Working with Catastrophic Scenarios

Establishing catastrophic scenarios for devising response or mitigation strategies requires considering the tenets of the business landscape and decide to ignore conventional wisdom. Unless a scientific, direct and independent reason exists, any assumption that is core to the business should be fair game. The condition or event needs to have a broad impact across the industry, and could trigger a ripple effect when combined with another event.

An example would be extreme cross-leverage (risks is being shared and divided repeatedly amongst the same players) combined with the collapse of the value of collateralized assets (like Real Estate, raw material claims or reserves, precious metal). Unbalanced reliance on a given product line, market segment or geography combined with a sudden market or geo-political disruption could also trigger a compound impact.

Using and expanding the use of scenarios such as the ones developed for regulatory purposes in the banking and financial industries provides an immediate benefit with the sobering analysis of the strategic and operational strengths and weaknesses of a business. Moreover, such analysis is based on an outward perspective, while typical SWOT analysis routinely carry the internal perception (for good reasons).

Catastrophic scenarios are exploring what would happen if the pillars of a business were collapsing, including societal, economic and industrial dimensions. Typical strategic or exploratory scenarios consider variations on the themes of organic and inorganic growth, market tensions and dynamics or competitive forces. The economic foundations of the business are rarely, if ever, considered in the business planning assumptions; it could be difficult to plan for business development while assuming that the world as we know it will come to an end.

Plan for the worst… and some

Catastrophic scenarios are not designed to spell out doomsday, but are tools to assess the strengths of the economic landscape and consider which events could be mitigated. Far from meteor crashing scripts bound for Hollywood, the scenarios consider severe impacts to the socio-economic landscape, such as a brutal change in currencies, interest rates, raw material, labor as well as sudden shifts of the market dynamics including disruptive innovations, regulatory changes, trade barriers or competitive pressure.

Once base scenarios have been selected, aggravating events acting as compound factors are thrown in, either undermining the recovery actions or making the impact more severe. If a scenario stitched together with a primary impact, then secondary, aggravating impacts need to be explored to assess how much of an additional impact they might generate.

What looked initially like a wild goose hunt starts to show a structure, as the number of fundamental events that could upset the business landscape is actually small. Some of the “Source” events and “compound” events can easily be interchanged, and the biggest impacts might be linked to “chain reactions”, when an event triggers another that in turn triggers another ne, etc.

The shrinking of the industrial growth in China for instance, could trigger a collapse in raw materials like copper and iron and a retreat of Chinese investors into foreign projects. Those in turn could generate a sudden halt in large projects in developing countries, put pressure on economies where Chinese financial flow helped secure debt, and incite some Asian countries to look into new or strengthened partners to make up for the lower exchanges.

Not all impacts are negative, and their analysis can provide a number of strategies to handle market volatility even if the fluctuations do not reach the level of a major shift.

Outside help can be necessary to ensure that an internal bias is not carried through the analysis. As the last financial crisis was unfolding, some companies were still operating under the belief that the complete collapse of the industry was not possible, and that the “market will regulate itself”. A strong belief remains in circles that the emergency rescue plans launched by a large number of countries were unnecessary, even after the governors of most central banks agreed that they were the only viable solution to the crisis.

Plan beyond common wisdom

The most difficult task in performing an independent analysis remains the – iconoclastic - challenge to common wisdom, certainties and beliefs that are the fabric of a company.  If a business is betting its success on the launch and growth of a product or service line, how in the world could they succeed at reversing their entire thinking and challenge their own assumptions?

In times of crisis, leaders tend to rely on “guts” feelings and experiential-based responses, consistent with their comfort zone (been there before), discounting the analytical approaches that they have a harder time relating to. Emotional intelligence and cognitive scientists have established that emotions prioritize our thinking; when the intensity of the situation overwhelms the decision makers, they might discontinue managing their emotions and let them influence attention and priorities. Tools or scripted processes help structure the response to a crisis; they are the backbone of risk management plans.

The three risk models can be summarized as follows:

Major events or disruptions can be harmful to a business. But with preparation and mitigation, the fatal situation might reduce to a major-impact level, no longer challenging the sustainability of the business. Although painful, the events are likely to impact other companies in the industry, which are not as prepared; this could create opportunities for a company to bounce back through external expansion or acquisition.

Identifying Unknown Key Risks

A practical mean to achieve a critical review of beliefs and assumptions is the systemic decomposition of the success factors for a business, followed by an independent analysis of each of the “core” pillars of the scenario. Operating into a capitalistic context provides guideline however: following the creation of value, the generation of revenue and the inter-dependencies between agents of the supply, sale and distribution chains is a good starting point (follow the money).

A new medical device must be manufactured with possibly partners, technologies and possible rare or expensive materials. The adoption of a new sneaker by customers will rely on a combination of marketing efforts and a solid retail channel. The generation of the revenue for a financial services company will depend on the attractiveness of their solutions, but also on the size and accessibility of their target market.

In each case, core parameters are implicitly assumed, such as the approval decisions by government structures, raw material markets, absence of major hidden defects after launch or market dynamics.  Finding out the second-tier of the parameters is the hard, but critical part; these are the parameters that would make a core parameter troubles worse. The decision of a regulatory body to stop or delay approvals for new devices in a country for instance, could harm the launching of a new product. But if this movement is followed by trade or medical administrations in countries from the same world segment, the effect could be devastating. Would this happen after large funding has been invested into marketing and promotion, and the business could be in trouble while finished products are piling up into warehouses and operating costs keep rising.

Disruptions as a Threat

Analyzing risks implies in most cases looking at events or correlated events which together, cause a severe or critical impact to the organization. Business continuity and contingency planning best practices introduced the concept of disruption as well. A disruption is a relatively minor impact to the operations or functions of the organization. If the disruptions multiply or amplify, they can reach a level where the normal operations of the business can no longer be sustained. Continuing to increase the density of the disruptions can cause the entire organization to be unable to operate and continue its business.

 As the level of disruption raises, thresholds exist which codify the degree of severity of the disruptions, altogether. A difference with major events is that each item might be causing a minor or even negligible impact. The disruptive impact comes from the number of simultaneous events, illustrating the concept of “death from a thousand cuts”.

Smaller disruptions might not be considered as a threat as long as they are not correlated, appearing in insulation. Disruptive situations appear when many uncorrelated small events keep hitting the core operations, slowly raising the level of impact and exhausting solutions and reserves, even no nominal impact exceeds alarm thresholds.

Considering disruptions as a threat is turning around the risk model as the primary driver is the amount of operational disruption, while the source might be varied or still undetermined. A business can establish a set of thresholds to codify the impact of disruptive situations. The Maximum Acceptable Disruption (MAD) is the level beyond which a business needs to take action as the disruption creates unacceptable impacts. The second and more severe threshold is the Maximum Tolerable Period of Disruption (MPTOD) which is the accumulated amount of disruption beyond which a business can no longer sustain its activities, which resumption might not be possible. 

The source of the disruptions and to a lesser extent, of major events is not always defined when the scenarios are built. The impact is the primary criteria, from which the origin of the event or disruption can be assessed or modeled. This reverse approach of the traditional risk management allows to escape the cultural (wisdom) and experiential limitations of traditional risk planning in addressing catastrophic events.

The need to do more than just surviving

Volatile markets can be a source of major events and disruptions, which are neither driven nor impacted by the decisions of a business. Stable segments are also (counter-intuitively) good sources for disruptive innovations and harder nuts to crack as few in the industry would even consider that core market parameters might change, let alone be upset; this makes them perfect targets for unforeseen disruptions.

While regulators pursue their own agenda, mainly to preserve solvency of key operators and ensure continued market availability for customer solutions, a business carries a broader charter, like a mandate to grow and prosper. Generating shareholder value and executing their Mission come high in corporate priorities. When a regulator requires a certain level of reserves to be satisfied, a business might also consider options to reduce the potential need to tap into those reserves. This additional mandate drives the pursuit of unforeseen risks and disruptions beyond ensuring the sustainability of the activity, into reducing the most damaging impacts on operations and profitability.

Gradually releasing marketing investments as the deployment of the product unfolds, keeping a distinct market segment as a secondary target, maintaining an in-house elementary capability to supplement fragile partners are examples of mitigating the potential impact of a severe adverse market event. Well prepared, such mitigating dispositions bear a minimal impact onto the business agility and growth. Turning the mitigation of large risks into a strategic direction does not prevent catastrophic events from happening, but can greatly reduce their direct impact on the sustainability of the business.

Scenarios as a Tool

Leveraging scenarios based approaches can provide an effective tool to recognize and mitigate key risks, including catastrophic events. They also help identify early warning signs foretelling of a major event in the making, which means a longer time to prepare and find alternate solutions. A smart dashboard can both monitor key risk triggers, but also recognize the combined effect of correlated risks emerging, indicating a possible compound effect.In the absence of a particular risk event, scenarios help build more resilient business plans and strategies. Strategic planning relies on scripted stories to describe how the strategy is expected to unfold. Alternate strategies, considered in case the primary strategy does not work, are in effect key risks events applied to the strategic drivers. The difference between strategy and risk management is that strategic plans ideally combine the most likely adverse scenarios to create a more resilient roadmap. Risks management combines scenarios to prepare for the absolute worst case, creating sustainability.

Scenarios, or as they are also called, story lines and narratives, are great tools to harden business operations and strategic plans. Companies that are better prepared for unforeseen events and major impacts are likely building a more robust business, less sensitive to external factors and more capable of handling adverse situations. Over time, this becomes a competitive advantage, as the thinking gets engrained into the organization’s culture.

Developing the narrative to a greater level of details is an effective tool to obtain congruence and operationalize an executive vision. When used to drill down potential operating or market disruptions, they increase the preparedness of the organization at once, shortening the time to implement a mitigation plan.

Relying on scenarios to build solid plans, mitigate adverse execution performance or increase resiliency is an often forgotten tool readily available, that requires little knowledge or practice to pay off. The reliance of scripted analysis for process optimization, forensic analysis and strategic planning are only a few of the potential uses of scenario playing and analysis; they can be applied to in many other aspects of a business, including risks, operations, marketing and transformations to name a few.

Why don't you give it a try?