While some crises are impossible to predict, having a plan to handle them isn’t
Commercial banker Michael Schneider knows “hope is not a strategy” when it comes to managing risk.
He remembers hearing the phrase from a team leader early in his career and has not forgotten its message.
“What you don’t want to hear is, ‘Well, I hope things get better in the economy,’ or ‘I hope people start spending money again,’” he said. “That’s not a strategy.”
Whether a business constructs buildings, sells the latest tech gadgets, transports products across the country or arranges travel, potential risks can come from nowhere or approach with early warnings. Companies that plan for different types of threats that can affect their financial health are in a much better position to avoid, prevent or at least mitigate risk.
Some risks are impossible to predict, but some strategic planning can go a long way as a defense.
Companies can develop a risk management plan based on some textbook principles, said Mark Wobbe, principal for commercial risk management at the insurance brokerage firm Gibson in South Bend, including these four steps:
- First, identify the risks that could interrupt their specific business or industry.
- Second, analyze risks and consider their probability and potential impact.
- Third, develop processes or procedures and build in company accountability.
- Fourth, examine financial liability and the necessary insurance coverage for any number of possibilities.
Schneider, group senior vice president and commercial team lead at Wintrust in Dyer, helps his clients with that process by analyzing a company’s financial health in the current economy and helps devise workable strategies for profitability and loan repayment.
Wobbe said most small businesses and middle-market businesses don’t have the luxury of having a formal risk management team.
“It’s management by committee, and it’s somewhat of a hot potato,” he said. But companies need to ask, “How do we identify and quantify risk, and do we have any accountability in our org chart?”
Impact of ‘black swans’
Some crises are impossible to manage, and the pandemic was an example of that.
“We talk in terms of risk all the time,” says George Bonin, owner of Trutility LLC in South Bend. “People talk about ‘black swan’ events, and what if one of these ‘black swan’ events happens?”
Nassim Nicholas Taleb, a Wall Street trader, wrote about the “black swan theory” in his book, “Fooled by Randomness.” The term “black swan” quickly grew in popularity after the book was published in 2001, reports the Corporate Finance Institute. Taleb identified a “black swan” as an unpredictable event with massive impact on people and the financial market, such as the 9/11 terrorist attacks, the 2008 financial crisis and the recent pandemic.
“When you talk about ‘black swan’ planning, disaster recovery is the way I normally think of it,” Bonin said. “The complexities of what COVID brought us I don’t think anyone could prepare for; you had to manage it as you went through it.”
Bonin, of South Bend, has been a CFO and analyst for operations and finance. He started Trutility in 2016 and works as a contract CFO mainly for manufacturing companies, including recreational vehicle builders.
“A lot of businesses view (risk management) as a math equation, and it’s not a simple math equation,” Bonin said. “They’re trying to do math on the unknowns of the future, and that creates a lot of variables.”
Wobbe said a lot of businesses felt some relief from the pandemic last year and managed risk better in 2022.
Although another similar crisis might not surface in most company owners’ lifetimes, myriad other risks can cause financial pain for businesses. The lessons learned recently could offer ways to mitigate risk in the future.
“Tomorrow’s crisis might not be the same, but if the leadership team has gone through any crisis, then they probably have some learned behaviors, patterns of actions or communication they know work or don’t work,” Wobbe said.
Or, if an organization has conducted a formal crisis management training, workshop or practice drill, any of those can serve as a model for most crises.
“You strip away all the technical words, and the principles of it are all the same,” he said.
When money is not cheap
Other risk factors might not be natural in nature, say like a tornado, but they can be just as devastating. Wobbe said inflation is one of those unforeseen obstacles that led to changes in interest rates.
“There are so many different varieties of debt, whether short-term or long-term, so it probably plays out differently for everybody,” Wobbe said. “Any money was cheap for so long, and I think the sudden change in interest rates had to have had an impact on almost everybody to some degree.”
Inflation, at least, is a type of risk financial experts watch for.
“Inflation is one risk we regularly keep on our radar,” Schneider said.
He looks at whether his bank clients can increase the price of their products or services in tandem with rising wages and increased inventory costs.
“We’ve been very fortunate that, even with what we’ve seen as some rapid increase in the interest rates over the past few years, our client base has done a good job of weathering that storm,” Schneider said. “When we’re planning the metrics and things we do in the underwriting process, we stress test our loans.”
Because interest rates affect inflation, “the two are married,” said Pat Obi, the White Lodging Endowed Professor of Finance and Carnegie Fellow at Purdue University Northwest. “Inflation is usually a short-term phenomenon, and sometimes people think it’s interest rates across the board, such as the interest rate on bonds that we may buy on long term.”
But, he said, long-term rates are not necessarily affected by inflation the same way short-term rates are, and over the past six months, long-term interest rates have been going down.
This phenomenon creates an opportunity to borrow more cheaply over five years or longer — one way to mitigate risk.
“Short-term rates are higher because the Fed keeps jacking them up as a way to contain inflation, while long-term interest rates are going down because not a whole lot of businesses are borrowing long-term money,” Obi said.
Obi said not wanting to borrow long term is connected in part to a fear of a recession, another risk factor.
“I believe that virtually all analysts and people out there in the financial markets think a recession would be short term,” should one occur, Obi said. “The economic basis upon which a long-term recession would exist is just simply not there.”
His reasoning is that low unemployment, such as the 3.6 percent the U.S. announced in March, is a factor of a short-term recession.
This type of analysis helps financial advisers make sure their clients are thinking about many kinds of risk.
Schneider said he runs a lot of scenarios for not only cash flow but also to identify the value of collateral such as real estate or machinery. He also projects a client’s potential performance with a debt structure at the current interest rate and builds into the model higher interest rates, should they increase.
Most of his clients do a great job at risk management, Schneider said, and planning for any number of contingencies helps support that environment.
Even so, there may be times when proactive planning doesn’t work. There is always the potential for a “we did not see that coming” event.
“It’s often when there are multiple things all working together into a perfect storm that can catch businesses off guard,” he said.
One of Bonin’s clients faced this type of challenge. A contract to build a product for a customer was set at a fixed price. The materials ordered for the project were backordered, and when they became available, the prices had increased exponentially. Unfortunately, the company could not adjust the price of the project.
“The dramatic increases we saw combined with the lack of availability of the materials extended the product timeline even further, and the prices went up even more,” Bonin said. “That crippled companies in 2022. It was a really rough year for some businesses. There are other companies that don’t have long-term contracts; that’s an extreme case where the company really got burned by a hidden risk.”
Operating within margins
Risks that threaten businesses are either avoidable, preventable or can be mitigated through identifying and quantifying them and having a plan of action before a crisis occurs.
Wobbe’s best advice is that once companies have identified and quantified different types of risk — from high-interest rates and inflation to accidents and extreme and damaging weather events — they can talk about insurance coverage.
“Too often what happens is it all gets commingled into one thing,” Wobbe said, “and then the process of purchasing the insurance for the business takes over. If you’re just trying to get the process moving on the insurance, that’s not really managing risk. Insurance is the financial piece that protects you.”
Wobbe said the two — risk management and insurance — should be separated.
Schneider recommends that businesses look at potential risks more broadly rather than in a granular way. He says it is less important which category a risk falls into, whether it is hikes in employee wages, health care costs or materials costs.
“Don’t just focus in on one of those,” Schneider said. “Look at it as a broad category. Look at risks as business interruptions, and consider ‘what if my overhead margins decrease by 5 percent?’ That covers a broad range of things.”
Trying to understand those variables while looking forward and thinking of the possible pitfalls that are out there allows companies to plan accordingly.
While hope definitely is not a strategy, it ultimately doesn’t hurt businesses to think about how they would tackle a crisis even if something bad doesn’t happen.
“Maybe we spent a little extra money, but we were prepared, so we feel OK about that,” Bonin said.
And if a crisis does occur, “we don’t suffer the same fate as people who didn’t prepare properly.”
Read more stories from the current issue of Northwest Indiana Business Magazine.
Editor's note: This story has been updated to reflect incorrect attribution in the original story.