The risk of self-deception

2011

High-profile corporate failures don't just happen. As a new study reveals, they occur because boards and executives are fatally blind to fundamental risks to their business model and reputation and too focussed on pursuing growth at any cost.

This is one conclusion of a new report by Cass Business School, part of City University London, undertaken on behalf of the risk management association Airmic.

This failure lies behind many big corporate failures, say the researchers, and it will continue to do so until lines of communication are improved.

The Cass research, "Roads to Ruin", looks in detail at twenty three companies with aggregate pre-crisis assets of more than $6 trillion, all of which suffered potentially life-threatening corporate crises. They include AIG, Arthur Andersen, BP, Northern Rock and Cadbury Schweppes.

Six of the firms studied collapsed (with three having to be rescued by the state). In 16 cases the companies and/or its executives personally suffered financial penalties or fines, and in four cases executives received prison sentences. Most companies - and their shareholders – suffered severe, uninsurable losses and most reputations suffered severe damage. None of the companies emerged without obvious immediate harm.

Around twenty chief executives and chairmen subsequently lost their jobs, and many NEDs were removed or resigned in the aftermath of the crises.

"Events that bring down or seriously damage otherwise successful companies don't just happen. They are commonly the result of boards failing to see underlying risks that threaten the company," said Professor Chris Parsons, who led the Cass research team.

"This report makes clear that there is a pattern to the apparently disconnected circumstances that cause companies in completely different sectors to fail," said Airmic chief executive John Hurrell.

"More big corporate failures are inevitable as long as directors are blind to the risks they face."

So what are the underlying risks that cause these corporate crises? Seven key issues emerge from the report.

  1. Inadequate board skills and inability of NED members to exercise control
  2. Blindness to inherent risks, such as risks to the business model or reputation
  3. Inadequate leadership on ethos and culture
  4. Defective internal communication and information flow
  5. Organisational complexity and change
  6. Inappropriate incentives, both implicit and explicit
  7. 'Glass Ceiling' effects that prevent risk managers from addressing risks emanating from top echelons.

Given that these risks are integral to the ethos, safety, reputation and longevity of a business and to its ability to use its own information effectively, why is it that they are not acknowledged and discussed?

One reason, the report argues, is that NEDs and other board members often lacked the skills to monitor and control executives nominally under their supervision, and they often showed risk blindness as they pursued reward and opportunity.

But what is also particularly striking here, as Anthony Fitzsimmons, one of the report's authors pointed out, is that these risks are often apparent to others within the organisation but not to its senior leadership.

"NEDs should be aware that there may be important 'unknown knowns' - things that are known within the company but unknown to its leadership," he said.

"It's typically a deep-seated culture or wrong incentives that keep them hidden."

In other words, these risks can become virtually taboo internally, because they touch on the behaviour, decisions, performance and perceptions of the senior echelons of the company.

But as the report points out, without listening to outsiders, boards can only see themselves as in a mirror. They cannot see themselves as others do and so they risk self-deception.

The report calls on companies to re-think risk management at all levels so that the missing risks are included in risk maps. It adds that risk and internal audit professionals may need to develop additional skills to fulfil this role adequately.

"Our report shows that boards, and particularly their Chairmen and NEDs, need to recognise the importance of risks that are not captured by current techniques", said Professor Steve Haberman, Deputy Dean of Cass Business School.

"They also need to find ways of ensuring that the missing risks are captured."

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