A couple of days ago I participated in a discussion concerning risk management systems. A specific emphasis was given on strategic risks and their management. Identification and delimitation were described as two major problems when starting to manage this risk type.
Well, that is basically not an unusual situation within an organization. Before managing a specific risk type it is essential to define this type to ensure that every involved participant within the organization does understand what this risk is and what it is not. So how can we distinguish strategic risks from other risk types?
To distinguish strategic risks and operative risks the two attributes scope of risk effects and level of uncertainty can be used. I have to explain that this is an initial idea that can be used as a good starting point for a discussion in your organization. In general the level of uncertainty for strategic risks is higher, since the time frame for risks impact is bigger than for operational risks. In terms of the scope concerning risks effects strategic risks have a general potential for a larger scope than operational risks.
But the attribute scope of risk effects to distinguish risk types has some disadvantages, too. Other risk types, e.g. interest rate related risks, can have a huge impact on the survivability of an organization. Furthermore time frame that has to be considered to classify risks is not sufficient enough to offer a clear definition, too. Given the example of a long term credit approval a bank has made a long term decision; however this decision is part of the organization’s day-to-day business and does not a strategic decision. On the other side an organization can made a strategic acquisition of another organization but does not hold the shares for a long time. Both attributes “scope of risks effects” and “time frame” help to make a differentiation between strategic risks and operational risks. But both attributes are not able to distinguish strategic risks and operational risks in all situations. Hence an additional specification is needed. To achieve this specification the concepts of strategy and strategic management should be taken into account from your organization.
Strategy and potentials for success and their links to strategic risks
A large number of concepts and definitions for the term strategy and strategic management can be found in business and academic literature. So let us take this definition: A strategy consists of all measures that have the objective to ensure the long term success of an organization. Therefore potentials for success have a major impact for an organization. Taking this into consideration it can be argued that all those measures (better: only those measures!) can be named “strategic” if they generate or ensure potentials for success. So what is the specific meaning of potentials for success?
Current and future potentials for success represent the input parameters for success (in its widest sense) and financial liquidity of an organization. Two types of potentials can be distinguished. There are external potentials for success in the form of market potentials, e.g. a market share that is higher than average. Internal potentials for success represent the second type and can be found in form of performance potentials and cost potentials. Examples for these are advantages in terms of cost structure, quality or distribution. Potentials for success are affected by so called success factors. Given the example that the financial strength represents an internal potential for success in a capital intensive industry, some specific success factors will have an impact on this potential. There can be internal success factors like capital structure and tax advantages arising from organization’s legal structure. There can also be external success factors like interest rates and foreign exchange rates that will have an impact on the financial strength from outside on the organization.
Potentials for success cause the upper limit for the success of an organization. Of course, wrong operational decisions can cause that an organization does not exploit all existing potentials. Therefore strategic management establishes (only) the premises for success options by ensuring existing potentials for success and by arranging new potentials. Opposite to this operational management has the objective to ensure the exploitation of potentials. Hence success and liquidity of the organization belong to the operational management. Existing and future potentials for success belong to the strategic management function.
This approach can be transferred to the definition of risk types. Strategic risks have an interrelationship with the existing or future potentials for success of an organization. Operational risks instead have a direct or indirect link with organizational success and with financial liquidity. Given the example that the legal structure gives your organization a tax advantage and therefore a financial benefit, a legal change that destroys or deactivates that structure represents a strategic risk. Having those factors identified your next task is to forecast the change and to evaluate the financial effect on your organization. This forecast can be seen as the most difficult part of managing strategic risks. Of course, scenario techniques and some cash flow and /or return models represent excellent approaches for this job.