from thousands of news information sources, in different formats and languages. This play can win across sectors. Many consumer-packaged-goods companies quickly adapted their channel mix, launched direct-to-consumer (D2C) offerings, tailored products for comfort and at-home use, and de-emphasized items like suits or corporate-office furniture and equipment. Materials companies moved downstream, often using D2C or white-label brands where their inputs could capture more value. And financial institutions, which commonly catered to business-to-business or other institutional investors, successfully entered retail banking.

?Making business building part of the resilience agenda

In a McKinsey survey in 2020, findings suggested that 24 % of new businesses started by large corporations went on to become viable, large-scale enterprises. In the current environment, more companies could benefit from the resilience new businesses can provide. But building new businesses is not without risk. Just 20 % of incumbent companies created 66 % of the viable, large-scale businesses that have been built in the past ten years.7?While today’s heightened uncertainty could make the prospect of building new businesses less attractive to executives occupied with the health of existing businesses, the risk of?not?broadening the business portfolio could be even greater. Corporate longevity has never been lower, and more than 50 % of all revenue over the next five years is expected to come from businesses and offerings not in existence today. Research suggests that the risks of building new businesses can be mitigated and that incumbents possess certain advantages over start-ups.?Take a look at what established companies can do to boost their new businesses’ odds of success. Follow a proven playbook.?Applying a rigorous business-building methodology can raise the success rate of new businesses and avoid common critical pitfalls. Make business building a habit.?Our 2020 survey found that frequent business builders—those that launched four or more businesses in the past ten years—see higher returns on investment, on average than those building fewer new businesses. These frequent business builders are 2.2 times more likely than other companies to generate returns of five or more times their original investment. The difference can be attributed, in part, to the benefits of having a portfolio of new companies and developing capabilities to build and scale these ventures. Start today.?Our research suggests those that who innovated and built new businesses in the last downturn outperformed by?10 % in the crisis and 30 % through the cycle. Market discontinuities can create opportunities the time to start is now. Business building is not without risk, but not taking the leap may be even riskier.

CONCLUSION

As we enter the new year, it’s worth considering the potential developments and disruptions that could shape the financial landscape in 2023 and beyond. AI, automation, and new, more proactive modes of employee hiring and retention are poised to be trends that shape the new year and finance and accounting departments. Finance embraces intelligent applications, and Finance BPOs reframe and re-architect their value proposition.FinOps will become a mainstream part of finance.

FinOps, a part of cloud cost management and optimization, is poised to become an integral part of budgeting, planning, and other finance workstreams. FinOps drives maximum business value, especially as many enterprises’ cloud computing costs continue to rise. But beyond the practicality of the FinOps methodology, at its core, FinOps is also a cultural philosophy designed to bring an?attitude?of financial accountability to an enterprise and enable trade-offs between the speed, cost, and quality of cloud architecture and other key financial decisions.

AI-based automation will become a strategic advantage for finance.

While AI was once seen as “cool,” it has transformed to become a strategic advantage for companies looking to stay one step ahead of the competition. AI-based automation transforms the finance office into a modern, efficient digital engine, thanks to cloud-based intelligent applications that help streamline general and administrative costs and increase productivity. Expect AI to revitalize and revamp finance in critical areas, including data extraction, encryption, threat protection, statistical and predictive forecasting and planning, and process automation.

?Finance will need to fight for quality talent.

The demand for financial professionals is at an all-time high, and continued business growth is set to create an even more competitive recruitment market. Unfortunately, there’s also a shortage of skilled professionals, which is turning up the heat on enterprises looking to hire and?keep?top talent. Plus, with the economic downturn, fewer people will likely be doing the same amount of work. To succeed in the new year, finance must balance automation and quality talent to stay relevant and strategically minded. Expect 2023 to be the year of using tools imbibed with AI and ML technology to find, hire and retain talent while at the same time streamlining operations, slashing the need for humans to perform redundant and mundane tasks. These are only a few of the many changes both finance and businesses across the board will face in the coming year. The bottom line is finance must continue to be agile and embrace technology to accelerate finance transformation and boldly move to a more intelligent future.