Risk Management: Cubes To Doughnuts

Let’s imagine that your private equity fund is considering a long term investment in an American energy company that ships millions of barrels of crude oil through Philippine waters each year. When Filipino President Duterte unexpectedly calls American President Obama a “son of a whore” while promising to “continually engage China in a diplomatic dialogue rather than anger officials there,” do you change your mind about the investment opportunity?

Under normal circumstances, in order to make an informed decision, you would prepare a valuation analysis that compares the investment’s immediate cost against the present value of its future benefits. But how can you possibly assess its future benefits when massive uncertainty over President Duterte’s evolving foreign policy makes it impossible to render any predictions about the future?

For guidance in managing such risks, we generally turn to the Enterprise Risk Management (ERM) framework that is promulgated by the Committee Of Sponsoring Organizations (COSO) of the accounting profession. The current cube-shaped framework prescribes eight component activities for managing such risks, with Event Identification representing the first of its four central activities.

Indeed, one of the reasons for this framework’s enduring popularity is its reliance on the identification of clearly definable risk events. Thus, when a risk factor can be defined in terms of future discrete events, the COSO cube is a natural choice for risk managers.

Worried about the impact of potential hurricane damage on a waterside property, for instance? A hurricane is a future discrete event. It will either occur or not occur, and the consequences of its occurrence or non-occurrence are relatively easy to estimate. If a hurricane occurs, there will be massive losses. And if not, the status quo will continue unabated.

But what if a risk factor cannot be defined as a discrete event? What if the long term impact of a risk factor depends on slowly evolving circumstances that are extremely difficult to even define, let alone assess? Does COSO have a different framework for such factors?

Yes, it does. A new version of the framework is only available in a draft exposure format at the moment, but it is expected to be finalized shortly. It uses a doughnut symbol, instead of a cube. And although Risk Identification continues to represent an important underlying function of ERM, it no longer appears prominently on the face of its new framework.

Whereas the older cubic framework prescribes a list of eight rigidly defined and sequenced component activities, the newer circular doughnut framework relies on 23 broad principles like “Commitment to Integrity and Ethics” and “Develops Portfolio View.” So, with these two frameworks in mind, let’s think about the political risk that is challenging our private equity investor.

On the one hand, President Duterte’s colorful comments will undoubtedly impact the short term relationship between his nation and the United States. But on the other hand, this relationship will continue to evolve over time, and will be impacted by numerous unpredictable future circumstances. So even though President Duterte’s eventful actions can influence the future Filipino-American relationship, he cannot unilaterally determine it.

That’s why we need a doughnut shaped framework, with its 23 principles, to assess such complicated circumstances. Although the event-centric cubic framework is sufficient for more easily defined risks, the circular framework is required to analyze the complex risks that challenge us in our multi-dimensional environment.

China’s Curious Growth Data

What significant economic news from Asia cheered the global markets last week? The Chinese central bank decided to permit many financial institutions to lend more of their cash deposits to borrowers, a move that is expected to stimulate their economy.

As a result, analysts estimate that 1.5 trillion additional yuan (i.e. approximately $242 billion in American dollars) will be placed into the hands of Chinese businesses. China clearly needs this economic stimulus, given that the nation may miss its annual economic growth target for the first time since 1998.

Oddly enough, though, no one appears to have stopped for a moment to ponder the meaning of an annual target that has not been missed in sixteen years. Indeed, most pundits appear to share the universal assumption that the Chinese economy has been enjoying a perfect winning streak of real growth during that entire period.

Of course, that is certainly possible. And yet, sometimes, entities only appear to achieve an unparalleled string of economic or financial success through the adroit manipulation of statistics. General Electric, for instance, used advanced “earnings management” strategies to generate an astonishingly smooth and consistent string of annual profit announcements during the final years of the twentieth century.

To be sure, Nobel Prize winning economist Paul Krugman and others have cast occasional doubts on the validity of China’s statistical announcements. Nevertheless, generally speaking, most Western news organizations simply accept these announcements at face value and repeat them for public discourse.

So what should we make of this sixteen year Chinese winning streak that suddenly appears to be in peril? If most news organizations are correct, and if the winning streak is a real one, then the sudden threat to its continuation is indeed a serious concern about an unforeseen slump in economic growth.

And yet if the streak is simply a product of an actively “managed” series of economic statistics, then the sudden threat may represent far more than a simple slump. Indeed, it may represent the government’s unwillingness to continue to “manage” its economic statistics, a new position that may portend a long term shift towards a more transparent (and thus a healthier) Chinese economy.

Senkaku Vs. Diaoyu: An Asian Crisis

When global news organizations address concerns about the global economy, they often focus on extremely sophisticated technological or financial risks. From time to time, however, simple geographical border disputes and other geopolitical conflicts actually pose the greatest threats to our fiscal stability.

For instance, the ongoing split within the European Union between the fiscally conservative northern nations and the debt ridden Mediterranean states may lead to the collapse of the common Euro currency. And several countries that share access to the South China Sea continue to argue over their rights to exploit the natural resources of that body of water.

Other geopolitical crises have flared up periodically as well. South Sudan, for instance, remains locked in a tense stand-off with Sudan over a variety of territorial arguments. And the Arab Spring has produced tensions that extend from political disputes in Egypt to an outright civil war in Syria.

All of these conflicts, though, may pale in comparison to one that unexpectedly flared last week between China and Japan, the second and third largest nations (economically speaking) in the world. It concerns a tiny, undeveloped cluster of islands in the western Pacific Ocean.

A Territorial Dispute

The dispute involves a region known as the Diaoyu Islands in China, the Senkaku Islands in Japan, and the Diaoyutai Islands in Taiwan. The three nations do not agree on a common name for the islands and, in fact, each claims territorial rights over the land itself.

The Diaoyu (or Diaoyutai) Islands were considered Chinese territory until 1895, when the Imperial Japanese government annexed the land and renamed it Senkaku. The islands were then administered by the United States from the end of the second world war until 1972, when America agreed to return them to Japanese control.

But the mainland Chinese government, as well as the Taiwanese government, continue to claim ownership of the territory. And during the past two months, national activists from all three Asian countries took turns staging protests at sea, on the islands themselves, and at home.

Last week, in fact, violent anti-Japanese protests broke out in mainland China over the ownership rights to the island chain. Might China and Japan actually go to war over the land?

Historical Precedents

Major nations have fought armed conflicts over relatively small areas of land throughout modern history. Great Britain, for instance, repelled an Argentinian invasion of the Falkland Islands in 1982, a war in which Prince Andrew (the second in line to the throne, behind Price Charles) served as a helicopter co-pilot. And one year later, President Ronald Reagan authorized the United States Marines to invade and overthrow the government of the Caribbean island of Grenada, a group of military rulers that had recently seized power in a bloody coup d’etat.

At other times, similar disputes have been settled through far more peaceful methods instead. During the Carter administration, for instance, the United States agreed to transfer ownership of the Panama Canal Zone to the Panamanian government after more than seven decades of American control. But the debate stirred much angry debate in the American press, with Senator S.I. Hayakawa mocking the arguments of opponents of the transfer by describing their position with the phrase “We Stole It, Fair and Square.”

All of these disputes, though, lasted for relatively brief periods of time, and thus none caused significant damage the global economy. Nevertheless, there are many other examples of geopolitical disputes that wreaked tremendous economic damage over many years.

The political assassination of the Archduke Franz Ferdinand of Austria, for instance, triggered a series of catastrophic events that cascaded into the first world war. And Adolph Hitler’s Nazi invasion of Poland likewise intensified from a local dispute into the second world war. Both conflicts decimated the economies of the European nations, and greatly damaged those of other regions as well.

Who Can Help?

So what can the international community do to help prevent a potentially devastating conflict between the Chinese and Japanese nations? Are there any institutions that can employ diplomacy to resolve the dispute before it ignites into a full-fledged war with devastating consequences?

Indeed, after the conclusion of the second world war, the United Nations was created to serve such a purpose. But the organization has failed to resolve several major conflicts during the past decade; its track record in places like Afghanistan, Iraq, and Syria is mixed at best. Some human rights advocates, in fact, even accuse the U.N.’s blue-helmeted peace keepers of standing by and not intervening while atrocities have been committed in war zones.

Outside of U.N. auspices, other diplomatic initiatives, such as the Bush Administration’s “Coalition of the Willing” in Iraq and the “Six Party Talks” addressing the Korean Conflict, have made little or no progress in resolving global conflicts. It thus appears that the Chinese and Japanese may need to take matters into their own hands to reach a peaceful resolution to the Diaoyu / Senkaku dispute.