This is the second of a three-part series looking at the global economy and uncertainty in 2016. In our first post, we addressed the challenges of slow growth in developed and emerging markets. In our next post, we will focus on the outlook for 2017.
DJ Peterson, President, Longview Global Advisors
Businesses need supportive, stable political and legal institutions to prosper, yet the global landscape has become increasingly unstable as many once-implausible events have become realities.
Since the start of 2016, the United Kingdom has voted itself out of the European Union. The U.S. Republican Party is pulling itself apart over policy and personalities. In Europe, fences are replacing open borders and Jihadi terrorists are targeting festivals, shopping centers, churches, and other public gathering places. Investors pay to lend their money to governments even as debt risks mount.
In conversations, business leaders and directors repeatedly express surprise and concern at the turn of events. What’s fueling this instability? Are recent events indicative of a “new normal,” a brief detour, or a transition to a new equilibrium? And, as the end-of-year business strategy season approaches, what should corporate directors and executives focus on?
Each country has unique characteristics, but there are some important interdependencies. Four powerful, converging political forces are at play.
1. Slow growth is fueling political volatility
As noted in a previous post, global growth has been muted and uneven since the global financial crisis, prompting some economists to ask whether the world has entered a period of “secular stagnation.” Energy and commodities exporters such as Australia, Brazil, Russia, and countries in much of Africa have been particularly hard hit.
Economic hardship often leads to political volatility, but there is a larger political force at play today: A lack of policy consensus and latitude. To turn the situation around, global financial institutions have been calling on governments to undertake bold structural reforms and assertive stimulus measures such as investing in infrastructure. But thanks to large debt piles and continuing calls for austerity from fiscal hawks, big spending increases are not politically feasible in the U.S. and Europe. Emerging markets dependent on commodities exports have been forced into belt-tightening mode as well. The inability of governments to reignite growth has forced central bankers to step into the breech with extraordinary measures.
Policymakers struggle to reignite growth, people are disaffected, and the sum of this instability is the political uncertainty and volatility we are experiencing today.
2. Inequality is adding to political frustrations
Free market liberalism is predicated on creating economic opportunity, but the benefits have not been shared. In many countries, inequality has surged since the 1980s. More recently, quantitative easing, a response to slow growth, has lifted a few boats greatly. In the past, governments often played the role of an equalizer; now proximity to political power is seen as conferring huge economic benefits, creating the belief that “the system” is not fair.
Free trade could be a casualty of increasing inequality and diminished opportunity. The perception that the benefits of globalization accrue disproportionately to certain segments of the population while the losers are left to fend for themselves is pervasive. Anti-immigrant sentiment is another by-product of limited opportunity.
Animosity towards politically connected elites in authoritarian markets is kept in check by repression. Open societies may be more at risk to economic and political polarization. As we see with Brexit, the pushback against globalization, and with the rise of anti-immigrant pressures, middle-ground policy pragmatism—a hallmark of stable democracy—is losing credibility in a world of economic resentments.
3. Populists are exploiting the governance gap
The widespread belief that establishment elites are incapable of solving important problems has created a volatile atmosphere where disaffected voters are willing to take risks and throw wrenches.
Private sector entrepreneurs exploit gaps in the market and find new ways to satisfy needs. Political entrepreneurs do the same in the public sphere: They take advantage of volatility, peddle new solutions (often from both left and right), and break rules.
Dramatic, frustration-driven policy stances of political entrepreneurs make compelling platforms—such as Philippine President Rodrigo Duterte’s anti-drug dealer campaign and French presidential candidate Marine Le Pen’s anti-immigrant stance. Donald Trump and Bernie Sanders are political entrepreneurs too.
But that’s only half the story. In this context, calls for pragmatism and staying the course (“Vote Remain!”) from establishment figures sound tired, if not suspect.
4. Social media is catalyzing volatility
Thanks to social media, populists can peddle their ideas with greater ease than previously seen, without having to adhere to the agenda of establishment media and institutions. (The self-described Islamic State is the most extreme example.) Being provocative is essential to gaining visibility in today’s crowded media landscape and this imperative promotes extreme points of view and places pressures on policymakers to react—even though in representative democracies governments are designed to be deliberative and consensual.
Just as individuals may be overwhelmed by the pace and quality of information flows, so too can governing institutions that were built to be slowed by checks and balances. Few would say policymaking in the U.S. has improved over the past couple of decades thanks to better information. Nationalism, ethnocentrism, and religious animosities seem more powerful than ever.
What can corporate directors do?
Western multinationals can no longer take political stability for granted. In these volatile times, directors have an important role to play in asking the right questions and discerning material risks and opportunity in a time of uncertainty.
Integrate political and economic risk assessment into corporate strategy setting. The political forces outlined above are unlikely to change in the foreseeable future which suggests a number of scenarios. Slow growth and low interest rates are likely to persist. The U.S. presidential election is unlikely to fundamentally change the country’s political climate for the better—indeed, it could lead to more disaffection, polarization, and gridlock. Uncertainty will increase in Europe with Brexit negotiations and national elections in France and Germany in 2017. Boards should pressure test macro-assumptions from management about the external environment affecting strategy over the next 12-24 months. What are the most important moving variables and how will they affect growth prospects?
Look for pockets of opportunity. Volatility creates opportunities as well as risks. Good governance and sound policies are differentiators between countries poised to sustain relatively stronger economic performance, and those that will continue face serious challenges in volatile markets. Watch for improving and more agile governance in Brazil, Columbia, Argentina, India, and Myanmar.
Evaluate the firm’s societal commitments.Proactive companies are seeking to address today’s societal challenges rather than just defend themselves from risks. There is a business case for promoting more inclusive growth: Work by International Monetary Fund researchers has shown that, around the world, higher levels of income inequality are correlated with slower growth. Higher wages support increased consumer spending and broader prosperity. On the other hand, failing to address inequality and other societal ills risks lowers productivity, and leads to more regulation, taxation, and labor radicalization.
NACD’s Global Board Leaders’ Summit, themed around the issue of convergence, will have dedicated sessions on global economic and political disruption, featuring subject-matter experts and seasoned directors. Review the Summit agenda to attend Peterson and others’ sessions addressing global disruption.
Reputation is a precious but fragile enterprise asset. What takes decades to build can be lost in a matter of days once the spotlight shines on unethical or illegal practices that place an organization’s stakeholders or the public at risk. Environmental catastrophes, financial restatements, fraudulent reporting to regulators, massive product recalls, efforts to mislead investors, and other highly publicized events erode brands and impair reputation. We define reputation risk as the current and prospective impact on earnings and enterprise value arising from negative stakeholder opinion.
We see 10 key functions of the board’s oversight of reputation risk management, and classify them in five critical areas below.
Effective board oversight – Reputation risk management starts at the top. Strong board oversight on matters of strategy, policy, execution, and transparent reporting is vital to effective corporate governance, a powerful contributor to sustaining reputation, and is the ultimate checkpoint on CEO performance. The board’s active risk oversight effort is important because effective, early identification, and management of risks can reveal major threats to the company’s reputation and ensure that the threats are reduced to an acceptable level.
Integration of risk into strategy-setting and business planning – The board must ensure that risk is not an afterthought in the strategy-setting and business planning processes. Integrating awareness of risks with core management processes makes risk a relevant factor at the decision-making table, facilitates a big picture view to undertaking risk, and intersects risk management with performance In an effort to make the strategy more robust, directors should understand the critical assumptions underlying the strategy; ask tough, constructive questions to challenge assumptions; and consider plausible scenarios that could render one or more assumptions invalid.
Effective communications and image- and brand-building – Building brand recognition unique to a business is vital and, when all else is working well, augments reputation. A good story is easier to tell than one with flaws, but every savvy board knows that some companies are better at telling their stories than others. Therefore, directors need to understand management’s image- and brand-building game plan and how significant changes to that plan could present a significant risk to the company’s reputation.
Strong corporate values, supported by appropriate performance incentives – The notion that, if tone at the top is good, the organization’s culture must be good, doesn’t always hold. Lower-level employees often pay more attention to the messaging and behavior of their supervisory middle managers than to communications from the organization’s leaders. Boards need to ensure that executive management implements a strong tone at the top, effective escalation processes, and periodic assessments of the tone in the middle and at the bottom. Directors need to ensure that management is paying attention to warning signs posted by independent risk management functions and in audit reports: failure to give these warning signs adequate attention on a timely basis reflects on the tone set by executive management. For example, the executive leadership of Barings ignored warnings from internal audit of the consequences of the lack of segregation of duties in its Singapore operations because those operations were making the bank a lot of money. Ultimately, the hidden trading losses took down the institution.
Positive culture regarding compliance with laws, regulations and internal policies – Few incidents undermine reputation more than serious, highly publicized compliance violations. Directors should ascertain that effective internal controls – including monitoring processes and robust training of employees – over compliance matters are implemented and executive management: “walks the talk” with respect to compliance; periodically conducts a comprehensive risk assessment; refreshes the compliance program for changes arising from new regulatory developments; and understands the players and third-party agents in countries in which the organization does business and monitors their dealings closely.
Priority focus on positive interactions with stakeholders – The board should ensure that there is a passionate focus on improving stakeholder experiences. These are the accumulation of day-to-day interactions that customers, employees, suppliers, regulators, shareholders, lenders, and other stakeholders have with a company as a result of its business operations, branding, and marketing. These interactions constitute moments of truth that, if internalized and acted upon, provide a powerful driving force for improving and sustaining reputation.
Quality public reporting – The markets take quality public reporting at face value. Once a company loses the public’s confidence in its reporting, it’s tough to earn it back. These points suggest that a strong audit committee is an imperative.
Strong control environment – A critical component of internal control, the control environment lays the foundation for achieving operational, compliance and reporting objectives. In addition to the board’s oversight and the organization’s commitment to integrity and ethical values, as mentioned above, the control environment consists of: the organizational structure and assignment of authority and responsibility; the processes for attracting, developing and retaining appropriate talent; and the rigor around setting the appropriate performance measures, incentives and rewards that drive accountability for desired results. Embarrassing control breakdowns can tarnish reputation; therefore, boards should demand a strong control environment.
Company performance relative to competitors – Market recognition of success is a huge validation of a company and its management team. Recognition of differentiating strategies, distinctive products and brands, proprietary systems, and innovative processes are intrinsic sources of value that can translate into superior quality, time, cost, and innovation performance relative to the company’s competitors. However, significant performance gaps can diminish reputation if not addressed in a timely manner. These factors should weigh heavily on a board’s evaluation of company performance over time.
World-class response to a high-profile crisis – Sooner or later, every company is tested. No company is immune to a crisis. As a crisis event is a severe manifestation of risk, crisis management preparation is a natural follow-on to risk assessment, particularly for high-impact risks with high velocity, high persistence, and low response readiness. The board should ensure that the risk assessment process is designed to identify areas where preparedness and a response team are needed. Fires cannot be fought by committee.
While a one-size-fits-all approach does not exist, the 10 keys listed above offer boards a framework for focusing on whether executive management is focused on the appropriate fundamentals for enhancing and preserving the enterprise’s reputation.
Jim DeLoach is managing director with Protiviti, a global consulting firm.
Recently, the world’s largest ongoing study of the internal audit profession—the Global Internal Audit Common Body of Knowledge (CBOK)—was completed by the Institute of Internal Auditors (IIA) and Protiviti to ascertain expectations from key stakeholders regarding internal audit performance at organizations of varying operational models and sizes. The study sought input from members of audit committees all over the world about their expectations of the internal auditor’s role in the organization. We think all directors will find the results of the study applicable to their work in the coming year and beyond.
Below are six imperatives for internal auditors from the CBOK study based on feedback from audit committee members.
1. Focus more on strategic risks. According to the CBOK study, two out of three board members believe internal audit should have a more active role in evaluating the organization’s strategic risks. Study respondents indicated that internal audit should focus on strategic risks (as well as operational, financial and compliance risks) during audit projects (86 percent) and periodically evaluate and communicate key risks to the board and executive management (76 percent). Accordingly, chief audit executives (CAE) must focus their function sufficiently on the bigger picture to think more strategically when evaluating risks, proposing risk-based audit plans, and formulating audit findings. By understanding the organization’s business objectives and strategy, and identifying risks that create barriers to the organization achieving its objectives and executing its strategy successfully, the CAE increases internal audit’s value proposition.
2. Think beyond the scope. The call for internal auditors to think strategically leads to another challenge: thinking beyond the scope of the audit plan. Thinking beyond scope means, for example, that the auditor should:
“Connect the dots” when considering enterprisewide implications of the findings of multiple audits, particularly findings with significant business model underpinnings;
Broaden the focus on operations, compliance, and nonfinancial reporting issues; and
Watch for patterns or signs indicating a deteriorating risk culture.
By focusing more broadly on the implications of audit findings, and thinking beyond the expressed or implied boundaries set by the audit plan, internal audit is better positioned to deliver stronger, more practical, and harder-hitting recommendations aligned with what directors are seeking.
3. Add more value through consulting. In today’s era of slower economic growth, a high premium is placed on operational effectiveness and efficiency. The CBOK study respondents picked up on this point, as 73 percent of respondents recommended that internal audit advise on business process improvements. For example, consulting activities by internal audit can result in: strengthening of the lines of defense that make risk management work; more effective collaboration with other independent functions focused on managing risk and compliance; improvements in the control structure, including greater use of automated controls; and suggestions for improving and streamlining compliance. These study findings underscore the benefit of investing in consulting services that will strengthen business processes.
4. Facilitate effective, high-quality communication. Board members generally rate internal audit’s communication at a high level of confidence. For example, a large majority of directors give high scores for the quality (83 percent) and frequency (81 percent) of internal audit’s communication. That’s good news and a great foundation on which to build the board’s satisfaction with the internal auditor’s role.
5. Elevate stature and perspective. Intentionally positioning the CAE and internal audit within the organization is vitally important to their ability to meet elevated expectations. Access and perspective have always been keys to positioning. Access has typically been attained through direct reporting to the audit committee, as well as to the C-suite. But beyond these reporting lines, the study reports that two out of three board members rank the CAE’s participation in board settings beyond the traditional audit committee meetings as an effective strategy for broadening the CAE’s perspective. The board settings that are relevant in this context must be defined by directors to fit the organization’s specific needs. However the goal is defined, increased access to and more frequent interaction with the board broadens the CAE’s perspective of the organization and elevates the stature and visibility of the internal audit function within it. It also enables the CAE to establish relationships with directors, understand their views on addressing competing audit priorities, and earn the right to be viewed as a valued source of insight for the board.
6. Align with stakeholder expectations. In most organizations, not all stakeholders see eye to eye or want the same value from internal audit. This reality creates a significant challenge for CAEs tasked with building consensus among stakeholders. While directors may not expect their company’s CAE to address all of the above imperatives, they should initially and periodically assess whether internal audit is doing what matters based on previously-established imperatives. The CAE bears the brunt of the responsibility for addressing this challenge by articulating the value that a top-down, risk-based audit plan contributes to each facet of the organization, and by providing an assurance and advisory perspective that the board, executive management, and other stakeholders can understand.
Following are some suggested questions that directors may consider based on the risks inherent in the entity’s operations.
Does the board periodically evaluate the scope of internal audit’s activities and discuss whether modifications are needed in view of changes in company operations and the business environment? Is the board getting the insights it needs?
Does internal audit provide adequate attention to strategic risk issues, including barriers to the organization’s execution of the strategy?
Does internal audit have an appropriate mix of consulting and assurance activities?
Does internal audit have the stature and access necessary to maximize its effectiveness?
Jim DeLoach is managing director with Protiviti, a global consulting firm.