COVID-19: Tackling the Black Swan

March 22, 2020

According to the Corporate Finance Institute, a black swan event is “an extremely negative event or occurrence that is impossibly difficult to predict”. The term was popularised in the finance context by former Wall Street trader and finance professor Nassim Nicholas Taleb, and originated from the widespread belief in Europe that black coloured swans could not exist, until their later discovery in Australia.

 

It goes without saying that 2020 has taken an unexpected turn for the worse with a black swan event in the form of Coronavirus disease (COVID-19). Businesses and individuals alike are now presented with all sorts of challenges that could not have been predicted just a few months ago.

 

COVID-19 first surfaced in Wuhan in the Hubei province of China in December 2019. It has since spread to over 160 countries across the globe, being declared a pandemic by the World Health Organisation on 11 March 2020. Australia has now closed its borders to non-residents and various states are in the process of shutting down non-essential services in a bid to contain the spread and flatten the curve of infections and hospitalisations.

 

Shelves in supermarkets, pharmacies and officeware stores have been stripped bare as people panic at the thought of not being able to purchase essentials, prepare for stretches of self-isolation and migrate en masse to working from home arrangements. Businesses, small and large, are bracing for a period of inactivity and material segments of the workforce are being stood down. Share markets have plummeted beyond Global Financial Crisis (GFC) levels as a result of the economic impact and general uncertainty.

 

Talk about a rapidly emerging and evolving risk!

 

Management teams need to respond decisively and effectively, and a key step in the process involves undertaking an accurate risk assessment on a timely basis.

 

The (Substantive) Downside

 

Likely adverse impacts to business risk profiles and the realisation of risk events extend across the following risk categories:

 

Operational Risk

 

Business Continuity / Pandemic Risk

 

The potential for a pandemic at any time is a known risk, but one which has become a reality today. The ultimate impact and duration of disruption is yet to be seen.

 

Business continuity and pandemic plans have been activated at a vast number of organisations. Some organisations have had cases of infection amongst the employee base or COVID-19 scares, prompting office evacuations and implementation of contingency arrangements. Other organisations are simply taking precautions to minimise the chance of staff infection and help society flatten the curve by reducing the number of people in circulation to the extent possible. The adequacy of pre-existing plans and the ability to develop effective solutions on the fly is being well and truly tested.

 

Exposure also exists in respect of business disruption at service provider organisations, where they are not adequately prepared for a pandemic or the nature of their business operations doesn’t readily translate to a remote working setup.

 

People Risk

 

The people risks associated with COVID-19 are plentiful. For a start, there’s the obvious risk of loss of skilled and critical personnel from infection, necessary redundancies associated with business slowdowns and resignations from roles with high risk of exposure to the virus. There is also the impact of remote working on productivity and staff engagement over the short term, while people adapt to new ways of working. Some staff will also not have the capability and mindset to adapt effectively.

 

Also front of mind are the occupational health and safety exposures arising from the rapid transition to alternative working environments, with the proliferation of remote work spaces that have not been subject to risk assessments, and the impact of working from home on connectivity and mental health.

 

Cyber Risk

 

Cyber risk may increase as a result of the rapid shift to remote work and the use of personal devices in some circumstances, where appropriate security protocols are not able to be consistently enforced.

 

Financial Risk

 

Asset Valuation Risk

 

Equities have been smashed. Exchange rate adjustments further compound losses in respect of international equities. Unlisted assets may not be immune to the impact of COVID-19 on underlying economic drivers, depending on the duration of the crisis. Over the short and medium term, performance targets will not be hit be for the vast majority of investment strategies.

 

Liquidity Risk

 

People are panicking, whether you say ‘stop it’ or not. The inherent uncertainty associated with COVID-19 has created a state of anxiety and people are looking to de-risk their positions to ensure they have what they need to take care of their obligations. Though yet to be seen extensively, we can expect a flight to safety through investment switching and the withdrawal of liquid assets from investment markets. As per the GFC, there is the potential for investment freezes and activation of contingency clauses to protect investor value and solidify institutions during a period of market turmoil, creating liquidity risk exposures.

 

Solvency / Capital Adequacy Risk

 

Risks associated with the adequacy of solvency and capital adequacy metrics would be expected to increase as a result of interlinkages with other risks and financial drivers, including asset valuation, liability reserving and the profitability of business operations in the COVID-19 environment.

 

Counterparty Risk

 

The risk of non-recovery of outstanding balances from third parties may also increase as a result of insolvencies and financial difficulties arising from economic and business risks for various organisations.

 

Strategic Risk

 

Environmental Risk

 

The risk of corporate strategy not being fit for purpose becomes substantively more pronounced amidst the shifting economic and competitive environment associated with COVID-19. There has been an impact on consumer demand for various products, including the purchase of financial products such as travel insurance policies and additional contributions to investments. Further controls may be required, including more frequent iteration of strategic objectives and business plans, and the development and implementation of crisis management and tactical response plans.

 

Execution Risk

 

There is an increased risk of management teams not being able to execute on agreed business plans and financial targets due to a range of drivers across various risk categories, including business disruption, loss of key personnel, reduced productivity, prioritising responses to consumer needs in the COVID-19 environment, delay of project work, and financial losses.

 

All Risk Categories

 

Across all risk categories, organisations should expect an impact on culture as a result of varied work arrangements and the substantive change in the external environment. As a sub-set of organisational culture, an impact on risk culture should also be anticipated, given the increased potential for distraction and shifting priorities.

 

The effectiveness of controls may be adversely impacted, with the move to remote and/or rotating workforces potentially impacting the extent of managerial oversight and cross-functional coordination.

 

Inherent and residual risk exposures may increase as a result of the impacts relevant to individual organisations. Additional risk action plans may be required as a result, subject to the organisation's risk appetite and risk tolerance levels.

 

The (Limited) Upside

 

It’s not necessarily all doom and gloom though. Potential opportunities and upside risks include:

 

Operational Risk

 

Reputation Risk

 

COVID-19 presents various organisations with an opportunity to assist their customers in a profoundly difficult time. By going beyond the call of duty and developing initiatives to assist customers, organisations can invest in the reputation and brand. This is particularly pertinent for the financial services sector in the aftermath of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry.

 

People Risk

 

Notwithstanding the transitional risks highlighted above, there is the potential for longer term benefits to be derived through the development of new and more effective ways of working. Increased productivity and improved work / life balance for employees may be recognised over the longer term, which may not have been otherwise experimented with.

 

Compliance Risk

 

Regulatory Change Risk

 

Given the exceptional nature of COVID-19, there is a necessary and understandable re-evaluation of priorities to support businesses and individuals in navigating the challenges ahead. As such, the Council of Financial Regulators has publicly stated its intention to reassess timelines for the implementation of pending legislative and regulatory changes. Announcements from individual regulators have since commenced.

 

Depending on the level of preparedness for regulatory change prior to COVID-19, the lengthening of timeframes and temporary relief from specified regulatory obligations may act to reduce risk exposures.

 

Concluding Remarks

 

These are troubled times and many organisations may find themselves operating outside their risk tolerance ranges.  The systematic evaluation of evolving risk exposures and implementation of risk action plans will assist organisations in managing the downside, and best positioning themselves to bounce back when circumstances improve.

 

Need Help?

 

Hall Advisory is available to assist (on a remote basis at present) with a wide range of governance, risk, compliance and strategy consulting engagements, including:

 

* Facilitation of board, executive and business unit risk workshops and development of risk profiles / appetite statements / action plans.

 

* Review and enhancement of business continuity and pandemic plans.

 

* Facilitation of strategy days and development of strategic / business plans.

 

* Transitional resourcing support during periods of change and uncertainty.

 

* Management of compliance readiness projects for pending regulatory changes where in-house resources are diverted to other priorities.

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