There's little argument that a lack of risk management in many companies is one of the main reasons our economy has flamed out. After the catastrophic collapse of the financial system, it's essential that we debrief to garner lessons learned so we can be prepared for the next time something like this occurs. And it will happen again. Rep. Barney Frank (D., Mass.) recently called upon Freddie Mac and Fannie Mae to ease lending standards to prospective condo buyers in distressed areas. Sound familiar? When it comes to risk management in my finances or running a business, I apply a combat-tested methodology that I've adapted to the business world called ARSA: Avoid, Reduce, Spread, Accept. Avoid: The first option is to simply avoid the risk. But this strategy has other implications. By avoiding a risk you may impact your original strategy. Suppose I'm on an airborne mission with a target deep in enemy territory. If I discover there's a surface-to-air missile (SAM) site on the route to my target and no assets are available to take out the threat, I'll alter my flight path to avoid the SAM site. In doing so, however, the mission is impacted. For one, I will need additional fuel. I will have to request tanker support from the Air Force or a sister squadron. In addition, avoiding the risk will add time to the mission, and the aircraft carrier may have to change its planned course and speed.
Avoiding the risk will have consequences, but the risk of being shot down (in my humble opinion) outweighs those other factors. In the business world, avoiding risk is common. During the subprime lending boom from 2002 to 2005, Wells Fargo ( WFC) avoided the lure of easy money, determining that the risk was outside its comfort zone. In the end, the company was right. But while it avoided the risky subprime market, it exposed itself to the risk of cheap credit by pushing home equity loans, believing that they were safer. As housing prices fell, these home equity lines began to collapse in similar fashion to the subprime market. While Wells Fargo avoided the subprime risk, its diligence and risk management did not go far enough. Reduce: If you can't avoid a known risk, the next step in my risk management model is to reduce the possible impact it may have. As a leader, in the business world or military, you need to constantly evaluate whether the risk you're about to take is worth the return. I've been to more memorial services in the Navy than I care to count because a peer failed to properly identify a dangerous maneuver or situation. In February 2001, the USS Greenville, a fast-attack submarine based in Pearl Harbor, was conducting a DV (distinguished visitor) day trip off the island. The commanding officer (CO), seeking to impress visitors from his home state, disregarded checklists and procedures. The result was tragic.
The submarine performed an emergency ballast tank blow. Picture a large whale flying out of the ocean and slamming back down in a huge explosion of water. High-pressure air forces the water that had made the submarine submerge out of the ballast tanks, sending the vessel on an elevator ride up to the surface. It's not overly dangerous, but it's not risk free, especially when done incorrectly. The Greenville slammed into a Japanese fishery training ship, sending it to the bottom in five minutes, along with five sailors and four students. It would have been a completely avoidable tragedy if the CO had reduced the risk of the maneuver by following procedure. Spread: If you can't avoid or reduce the risk, you should look for ways to transfer the risk, hedge against it, or spread the risk around. The very volatile airline industry provides a prime example of successful hedging or spreading of risk. While many of the older legacy airlines such as Delta ( DAL) and United ( UAUA) wallow in or are on the verge of bankruptcy, low-cost carrier Southwest Airlines ( LUV) has fared better. Much of its success is due to a risk management policy that allows it to hedge against volatile jet fuel costs by using call options and fixed price-swap agreements. It buys fuel contracts today at a future price it selects. If in the future the price for jet fuel is higher than it pays today, it makes money. If it's lower, it loses money.
Accept: The last option is to simply accept the risk. In the business world, when Merck ( MRK) or Pfizer ( PFE) completes the long and extensive process of bringing a new drug to the market, the accepted risks are enormous, the most prominent of which is the potential outright failure of the drug and the impact on the health of customers. Even though these companies do exhaustive testing and research spanning years, the risk of failure still exists. But it is a risk they must accept. Bottom line: when you're faced with a hazard or risk, run through ARSA for the best way to deal with the situation so you can succeed.