This practices addresses a huge shortcoming within our economy and is available for both industrial and financial organizations. In certain ways, industrial firms must become more like financial firms. In addition, financial firms must understand the link between employee rewards and the risks that their organizations and shareholders are exposed to due to those rewards as well as other control, performance measurement, and compensation policies. All are endogenous variables–within the firm’s control.
Industrial Firms
Industrial firms need to find better ways to benefit from their risky environments, rather than solely trying to insulate themselves from variability of input and output prices. Too often, they pay massive, uncompetitive spreads to banks to “isolate” their profits or cash flows from environmental uncertainty.
How do you think banks and trading firms make so much money? (It’s by “picking-off” large, but relatively unsophisticated, clients.)
Unfortunately, those “hedge” contract often do not eliminate risk and sometimes do not mitigate it, but instead simply transfer it (like a game of whack-a-mole, where one type is eliminated and emanates as a new type, e.g., market risk morphs into counter-party credit risk). At best, such contracts can be closer to sledges or nedges–our made-up words that represent things that are Somewhat Like hEDGES, and Near hEDGES. (The difference between the uncertain, possibly harmful variable, and the one that you can hedge is known as basis risk.)
Managers at industrial and other non-financial firms and organizations must do more than append risk management methodologies and processes to their control framework. They must thoroughly integrate such practices and perspective into their strategic and tactical planning and control processes, such annual budgeting processes. That integration may include using methods and techniques like incorporation of (market-based) forward prices, stress testing and both routine and ad hoc scenario analyses.
Rather than run (or hide) from complex calculations and notions behind derivatives and other such contracts, senior managers must embrace the field, and receive the training that they need to properly evaluate their alternatives. (Unlike managers of financial firms, no one expects managers of industrial firms to inherently or already possess such knowledge, and that provides managers with the opportunity to lead in the classroom and elsewhere to gain the requisite knowledge.)
With that knowledge, managers can often identify, what we refer to as “natural hedges,” or changes in business practices and policies that mitigate risks. Those changes are far superior and often cheaper to implement than entering into options or derivatives contracts with large and sophisticated trading organizations. (Unlike the old men’s clothes advertisement, educated customers are not their best clients; they are their worst clients.)
Our expertise in managerial control and risk management allows us to go beyond “risk” management or “risk” mitigation, and help you answer: how can your firm embrace and profit from the risky environment rather than simply insulate itself?
Interested parties can read more about control and risk management or contact us.
Financial Firms
If nothing else, the past several years have shown that financial firms must address control issues, particularly incentive issues, and especially performance measurement issues, within their operations as a ways to influence behavior, reduce the magnitude of their feast-to-famine cycles, and mitigate potential disasters.
Relying on regulators, whether they are informed or not, to advise on control issues is an abdication of both personal responsibility and organizational due diligence.
By following our five-step performance measurement design approach, we provide innovative and creative ways to motivate and reward employees to generate the efficient risk-seeking or risk-mitigating behavior that the firm desires.
By definition, innovative and creative mechanisms are not industry standards. If you firm wants to find new ways (and performance measures) to motivate risk-takers and has the will and discipline to follow through, then contact us. As with everything else we do, our goals include No Unintended Consequences.
