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STRATEGIC PLANNING

Managing Risks: A New Framework by Robert S. Kaplan and Anette Mikes

FROM THE JUNE 2012 ISSUE

Editors’ Note: Since this issue of HBR went to press, JP Morgan, whose risk management practices are

highlighted in this article, revealed significant trading losses at one of its units. The authors provide

their commentary on this turn of events in their contribution to HBR’s Insight Center on Managing

Risky Behavior.

hen Tony Hayward became CEO of BP, in 2007, he vowed to make safety his top

priority. Among the new rules he instituted were the requirements that all

employees use lids on coffee cups while walking and refrain from texting while

driving. Three years later, on Hayward’s watch, the Deepwater Horizon oil rig exploded in the Gulf

of Mexico, causing one of the worst man-made disasters in history. A U.S. investigation commission

attributed the disaster to management failures that crippled “the ability of individuals involved to

identify the risks they faced and to properly evaluate, communicate, and address them.” Hayward’s

story reflects a common problem. Despite all the rhetoric and money invested in it, risk

management is too often treated as a compliance issue that can be solved by drawing up lots of rules

and making sure that all employees follow them. Many such rules, of course, are sensible and do

reduce some risks that could severely damage a company. But rules-based risk management will not

diminish either the likelihood or the impact of a disaster such as Deepwater Horizon, just as it did

not prevent the failure of many financial institutions during the 2007–2008 credit crisis.

Identifying and Managing Preventable Risks

In this article, we present a new categorization of risk that allows executives to tell which risks can

be managed through a rules-based model and which require alternative approaches. We examine

the individual and organizational challenges inherent in generating open, constructive discussions

about managing the risks related to strategic choices and argue that companies need to anchor these

discussions in their strategy formulation and implementation processes. We conclude by looking at

how organizations can identify and prepare for nonpreventable risks that arise externally to their

strategy and operations.

Managing Risk: Rules or Dialogue?

The first step in creating an effective risk-management system is to understand the qualitative

distinctions among the types of risks that organizations face. Our field research shows that risks fall

into one of three categories. Risk events from any category can be fatal to a company’s strategy and

even to its survival.

Category I: Preventable risks. These are internal risks, arising from within the organization, that are controllable and ought to be

eliminated or avoided. Examples are the risks from employees’ and managers’ unauthorized, illegal,

unethical, incorrect, or inappropriate actions and the risks from breakdowns in routine operational

processes. To be sure, companies should have a zone of tolerance for defects or errors that would

not cause severe damage to the enterprise and for which achieving complete avoidance would be

too costly. But in general, companies should seek to eliminate these risks since they get no strategic

benefits from taking them on. A rogue trader or an employee bribing a local official may produce

some short-term profits for the firm, but over time such actions will diminish the company’s value.

This risk category is best managed through active prevention: monitoring operational processes and

guiding people’s behaviors and decisions toward desired norms. Since considerable literature

already exists on the rules-based compliance approach, we refer interested readers to the sidebar

“Identifying and Managing Preventable Risks” in lieu of a full discussion of best practices here.

Category II: Strategy risks. A company voluntarily accepts some risk in order

to generate superior returns from its strategy. A

bank assumes credit risk, for example, when it

Companies cannot anticipate every circumstance or conflict of interest that an employee might encounter.

Thus, the first line of defense against preventable risk events is to provide guidelines clarifying the company’s goals and values.

The Mission

A well-crafted mission statement articulates the organization’s fundamental purpose, serving as a “true north” for all employees to follow. The first sentence of Johnson & Johnson’s renowned credo, for instance, states, “We believe our first responsibility is to the doctors, nurses and patients, to mothers and fathers, and all others who use our products and services,” making clear to all employees whose interests should take precedence in any situation. Mission statements should be communicated to and understood by all employees.

The Values

Companies should articulate the values that guide employee behavior toward principal stakeholders, including customers, suppliers, fellow employees, communities, and shareholders. Clear value statements help employees avoid violating the company’s standards and putting its reputation and assets at risk.

The Boundaries

A strong corporate culture clarifies what is not allowed. An explicit definition of boundaries is an effective way to control actions. Consider that nine of the Ten Commandments and nine of the first 10 amendments to the U.S. Constitution (commonly known as the Bill of Rights) are written in negative terms. Companies need corporate codes of business conduct

lends money; many companies take on risks

through their research and development

activities.

Strategy risks are quite different from preventable

risks because they are not inherently undesirable.

A strategy with high expected returns generally

requires the company to take on significant risks,

and managing those risks is a key driver in

capturing the potential gains. BP accepted the

high risks of drilling several miles below the

surface of the Gulf of Mexico because of the high

value of the oil and gas it hoped to extract.

Strategy risks cannot be managed through a rules-

based control model. Instead, you need a risk-

management system designed to reduce the

probability that the assumed risks actually

materialize and to improve the company’s ability

to manage or contain the risk events should they

occur. Such a system would not stop companies

from undertaking risky ventures; to the contrary,

it would enable companies to take on higher-risk,

higher-reward ventures than could competitors

with less effective risk management.

Category III: External risks. Some risks arise from events outside the company

and are beyond its influence or control. Sources of

these risks include natural and political disasters

and major macroeconomic shifts. External risks

require yet another approach. Because companies

cannot prevent such events from occurring, their

that prescribe behaviors relating to conflicts of interest, antitrust issues, trade secrets and confidential information, bribery, discrimination, and harassment.

Of course, clearly articulated statements of mission, values, and boundaries don’t in themselves ensure good behavior. To counter the day-to-day pressures of organizational life, top managers must serve as role models and demonstrate that they mean what they say. Companies must institute strong internal control systems, such as the segregation of duties and an active whistle-blowing program, to reduce not only misbehavior but also temptation. A capable and independent internal audit department tasked with continually checking employees’ compliance with internal controls and standard operating processes also will deter employees from violating company procedures and policies and can detect violations when they do occur.

See also Robert Simons’s article on managing preventable risks, “How Risky Is Your Company?” (HBR May 1999), and his book Levers of Control (Harvard Business School Press, 1995).

management must focus on identification (they

tend to be obvious in hindsight) and mitigation of

their impact.

Companies should tailor their risk-management

processes to these different categories. While a

compliance-based approach is effective for

managing preventable risks, it is wholly

inadequate for strategy risks or external risks,

which require a fundamentally different approach

based on open and explicit risk discussions. That,

however, is easier said than done; extensive

behavioral and organizational research has shown

that individuals have strong cognitive biases that

discourage them from thinking about and

discussing risk until it’s too late.

Why Risk Is Hard to Talk About

Multiple studies have found that people

overestimate their ability to influence events that,

in fact, are heavily determined by chance. We

tend to be overconfident about the accuracy of our

forecasts and risk assessments and far too narrow

in our assessment of the range of outcomes that

may occur.

We also anchor our estimates to readily available evidence despite the known danger of making

linear extrapolations from recent history to a highly uncertain and variable future. We often

compound this problem with a confirmation bias, which drives us to favor information that supports

our positions (typically successes) and suppress information that contradicts them (typically

failures). When events depart from our expectations, we tend to escalate commitment, irrationally

directing even more resources to our failed course of action—throwing good money after bad.

Organizational biases also inhibit our ability to discuss risk and failure. In particular, teams facing

uncertain conditions often engage in groupthink: Once a course of action has gathered support

within a group, those not yet on board tend to suppress their objections—however valid—and fall in

line. Groupthink is especially likely if the team is led by an overbearing or overconfident manager

who wants to minimize conflict, delay, and challenges to his or her authority.

Collectively, these individual and organizational biases explain why so many companies overlook or

misread ambiguous threats. Rather than mitigating risk, firms actually incubate risk through the

normalization of deviance,as they learn to tolerate apparently minor failures and defects and treat

early warning signals as false alarms rather than alerts to imminent danger.

Effective risk-management processes must counteract those biases. “Risk mitigation is painful, not

a natural act for humans to perform,” says Gentry Lee, the chief systems engineer at Jet Propulsion

Laboratory (JPL), a division of the U.S. National Aeronautics and Space Administration. The rocket

scientists on JPL project teams are top graduates from elite universities, many of whom have never

experienced failure at school or work. Lee’s biggest challenge in establishing a new risk culture at

JPL was to get project teams to feel comfortable thinking and talking about what could go wrong

with their excellent designs.

Rules about what to do and what not to do won’t help here. In fact, they usually have the opposite

effect, encouraging a checklist mentality that inhibits challenge and discussion. Managing strategy

risks and external risks requires very different approaches. We start by examining how to identify

and mitigate strategy risks.

Managing Strategy Risks

Over the past 10 years of study, we’ve come across three distinct approaches to managing strategy

risks. Which model is appropriate for a given firm depends largely on the context in which an

organization operates. Each approach requires quite different structures and roles for a risk-

management function, but all three encourage employees to challenge existing assumptions and

debate risk information. Our finding that “one size does not fit all” runs counter to the efforts of

regulatory authorities and professional associations to standardize the function.

Independent experts.

Some organizations—particularly those like JPL that push the envelope of technological innovation

—face high intrinsic risk as they pursue long, complex, and expensive product-development

projects. But since much of the risk arises from coping with known laws of nature, the risk changes

slowly over time. For these organizations, risk management can be handled at the project level.

JPL, for example, has established a risk review board made up of independent technical experts

whose role is to challenge project engineers’ design, risk-assessment, and risk-mitigation decisions.

The experts ensure that evaluations of risk take place periodically throughout the product-

development cycle. Because the risks are relatively unchanging, the review board needs to meet

only once or twice a year, with the project leader and the head of the review board meeting

quarterly.

The risk review board meetings are intense, creating what Gentry Lee calls “a culture of intellectual

confrontation.” As board member Chris Lewicki says, “We tear each other apart, throwing stones

and giving very critical commentary about everything that’s going on.” In the process, project

engineers see their work from another perspective. “It lifts their noses away from the grindstone,”

Lewicki adds.

The meetings, both constructive and confrontational, are not intended to inhibit the project team

from pursuing highly ambitious missions and designs. But they force engineers to think in advance

about how they will describe and defend their design decisions and whether they have sufficiently

considered likely failures and defects. The board members, acting as devil’s advocates,

counterbalance the engineers’ natural overconfidence, helping to avoid escalation of commitment

to projects with unacceptable levels of risk.

At JPL, the risk review board not only promotes vigorous debate about project risks but also has

authority over budgets. The board establishes cost and time reserves to be set aside for each project

component according to its degree of innovativeness. A simple extension from a prior mission

would require a 10% to 20% financial reserve, for instance, whereas an entirely new component that

had yet to work on Earth—much less on an unexplored planet—could require a 50% to 75%

contingency. The reserves ensure that when problems inevitably arise, the project team has access

to the money and time needed to resolve them without jeopardizing the launch date. JPL takes the

estimates seriously; projects have been deferred or canceled if funds were insufficient to cover

recommended reserves.

Facilitators. Many organizations, such as traditional energy and water utilities, operate in stable technological

and market environments, with relatively predictable customer demand. In these situations risks

stem largely from seemingly unrelated operational choices across a complex organization that

accumulate gradually and can remain hidden for a long time.

Since no single staff group has the knowledge to perform operational-level risk management across

diverse functions, firms may deploy a relatively small central risk-management group that collects

information from operating managers. This increases managers’ awareness of the risks that have

been taken on across the organization and provides decision makers with a full picture of the

company’s risk profile.

We observed this model in action at Hydro One, the Canadian electricity company. Chief risk officer

John Fraser, with the explicit backing of the CEO, runs dozens of workshops each year at which

employees from all levels and functions identify and rank the principal risks they see to the

company’s strategic objectives. Employees use an anonymous voting technology to rate each risk,

on a scale of 1 to 5, in terms of its impact, the likelihood of occurrence, and the strength of existing

controls. The rankings are discussed in the workshops, and employees are empowered to voice and

debate their risk perceptions. The group ultimately develops a consensus view that gets recorded on

a visual risk map, recommends action plans, and designates an “owner” for each major risk.

Risk management is painful—not a natural act for humans to perform.

The danger from embedding risk managers within the line organization is that they “go native”—becoming deal makers rather than deal questioners.

Hydro One strengthens accountability by linking capital allocation and budgeting decisions to

identified risks. The corporate-level capital-planning process allocates hundreds of millions of

dollars, principally to projects that reduce risk effectively and efficiently. The risk group draws upon

technical experts to challenge line engineers’ investment plans and risk assessments and to provide

independent expert oversight to the resource allocation process. At the annual capital allocation

meeting, line managers have to defend their proposals in front of their peers and top executives.

Managers want their projects to attract funding in the risk-based capital planning process, so they

learn to overcome their bias to hide or minimize the risks in their areas of accountability.

Embedded experts. The financial services industry poses a unique challenge because of the volatile dynamics of asset

markets and the potential impact of decisions made by decentralized traders and investment

managers. An investment bank’s risk profile can change dramatically with a single deal or major

market movement. For such companies, risk management requires embedded experts within the

organization to continuously monitor and influence the business’s risk profile, working side by side

with the line managers whose activities are generating new ideas, innovation, and risks—and, if all

goes well, profits.

JP Morgan Private Bank adopted this model in 2007, at the onset of the global financial crisis. Risk

managers, embedded within the line organization, report to both line executives and a centralized,

independent risk-management function. The face-to-face contact with line managers enables the

market-savvy risk managers to continually ask “what if ” questions, challenging the assumptions of

portfolio managers and forcing them to look at different scenarios. Risk managers assess how

proposed trades affect the risk of the entire investment portfolio, not only under normal

circumstances but also under times of extreme stress, when the correlations of returns across

different asset classes escalate. “Portfolio managers come to me with three trades, and the [risk]

model may say that all three are adding to the same type of risk,” explains Gregoriy Zhikarev, a risk

manager at JP Morgan. “Nine times out of 10 a manager will say, ‘No, that’s not what I want to do.’

Then we can sit down and redesign the trades.”

The chief danger from embedding risk managers within the line organization is that they “go

native,” aligning themselves with the inner circle of the business unit’s leadership team—becoming

deal makers rather than deal questioners. Preventing this is the responsibility of the company’s

Understanding the Three Categories of Risk The risks that companies face fall into three categories, each of which requires a different risk-management approach. Preventable risks, arising from within an organization, are monitored and controlled through rules, values, and standard compliance tools. In contrast, strategy risks and external risks require distinct processes that encourage managers to openly discuss risks and find cost-effective ways to reduce the likelihood of risk events or mitigate their consequences.

senior risk officer and—ultimately—the CEO, who sets the tone for a company’s risk culture.

Avoiding the Function Trap

Even if managers have a system that promotes rich discussions about risk, a second cognitive-

behavioral trap awaits them. Because many strategy risks (and some external risks) are quite

predictable—even familiar—companies tend to label and compartmentalize them, especially along

business function lines. Banks often manage what they label “credit risk,” “market risk,” and

“operational risk” in separate groups. Other companies compartmentalize the management of

“brand risk,” “reputation risk,” “supply chain risk,” “human resources risk,” “IT risk,” and “financial

risk.”

Such organizational silos disperse both

information and responsibility for effective risk

management. They inhibit discussion of how

different risks interact. Good risk discussions

must be not only confrontational but also

integrative. Businesses can be derailed by a

combination of small events that reinforce one

another in unanticipated ways.

Managers can develop a companywide risk

perspective by anchoring their discussions in

strategic planning, the one integrative process

that most well-run companies already have. For

example, Infosys, the Indian IT services company,

generates risk discussions from the Balanced

Scorecard, its management tool for strategy

measurement and communication. “As we asked

ourselves about what risks we should be looking

at,” says M.D. Ranganath, the chief risk officer,

“we gradually zeroed in on risks to business

objectives specified in our corporate scorecard.”

The Risk Event Card The Risk Report Card

In building its Balanced Scorecard, Infosys had

identified “growing client relationships” as a key

objective and selected metrics for measuring

progress, such as the number of global clients

with annual billings in excess of $50 million and

the annual percentage increases in revenues from

large clients. In looking at the goal and the

performance metrics together, management

realized that its strategy had introduced a new

risk factor: client default. When Infosys’s

business was based on numerous small clients, a

single client default would not jeopardize the

company’s strategy. But a default by a $50 million

client would present a major setback. Infosys

began to monitor the credit default swap rate of

every large client as a leading indicator of the

likelihood of default. When a client’s rate

increased, Infosys would accelerate collection of

receivables or request progress payments to

reduce the likelihood or impact of default.

To take another example, consider Volkswagen do Brasil (subsequently abbreviated as VW), the

Brazilian subsidiary of the German carmaker. VW’s risk-management unit uses the company’s

strategy map as a starting point for its dialogues about risk. For each objective on the map, the group

identifies the risk events that could cause VW to fall short of that objective. The team then generates

a Risk Event Card for each risk on the map, listing the practical effects of the event on operations,

the probability of occurrence, leading indicators, and potential actions for mitigation. It also

identifies who has primary accountability for managing the risk. (See the exhibit “The Risk Event

Card.”) The risk team then presents a high-level summary of results to senior management. (See

“The Risk Report Card.”)

VW do Brasil uses risk event cards to assess its strategy risks. First, managers document the risks associated with achieving each of the company’s strategic objectives. For each identified risk, managers create a risk card that lists the practical effects of the event’s occurring on operations. Below is a sample card looking at the effects of an interruption in deliveries, which could jeopardize VW’s strategic objective of achieving a smoothly functioning supply chain.

VW do Brasil summarizes its strategy risks on a Risk Report Card organized by strategic objectives (excerpt below). Managers can see at a glance how many of the identified risks for each objective are critical and require attention or mitigation. For instance, VW identified 11 risks associated with achieving the goal “Satisfy the customer’s expectations.” Four of the risks were critical, but that was an improvement over the previous quarter’s assessment. Managers can also monitor progress on risk management across the company.

Beyond introducing a systematic process for identifying and mitigating strategy risks, companies

also need a risk oversight structure. Infosys uses a dual structure: a central risk team that identifies

general strategy risks and establishes central policy, and specialized functional teams that design

and monitor policies and controls in consultation with local business teams. The decentralized

teams have the authority and expertise to help the business lines respond to threats and changes in

their risk profiles, escalating only the exceptions to the central risk team for review. For example, if a

client relationship manager wants to give a longer credit period to a company whose credit risk

parameters are high, the functional risk manager can send the case to the central team for review.

These examples show that the size and scope of the risk function are not dictated by the size of the

organization. Hydro One, a large company, has a relatively small risk group to generate risk

awareness and communication throughout the firm and to advise the executive team on risk-based

resource allocations. By contrast, relatively small companies or units, such as JPL or JP Morgan

Private Bank, need multiple project-level review boards or teams of embedded risk managers to

apply domain expertise to assess the risk of business decisions. And Infosys, a large company with

broad operational and strategic scope, requires a strong centralized risk-management function as

well as dispersed risk managers who support local business decisions and facilitate the exchange of

information with the centralized risk group.

Managing the Uncontrollable

External risks, the third category of risk, cannot typically be reduced or avoided through the

approaches used for managing preventable and strategy risks. External risks lie largely outside the

company’s control; companies should focus on identifying them, assessing their potential impact,

and figuring out how best to mitigate their effects should they occur.

Some external risk events are sufficiently imminent that managers can manage them as they do

their strategy risks. For example, during the economic slowdown after the global financial crisis,

Infosys identified a new risk related to its objective of developing a global workforce: an upsurge in

protectionism, which could lead to tight restrictions on work visas and permits for foreign nationals

in several OECD countries where Infosys had large client engagements. Although protectionist

legislation is technically an external risk since it’s beyond the company’s control, Infosys treated it

as a strategy risk and created a Risk Event Card for it, which included a new risk indicator: the

number and percentage of its employees with dual citizenships or existing work permits outside

India. If this number were to fall owing to staff turnover, Infosys’s global strategy might be

jeopardized. Infosys therefore put in place recruiting and retention policies that mitigate the

consequences of this external risk event.

Most external risk events, however, require a different analytic approach either because their

probability of occurrence is very low or because managers find it difficult to envision them during

their normal strategy processes. We have identified several different sources of external risks:

Natural and economic disasters with immediate impact. These risks are predictable in a general

way, although their timing is usually not (a large earthquake will hit someday in California, but

there is no telling exactly where or when). They may be anticipated only by relatively weak

signals. Examples include natural disasters such as the 2010 Icelandic volcano eruption that

closed European airspace for a week and economic disasters such as the bursting of a major asset

price bubble. When these risks occur, their effects are typically drastic and immediate, as we saw

in the disruption from the Japanese earthquake and tsunami in 2011.

Geopolitical and environmental changes with long-term impact. These include political shifts such

as major policy changes, coups, revolutions, and wars; long-term environmental changes such as

global warming; and depletion of critical natural resources such as fresh water.

Competitive risks with medium-term impact. These include the emergence of disruptive

technologies (such as the internet, smartphones, and bar codes) and radical strategic moves by

industry players (such as the entry of Amazon into book retailing and Apple into the mobile

phone and consumer electronics industries).

Companies use different analytic approaches for each of the sources of external risk.

Tail-risk stress tests. Stress-testing helps companies assess major changes in one or two specific variables whose effects

would be major and immediate, although the exact timing is not forecastable. Financial services

firms use stress tests to assess, for example, how an event such as the tripling of oil prices, a large

swing in exchange or interest rates, or the default of a major institution or sovereign country would

affect trading positions and investments.

The benefits from stress-testing, however, depend critically on the assumptions—which may

themselves be biased—about how much the variable in question will change. The tail-risk stress

tests of many banks in 2007–2008, for example, assumed a worst-case scenario in which U.S.

housing prices leveled off and remained flat for several periods. Very few companies thought to test

what would happen if prices began to decline—an excellent example of the tendency to anchor

estimates in recent and readily available data. Most companies extrapolated from recent U.S.

housing prices, which had gone several decades without a general decline, to develop overly

optimistic market assessments.

Scenario planning.

A firm’s ability to weather storms depends on how seriously executives take risk management when the sun is shining and no clouds are on the horizon.

This tool is suited for long-range analysis, typically five to 10 years out. Originally developed at Shell

Oil in the 1960s, scenario analysis is a systematic process for defining the plausible boundaries of

future states of the world. Participants examine political, economic, technological, social,

regulatory, and environmental forces and select some number of drivers—typically four—that would

have the biggest impact on the company. Some companies explicitly draw on the expertise in their

advisory boards to inform them about significant trends, outside the company’s and industry’s day-

to-day focus, that should be considered in their scenarios.

For each of the selected drivers, participants estimate maximum and minimum anticipated values

over five to 10 years. Combining the extreme values for each of four drivers leads to 16 scenarios.

About half tend to be implausible and are discarded; participants then assess how their firm’s

strategy would perform in the remaining scenarios. If managers see that their strategy is contingent

on a generally optimistic view, they can modify it to accommodate pessimistic scenarios or develop

plans for how they would change their strategy should early indicators show an increasing

likelihood of events turning against it.

War-gaming. War-gaming assesses a firm’s vulnerability to disruptive technologies or changes in competitors’

strategies. In a war-game, the company assigns three or four teams the task of devising plausible

near-term strategies or actions that existing or potential competitors might adopt during the next

one or two years—a shorter time horizon than that of scenario analysis. The teams then meet to

examine how clever competitors could attack the company’s strategy. The process helps to

overcome the bias of leaders to ignore evidence that runs counter to their current beliefs, including

the possibility of actions that competitors might take to disrupt their strategy.

Companies have no influence over the likelihood of risk events identified through methods such as

tail-risk testing, scenario planning, and war-gaming. But managers can take specific actions to

mitigate their impact. Since moral hazard does not arise for nonpreventable events, companies can

use insurance or hedging to mitigate some risks, as an airline does when it protects itself against

sharp increases in fuel prices by using financial derivatives. Another option is for firms to make

investments now to avoid much higher costs later. For instance, a manufacturer with facilities in

earthquake-prone areas can increase its construction costs to protect critical facilities against severe

quakes. Also, companies exposed to different but comparable risks can cooperate to mitigate them.

For example, the IT data centers of a university in North Carolina would be vulnerable to hurricane

risk while those of a comparable university on the San Andreas Fault in California would be

vulnerable to earthquakes. The likelihood that both disasters would happen on the same day is

small enough that the two universities might choose to mitigate their risks by backing up each

other’s systems every night.

The Leadership Challenge

Managing risk is very different from managing strategy. Risk management focuses on the negative—

threats and failures rather than opportunities and successes. It runs exactly counter to the “can do”

culture most leadership teams try to foster when implementing strategy. And many leaders have a

tendency to discount the future; they’re reluctant to spend time and money now to avoid an

uncertain future problem that might occur down the road, on someone else’s watch. Moreover,

mitigating risk typically involves dispersing resources and diversifying investments, just the

opposite of the intense focus of a successful strategy. Managers may find it antithetical to their

culture to champion processes that identify the risks to the strategies they helped to formulate.

For those reasons, most companies need a separate function to handle strategy- and external-risk

management. The risk function’s size will vary from company to company, but the group must

report directly to the top team. Indeed, nurturing a close relationship with senior leadership will

arguably be its most critical task; a company’s ability to weather storms depends very much on how

seriously executives take their risk-management function when the sun is shining and no clouds are

on the horizon.

That was what separated the banks that failed in the financial crisis from those that survived. The

failed companies had relegated risk management to a compliance function; their risk managers had

limited access to senior management and their boards of directors. Further, executives routinely

ignored risk managers’ warnings about highly leveraged and concentrated positions. By contrast,

Goldman Sachs and JPMorgan Chase, two firms that weathered the financial crisis well, had strong

internal risk-management functions and leadership teams that understood and managed the

companies’ multiple risk exposures. Barry Zubrow, chief risk officer at JP Morgan Chase, told us, “I

may have the title, but [CEO] Jamie Dimon is the chief risk officer of the company.” Risk

management is nonintuitive; it runs counter to many individual and organizational biases. Rules

and compliance can mitigate some critical risks but not all of them. Active and cost-effective risk

management requires managers to think systematically about the multiple categories of risks they

face so that they can institute appropriate processes for each. These processes will neutralize their

managerial bias of seeing the world as they would like it to be rather than as it actually is or could

possibly become.

A version of this article appeared in the June 2012 issue of Harvard Business Review.

Robert S. Kaplan is a senior fellow and the Marvin Bower Professor of Leadership

Development, Emeritus, at Harvard Business School. He is a coauthor, with Michael E. Porter, of “How

to Solve the Cost Crisis in Health Care” (HBR, September 2011).

Anette Mikes is an assistant professor in the accounting and management unit at Harvard