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.

On managing risk

In banking, as it is in any enterprise, managing risks constitutes a very important aspect of the business. The longevity and even survival of the organisation depends on how well are risks managed. There are instances of otherwise well run organisations with long vintage facing bankruptcy due to misses in this important domain. And yet, we see many organisations treating this important subject with surprisingly low attention and priority.

This blog is no thesis on risk management and is rather a introduction to the subject. The objective of this blog is to create awareness and ensure due weightage is given to this important subject in the course of managing ones business.

There is a story of a man who once fell inside a well and was shouting for help. One good Samaritan, who was passing by, came to the well and offered to throw down a rope and pull the man up. The man who had fallen down asked the following questions:
1. What if the rope is not strong enough to bear my weight?
2. What if it slips off your hand when I am on my way up?
3. What if you are unable to lift me up due to lack of strength?
4. What if you too fall inside attempting to rescue me?

Obviously, he would have made a good risk manager. A good risk manager always thinks of the risks of any plan, process or strategy. He is always obsessed with failure possibilities. Besides thinking of known risks, he should also ponder about unknown risks. His objective, of course, is only to ensure success and come up with a fool proof plan. Under no circumstances should he keep thinking risks without offering solutions. Otherwise he risks staying inside the well !!

Risk management is covered under the following broad heads:
a) Operations Risk - Risks arising out of the operations of the bank due to failures in the design of the processes or in the execution of the same.
b) Market Risk - Risks arising out of changes in the market place which are beyond the control of the bank - for e.g. change in the interest rates or changes in share prices which can impact profitability of the book or reduce the security cover for credit lines.
c) Credit risk - Risks arising out of failure of the borrower to repay due to a variety of reasons like business failure or wilful default.

Each of the above needs to be managed differently and I will cover them at length in future blogs.

Every bank needs to have a structure in place to manage risks and I cover some of the key elements of a good structure below:
1. Well established process for creating and approving products, policies and processes.
2. Clear guidelines on trigger events which can cause alarm.
3. Systematic and objective analysis of data and periodic reviews of each product / portfolio.
4. Strong system of internal checks and controls including audit at regular intervals.
5. A proper system of delegation of authority and empowerment.
6. A process of reporting - frequency based on type and significance of transactions.
7. Fraud management processes.
8. An effective recovery system and process.
9. Good documentation and custodial function.
10. An overall control in form of limits.
11. A strong culture in the organisation which prevents problems.

The operative word for effective risk management is to have independence and objectivity in the process. Also, risk management needs to have independent reporting to the board to ensure that issues are highlighted to the appropriate level. Sufficient empowerment in form of veto rights may also be considered to prevent disasters from occurring.

Risk management is one of the pillars which give a solid foundation to any organisation and its importance cannot be belittled. An organisation which cultivates a strong risk culture will be able to deliver a steady and profitable growth with no surprises. At the same time, risk management should not forget the prime objective of the organisation - which is to do business.

To reach a port, we must sail – sail, not tie at anchor – sail, not drift – Franklin Roosevelt

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.