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New Risk Challenges and Enduring Themes for the Return McKinsey on Risk New risk challenges and enduring themes for the return Number 10, January 2021 McKinsey on Risk is written by Editorial Board: McKinsey Global Publications risk experts and practitioners Tucker Bailey, Bob Bartels, in McKinsey’s Risk & Resilience Richard Bucci, Holger Harreis, Publisher: Raju Narisetti Practice. This publication offers Bill Javetski, Carina Kofler, readers insights into value-creating Marie-Paule Laurent, Maria del Global Editorial Director: strategies and the translation of Mar Martinez, Luca Pancaldi, Lucia Rahilly those strategies into company Thomas Poppensieker, Inma Revert, performance. Kayvaun Rowshankish, Thomas Global Publishing Board Wallace, John Walsh, Olivia White of Editors: Lang Davison, Tom This issue is available online Fleming, Roberta Fusaro, Bill at McKinsey.com. Comments External Relations, Global Risk Javetski, Mark Staples, Rick Tetzeli, and requests for copies or for Practice: Bob Bartels Monica Toriello permissions to republish an article can be sent via email to Editor: Richard Bucci Copyright © 2021 McKinsey & [email protected]. Company. All rights reserved. Contributing Editors: David DeLallo, Roger Draper, This publication is not intended to be Cover image: Kristen Jennings used as the basis for trading © Henrik Sorensen/Getty Images in the shares of any company or for Art Direction and Design: undertaking any other complex Leff Communications or significant financial transaction without consulting appropriate Data Visualization: professional advisers. Richard Johnson, Matt Perry, Jonathon Rivait No part of this publication may be copied or redistributed in any Managing Editors: form without the prior written Heather Byer, Venetia Simcock consent of McKinsey & Company. Editorial Production: Roger Draper, Gwyn Herbein, LaShon Malone, Pamela Norton, Kanika Punwani, Charmaine Rice, Dana Sand, Sarah Thuerk, Sneha Vats, Pooja Yadav, Belinda Yu Table of contents Risk and resilience The emerging resilients: Resilience in a crisis: An interview 5 Achieving ‘escape velocity’ 12 with Professor Edward I. Altman The experience of the fast movers One of the leading researchers out of the last recession in corporate financial health teaches leaders emerging from discusses what executives can do this one to take thoughtful to help their companies endure the actions to balance growth, financial stresses of crisis times. margins, and optionality. Meeting the future: Dynamic risk A fast-track risk-management 18 management for uncertain times 26 transformation to counter The world is changing in the COVID-19 crisis fundamental ways, leading to An accelerated transformation dramatic shifts in the landscape of to enhance efficiency and risks faced by businesses. effectiveness will enable risk organizations to deal with the pandemic while addressing rising regulatory and cost pressures. Risk culture Strengthening institutional risk When nothing is normal: 39 and integrity culture 46 Managing in extreme uncertainty Many of the costliest risk and In this uniquely severe global integrity failures have cultural crisis, leaders need new operating weaknesses at their core. Here models to respond quickly to is how leading institutions are the rapidly shifting environment strengthening their culture and and sustain their organizations sustaining the change. through the trials ahead. A unique time for chief risk 54 officers in insurance Amid rising economic uncertainty, leading insurers are looking to their CROs to do even more than manage risks. Extraordinary risks The disaster you could have How the voluntary carbon market 63 stopped: Preparing for 72 can help address climate change extraordinary risks The voluntary carbon market is Ignoring high-consequence, low- gaining momentum and plays likelihood risks can be damaging an increasingly important role to an organization, but preparing in limiting global warming. for everything is impossibly costly. Here’s how. Here is how leaders can make the right investments.creative, pragmatic solutions. Derisking Derisking AI by design: How The next S-curve in 81 to build risk management into 91 model risk management AI development How banks can drive The compliance and reputational transformations of the model risks of artificial intelligence life cycle in a highly uncertain pose a challenge to traditional business landscape. risk-management functions. Derisking by design can help. Applying machine learning Derisking digital and analytics 97 in capital markets: Pricing, 101 transformations valuation adjustments, While the benefits of digitization and market risk and advanced analytics are well By enhancing crisis-challenged documented, the risk challenges financial models with machine- often remain hidden. learning techniques such as neural networks, banks can emerge stronger from the present crisis. 2 Introduction The tenth issue of McKinsey on Risk arrives as spirits, battered by public-health and economic hardships, have been lifted by the appearance of COVID-19 vaccines. Vaccines are beginning to reach priority and vulnerable populations, such as healthcare workers and long-term care residents. Governments and institutions are promising ever-wider distribution in the months ahead. Serious questions remain about production timelines and the completeness of vaccine delivery. For most economies, epidemiological uncertainty is the main factor complicating the conditions of return. Yet nations, sectors, companies, and individuals have endured different challenges and will travel different recovery paths, depending on the damage done. At the far end of the pandemic tunnel, some economies are demonstrating vibrant life. In other regions, the time for countries and organizations to grow again approaches at varying speeds. Those that prepare will benefit, as our lead article on the “emerging resilients” reveals. In the last recession, companies able to take thoughtful actions to balance growth, margin, and optionality separated themselves quickly from less resilient peers. Coming out of the current recession, which companies are poised to achieve “escape velocity”? Our authors—some of McKinsey’s most influential leadership voices—discuss the dynamic business landscape while pointing to a venerable metric that can help companies adjust for the needed balance. Taken as a whole, these discussions present McKinsey’s latest thinking and recommendations on risk and resilience—including optimal strategies and necessary transformative actions. Resilience as a business concept took on significance during the financial crisis of 2008–09. As cyclical stress levels rose in the global economy, challenges were magnified and new uncertainties were generated. Faced with proliferating risks and spiking volatility, organizations began to realize the need for dynamic risk management, by which serious threats can be prioritized and addressed as they arise. Today, as companies emerge from the pandemic-triggered economic crisis, risk organizations face extraordinary discontinuities on top of more familiar ongoing challenges. The highly complex risk landscape is marked by an accelerating digital revolution; massive environmental, regulatory, and industry changes precipitated by the changing climate; and rising stakeholder expectations about corporate behavior. Cost pressures, furthermore, mean that organizations must make significant, simultaneous improvements in risk efficiency and effectiveness. In pursuit of these improvements, companies in all industries are applying advanced quantitative capabilities to support faster operational decision making. Most are launching digital and analytics transformations—digitizing services and processes, increasing efficiency with agile approaches and automation, improving customer engagement, and capitalizing on new analytical tools. The present crisis is also creating a moment in which financial institutions can rethink their entire model landscape and model life cycle. Artificial intelligence, which promises to redefine how businesses work, is already marshaling the power of data to transform a range of business activities and functions. The inevitable consequences of all this innovation are elevated risk profiles, which many existing organizational approaches are incapable of addressing systematically. The following discussions illuminate the most compelling risk issues that companies in all sectors and geographies are confronting. Here, readers will find deep industry insight and structured risk-management approaches that are helping leaders build risk capabilities, strengthen institutional resilience, and navigate through this crisis toward restored performance. Let us know what you think, at [email protected] and on the McKinsey Insights app. Thomas Poppensieker Chair, Risk & Resilience Editorial Board Copyright © 2021 McKinsey & Company. All rights reserved. XXXXXXXXXXXXX 3 Risk and resilience The emerging 5 resilients: Achieving ‘escape velocity’ Resilience in a crisis: 12 Interview with Professor Edward I. Altman Meeting the future: 18 Dynamic risk management for uncertain times A fast-track risk-management 26 transformation to counter the COVID-19 crisis 4 McKinsey on Risk Number 10, January 2021 The emerging resilients: Achieving ‘escape velocity’ The experience of the fast movers out of the last recession teaches leaders emerging from this one to take thoughtful actions to balance growth, margins, and optionality. by Cindy Levy, Mihir Mysore, Kevin Sneader, and Bob Sternfels © Henrik Sorensen/Getty Images
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