Diversify risk

The last blog was about the importance of market share as well as product focus. We also saw how single product organisations like HDFC have done so well over the past few decades.

It is not true, however, that all single product companies will do well or have done well. In many ways, success depends on a variety of factors like vision, strong plan, processes, people, focus etc. Success also depends on the products chosen and how well the products do in the market place.

The housing sector, in India, has seen very few blips in its upward journey - thanks to the ever growing population and a growing economy. There have been a few 'corrections' in the past due to over-heating of the sector but overall the scenario has been good. As long as the organisation is conservative in its lending practices and not encouraged too much speculation, it is in a safe zone.

We are all aware that, in general, each sector has its cycle of ups and downs. When the going is good, every move that an organisation makes seems to be a winner. At the same time, when the cycle is down, a 'one-product-bank' soon finds itself in big time trouble.

Which brings us to the need for diversification of risk. Even though there are compelling reasons for product focus, the need to balance out the portfolio calls for a judicious mix of products which will help negate the effects of a bad cycle. The mix of products should be such that there is a support from one sector when there is a weakness in another.

Of course, when there is an overall weakness in the economy affecting most sectors, one can only fall back on the overall quality of the book in terms of selection and strong predictions / collection ability.

Each bank should analyse the source of its liabilities and assets to make sure that there is no over-dependence on any source. There should be a proper mix in terms of geography, sector etc. One thumb rule to be applied here is to be "mapped to market" - which means that the bank's sources would be similar to the demographic pattern of the market. For instances, if 80% of the savings accounts in the market comes from salaried individuals, the bank's pattern should match that. And within that if 10% comes from the IT sector, a similar pattern should be reflected in the bank. This rule does not apply if there are any emerging markets or new opportunities missed out by others.

Similarly, on the assets side also the mix of products and the sectors where the lending is done should be mapped to the market. When choosing product mix, attention should be paid to the mix between secured and unsecured assets. Within secured assets (which should normally form the bulk of any bank's assets), re-sale values and loan-to-value forms the bulk of the consideration. Ability to recover in the event of default either through collection or repossession is critical.

To summarise, product and market share focus is important for a bank to make best use of available band width of management and to avoid getting lost in a mire of products. Yet, diversification of risk is required to manage the inevitable market cycles.

I would love to hear your views on this blog. Please feel free to leave a comment on the blog or send me a mail at vish.sesh@gmail.com and I will quickly respond.