Managing business cycle risks

The probability for corporate success varies together with the business cycle, and there is no doubt that the state of the macro economy influences the rate of investor and corporate success. This means that the potential risks of changes in business cycle growth rate is a potential threat to all market participants, which needs to be handled through risk management.

This does not mean that it is possible to avoid business cycle risks altogether, but it simply means that these risks needs to be accounted for, and managed appropriately as part of a risk management scheme.

The fact that executive directors blame changes in the business cycle as arguments for why their companies are performing below expectations, suggests that business cycle risks are not given enough attention in their risk management schemes. Wim Van Der Stede (2009) states that there are clear tendencies that companies are relaxing their awareness about the business cycle when the economy is growing and performance is good.

On the other hand when the economy enters recessions there are clear signs of over-tightening and over-scrutiny. The famous quotes from the former CEO of Citigroup, Chuck Prince, in July 2007; . when the music is playing you have to get up and dance”1 when arguing that the financial markets were still nice and healthy, not long before the burst of the subprime bubble 2, is either a good example of a top manager who is neglecting the potential risks of a business cycle contraction, or simply indicates the existence of behavior like the fully invested bear who keeps investing even though he feels the market might be vulnerable3.

Nevertheless, this is an example of failure of business cycle risk management, and the likes of Citigroup did indeed get into massive trouble not long after this interview of Chuck Price.

In a later section Business cycle forecasting through economic indicators I will show that it is possible to understand where in the business cycle the economy is at the current, and further generate qualified expectations about how the economy will perform in the future through analysis of economic indicators. These expectations about the macro economy can help managers in creating internal future scenarios and hence implement justified preparations for future macro economic developments.

Upside and downside risk

Business cycles are by definition a measure of broad economic activity and will hence have an effect on most market participants. But the fact that we cannot remove the risks altogether does not mean that we should neglect preparations for the inevitable downturns incurred from changes in the cycle. We have experienced time and time again that the business cycles are recurrent, and so it seems only rational to monitor and control these risks and to prepare for the next stages.

As the business cycle contains both periods of growth and recession a full removal of its risks would not necessarily be something to go for even if we could. In the discussion of business cycle risk it is often only the risks of recession which are mentioned, but it is important to remember that the subjects of risk management deals with both upside and downside risks.

This means that the management of business cycle risk includes both the preparation for periods of growth and recession. I have already mentioned the statements of Van Der Stede (2009) that markets often get overly pessimistic during downturns and overly optimistic during periods of growth, but with the correct assessments of future economic activity it should be possible to take advantage of these situations instead of being surprised with poor strategies.

The illusion of control and insufficient adjustments

While the statements from financial institutions, such as Chuck Prince of Citigroup, ahead of and during the credit crunch of 2007 and 2008 might have been those of fully invested bears, Linda M. H. Lai (1994) points to research suggesting that actions like these are the results of managers entering a stage associated with an illusion of control during periods of growth.

She argues that long periods with results above expectations often results in an overconfidence which creates biases in the analysis of external factors such as the business cycle. This endangers their monitoring and interpretation of both threats and opportunities, and seems to make managers neglect the threats altogether.

This illusion of control leads managers to keep working with the same strategies which worked so well in the past, even though changes in business cycle risks suggests that internal modifications could be needed. This results in insufficient adjustments of strategies where the investor or corporation is always struggling behind the business cycle, instead of working proactively towards the threats and opportunities associated by peaks and troughs.

To be able to prepare for both upturns and downturns in the economy, business cycle forecasting through economic indicators could be a vital tool. If we are able to gain qualified expectations about the future developments of the business cycles it is also possible to help managers from entering the illusion of control, and to form the enterprise strategies to fit the future macroeconomic developments in the best possible way.

If we have expectations on how the external factors will develop in the future, we can create internal scenarios on how these developments will affect our business, and from this prepare strategies to minimize the internal impact of recessions and maximize the gains from opportunities.

1 Financial Times, July 9 2007 - Citigroup chief stays bullish on buy-outs

2 The analysis in section 6 will show that it was obvious at that time that a recession was in the loom.

3 Los Angeles Business Journal, March 20 2000 - High-Tech bears could turn vicious if market falters