Risk-assessment processes typically expose only the most direct threats facing a company and neglect indirect ones that can have an equal or greater impact.

Here is a brief excerpt from an article written by Eric Lamar and Martin Pergler for the McKinsey Quarterly, published by McKinsey & Company (2016). To read the complete article, check out other resources, learn more about the firm, obtain subscription information, and register to receive email alerts, please click here.

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The financial crisis has reminded us of the valuable lesson that risks gone bad in one part of the economy can set off chain reactions in areas that may seem completely unrelated. In fact, risk managers and other executives fail to anticipate the effects, both negative and positive, of events that occur routinely throughout the business cycle. Their impact can be substantial—often, much more substantial than it seems initially.

At first glance, for instance, a thunderstorm in a distant place wouldn’t seem like cause for alarm. Yet in 2000, when a lightning strike from such a storm set off a fire at a microchip plant in New Mexico, it damaged millions of chips slated for use in mobile phones from a number of manufacturers. Some of them quickly shifted their sourcing to different US and Japanese suppliers, but others couldn’t and lost hundreds of millions of dollars in sales. More recently, though few companies felt threatened by severe acute respiratory syndrome (SARS), its combined effects are reported to have decreased the GDPs of East Asian nations by 2 percent in the second quarter of 2003. And in early 2009, the expansion of a European public-transport system temporarily ground to a halt when crucial component providers faced unexpected difficulties as a result of credit exposure to ailing North American automotive OEMs.

What can companies do to prepare themselves? True, there’s no easy formula for anticipating the way risk cascades through a company or an economy. But we’ve found that executives who systematically examine the way risks propagate across the whole value chain—including competitors, suppliers, distribution channels, and customers—can foresee and prepare for second-order effects more successfully.

Risk along the value chain

Most companies have some sort of process to identify and rank risks, often as part of an enterprise risk-management program. While such processes can be helpful, our experience suggests that they often examine only the most direct risks facing a company and typically neglect indirect ones that can have an equal or even greater impact.

Consider, for example, the effect on manufacturers in Canada of a 30 percent appreciation in the value of that country’s dollar versus the US dollar in 2007–08. These companies did understand the impact of the currency change on their products’ cost competitiveness in the US market. Yet few if any had thought through how it would influence the buying behavior of Canadians, 75 percent of whom live within 100 miles of the US border. As they started purchasing big-ticket items (such as cars, motorcycles, and snowmobiles) in the United States, Canadian OEMs had to lower prices in the domestic market. The combined effect of the profit compression in both the United States and Canada did much greater damage to these manufacturers than they had initially anticipated. Hedging programs designed to cover their exposure to the loss of cost competitiveness in the United States utterly failed to protect them from the consumer-driven price squeeze at home.

Clearly, companies must look beyond immediate, obvious risks and learn to evaluate aftereffects that could destabilize whole value chains, including all direct and indirect business relationships with stakeholders. A thorough analysis of direct threats is always necessary—but never sufficient (Exhibit 1).

Companies are susceptible to interconnected cascades of risk.

Competitors

Often the most important area to investigate is the way risks might change a company’s cost position versus its competitors or substitute products. Companies are particularly vulnerable to this type of risk cascade when their currency exposures, supply bases, or cost structures differ from those of their rivals. In fact, all differences in business models create the potential for a competitive risk exposure, favorable or unfavorable. The point isn’t that a company should imitate its competitors but rather that it should think about the risks it implicitly assumes when its strategy departs from theirs.

Consider the impact of fuel price hedging on fares in the highly competitive airline industry. If the airlines covering a certain route don’t hedge, changes in fuel costs tend to percolate quickly through to customers—either directly, as higher fares, or indirectly, as fuel surcharges. If all major companies covering that route are fully hedged, however, that would offset changes in fuel prices, so fares probably wouldn’t move. But if some players hedge and others don’t, fuel price increases force the nonhedgers to take a significant hit in margins or market share while the hedgers make windfall profits.

Companies must often extend the competitive analysis to substitute products or services, since a change in the market environment can make them either more or less attractive. In our airline example, high fuel prices indirectly heighten the appeal of video-conferencing technologies, which would drive down demand for business travel.

Unknown and unforeseeable risks will always be with us, and not even the best risk-assessment approach can identify all of them. Even so, greater insight into the way they might play out can provide a more comprehensive picture of an industry’s competitive dynamics and help shape a better corporate strategy. Thinking about your risk cascades is a concrete approach to gaining that insight.

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Here is a direct link to the complete article.

Eric Lamar is a director in McKinsey’s Montréal office, where Martin Pergler is a consultant.