4.8.2011
By Simon Collinson
Poor risk management in increasingly complex environments underlies the growing number of industrial incidents, such as the BP oil spill in the Gulf of Mexico, the series of financial crises at the end of the last decade and the on-going financial vulnerabilities of EU economies. Complex competitive environments increase the costs and risks facing corporations and, therefore, increase the need for effective risk management. They also test the clarity of the strategies being followed by firms and the mechanisms by which firms communicate and coordinate these strategies.
A study conducted jointly by Warwick Business School and the Simplicity Partnership analysed the largest 200 firms out of the Forbes Global 500 to better-understand the relationship between complexity and performance. This included composite measures of both internal (structural and organisational) and external (strategic) complexity. Its findings reflect similar surveys by IBM, KPMG and PWC; however, this study quantified the impact of complexity on profits. It found that the 200 biggest companies in the world are losing 10.2 per cent of their profits on average each year due to complexity. This equates to $1.2 billion (£0.75 billion) each in lost EBITDA.
The resulting Global Simplicity Index (GSI) ranks these firms according to complexity and performance.
Plotting these firms on a graph comparing complexity against performance shows a distinctive trend line – an inverted U-shaped curve. Initially average performance increases as complexity increases, up to a tipping point, after which performance declines with any additional complexity. As companies add new products and services, expand internationally, engage in more M&A activity, increase the number of organisation divisions and layers of management, ‘good complexity’ adds value up to a point, after which added (bad) complexity overwhelms the firm and has a negative effect on performance.
British banks in the Global Simplicity Index
Banks and financial corporations represent the largest industry group amongst the British firms in this study, including Barclays, HSBC, Lloyds, Prudential and RBS. The research reveals RBS as the worst performer amongst the UK firms and one of the weakest in the sector globally. It ranks 156th out of 200 in the performance league and 168th out of 200 in terms of complexity. Many of the GSI measures for both performance and complexity are based on 5-year averages, so this ranking reflects embedded systemic problems rather than temporary or one-off dips in organisational efficiency or effectiveness.
RBS is what we call a ‘struggler’, combining high complexity with low performance. It sits alongside a large number of firms from very different industry sectors suffering the effects of costly complexity. By comparison Prudential is a ‘performer’; simpler in structure and above-average in terms of its performance. Lloyds is about average on both fronts, while Barclays and HSBC are interesting because they show above-average on both dimensions. These are what we term ‘complicators’. Neither firm is as complex as RBS, but both have clearly developed better mechanisms for coping with particular forms of complexity. In HSBC’s case the firm’s high level of geographic diversification is an important source of complexity and it appears to manage this better than most.
System-wide complexity
As part of their evolving regulatory role to monitor and assess the vulnerability of banks and the UK financial services industry the Financial Services Authority (FSA) subjects firms to a range of analyses, including the recent business model assessment. The FSA conducts stress tests on banks’ capital and liquidity positions as well as independent due diligence on likely risks taken in their trading positions.
But one of the conclusions reached back in 2009 by Andrew Haldane, executive director for financial stability at the Bank of England was that, prior to the 2008 crisis, firms relied heavily on stress testing that did not work. In fact it was based on models that simplified the complex realities of the industry and the economy and as a result were wrong.
As Haldane, at the Marcus-Evans conference on stress testing, stated: “Of course, all models are wrong. The only model that is not wrong is reality and reality is not, by definition, a model. But risk management models have during this crisis proved themselves wrong in a more fundamental sense.
They failed Keynes’ test – that it is better to be roughly right than precisely wrong. With hindsight, these models were both very precise and very wrong.”
Stress testing, which followed on from the ‘Value-at-Risk’ approaches of the previous decade, failed the financial institutions that hoped it would help simplify their risk management strategies and processes. It also failed the authorities that hoped it would help them monitor risk levels in these institutions. At the heart of the problem was a failure to account for the real levels of complexity in the global banking system.
Something is described as complex if it has many interrelated components or features. The complexity of any system or organisation increases according to:
1. The number and variety of components in the organisation/system.
2. The interrelationships between
the components.
3. The pace at which these relationships and the components are changing.
The global banking system is arguably one of the most complex systems known to man. It has evolved well-beyond the design parameters of any architect and beyond the plans of any regulator. Unpredictability and risk grow with complexity.
Network externalities are one of the major causes of risk in the banking world. Any portfolio of assets relies on links to other portfolios for its value, across a network of interdependent assets. This makes for a complex network, susceptible to what are called spillover or contagion effects.
Failure in one part of the network, such as the collapse of Lehman Brothers, has knock-on effects elsewhere which may be far greater than the original catalyst. Instability can become endemic.
These industry-specific sources of complexity in banking add to a wider range of factors driving business complexity. These are the usual suspects, including:
• globalisation and the associated growth in new competitors, markets, institutions and regulations
• technological change, which has had a significant impact on how banks operate, but has also spawned a specialist cluster of information and communications technology firms
• the speed of product and service innovation, driven by demanding customers and innovative competitors
• the growing importance of outsourcing, off-shoring, alliances and joint-ventures, blurring the boundaries of the firm and raising the importance of value-adding networks.
These external or environmental sources of strategic complexity are faced by all firms in the financial services industry. So, why do some seem to cope better than others in maintaining their performance levels in the face of all this complexity? The Simplicity Partnership survey provides some insights into what differentiates firms in this regard.
Complex Organisations
The Simplicity Partnership followed the GSI study with a survey of complexity and performance in over 400 managers from large firms across Europe. The findings provide some key insights into the sources and impacts of costly complexity. 63 per cent of managers in our survey reported that complexity was responsible for over 5 per cent of productivity loss in their business. 10 per cent of managers claimed that over 30 per cent of productivity losses were due to complexity.
Some key causes included:
• Changes in strategy or multiple project demands: 30 per cent of
managers are coping with six or more strategic initiatives at any one time; 12 per cent are coping with over 16
• Convoluted management hierarchies: 57 per cent report six or more levels of management in their firms; 19 per cent have over 16
• Monitoring, control and planning procedures: 56 per cent have five or more stages in their capital expenditure sign-off process; 11 per cent have over 11 stages. Also, 61 per cent of firms take four weeks or more for budget planning; 35 per cent take over six weeks and 10 per cent over
16 weeks.
• Processes and systems: 38 per cent of managers deal with six or more different kinds of specialised IT systems in their workplace; 13 per cent deal with over 16 systems
• Communication and coordination: 46 per cent of managers are regularly interacting with six or more other internal divisions; 14 per cent with over 11. Emails take up about 8 per cent of a manager’s time, on average. But for 16 per cent of managers dealing with emails consumes over 30 per cent of their time.
One of the contributing factors is the high rate of employee turnover. For 27 per cent of firms in our survey over 10 per cent of their workforce has been recruited within the last year. For 12 per cent of firms over 30 per cent of the workforce are newly-hired. For 32 per cent of these same firms over 10 per cent of the workforce left in the last year.
Organisational complexity can be costly because individual managers are: (1) unclear about the strategic priorities of the firm and how they add value to clients and customers because they are so far removed from where value is added; (2) distracted from strategic priorities by thousands of peripheral decisions and actions.
There are several causes of overwhelming complexity. Rapid growth, particularly when it involves international expansion and/or occurs through M&A, is one obvious cause. When new divisions and functions are added that are never fully integrated into the organisation, firms end up with multiple layers of management, numerous IT systems, overlapping roles and accountabilities and coordination failures. Also, when firms add procedures, processes and systems to keep pace with external change, without consolidating and streamlining, the same kinds of bad complexity develop.
RBS provides a good example of this. The GSI study shows it over-stretched its global structure, with a large number of subsidiaries and divisional offices across a wide range of overseas locations, relative to counterparts. This added coordination costs as well as the complexities of operating in many different institutional environments and across a variety of business cultures. The firm had already built up a large and complex portfolio of products and services relative to other banks, making its external strategic positioning, including the challenges of market segmentation vis-à-vis competitors, complicated. This had a direct effect on its internal organisation structure, with multiple business units and sub-divisions struggling to clearly prioritise the allocation of resources and effort to add value for clients and customers.
The UK Government’s Independent Commission on Banking, established in June 2010 “to consider structural and related non-structural reforms to the UK banking sector to promote financial stability and competition” came to a similar conclusion. In September 2010 it produced a report on the problems stemming from the scope and complexity of RBS’ operations. It also recommended a disposal programme addressing both its geographic spread and its over-extended product portfolio. Steps taken by RBS to consolidate its operations contributed to performance improvements in 2010.
For banks more generally there is another irony in that the rise in regulatory complexity across different markets has led to new compliance mechanisms and a huge variety of regulation-related procedures internally. Governance committees, reports and risk compliance analyses, and an explosion of poorly connected, coordinated or communicated projects appear to be adding to the complexity and reducing responsiveness and agility in the face of external change.
This is significantly compounded by a ‘misalignment’ of incentives, at two levels. First, within firms, those taking risks are not incentivised to disclose the full extent of these risks or the potential down-side of these risks to those responsible for monitoring and compliance. Second, the same principal-agent problem occurs between banks and external regulators. Even when regulatory authorities are in a position to fully understand the complexity of the abovementioned asset portfolio networks, they are unlikely to get clear and unbiased information on the extent of these risks from banks. In some cases complexity provides a convenient cover for financial vulnerability and instability.
Structural consolidation, strategic clarity and organisational streamlining
are all easier to write about than to implement. But recognition of the
complexity problem has provided the impetus to develop a range of analytical approaches and diagnostic tools to support managers in identifying, measuring and removing the kinds of complexity that limit profitability.
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