Tuesday, July 28, 2015

Ignore risks at your own risk

Govt. of Greece, Public sector banks in India suffering from high bad debt, infra companies with heavy debt being unable to service their loans and hundreds of farmers in Karnataka going dead - all have one thing in common. They did not manage their risks well.

When the infra and real estate companies in India took heavy debt, they and their lenders did not think of a situation in which the demand slows down and the capital costs increase. Now both the parties are in a difficult situation as interest outgo for the borrowers are more than the operational profits they earn. No amount of debt restructuring will help them. It is a clear case of failure in assessing business and operational risks.

If you start quantifying the risks, you will know that farming is a very risky business too. A rain dependent farmer is always throwing the dice when he sows. He is at the mercy of rain gods and pests. If the crop output is good but pricing is bad, like it is happening with sugarcane farmers, his venture turns a negative profit. It is a series of uncertain events. And the poor farmer borrows from unorganized market at higher rates than the banks lend, that adds to financial risks. Even if he is successful, he has to share profit with the loan sharks. But he won’t be successful every year. Luck too is a probability and highly inconsistent in nature.

When the improbable becomes unavoidable, organizations go bankrupt and the farmer stretches his hand to the pesticide and goes dead.

For the organized businesses, there are multiple ways to diversify, mitigate and transfer the risks. But yet they ignored risk management only to go bankrupt later. As for the farmers, there are not many risk mitigation options. If the Futures Market gets well developed, it can offer a great relief for the farmer. As a consumer I know how much onions and tomato I would need in future. Similarly retailers know how much food grains and vegetable they can sell in a day or a week or in a season. Wholesalers understand the pulse of market very well. Why can’t these parties participate in price risks and why alone farmers should take that burden? If farmers know that price is dropping in the Futures market, he has an option to change the crop and avoid the distress. That way supply and demand would find a balance without too much variation in price. The forward market can be regulated by limiting the number of contracts one holds to avoid manipulation and risk concentration.

Derivatives (Futures and Options) are good hedging tools but at the hands of speculators they can become a toy of gambling. Holders of out of the money Put and Call options watch their contracts turning worthless over time. But it does not mean option writers win all the time. When the Black Swan visits them, they hear only one thing – a swan song. That’s how Lehman Brothers collapsed and the global financial crisis broke out in 2008.

No risk management or too much play in derivatives (risk concentration) both leads to disasters. Better way to manage risks would be to break it into manageable size. A poor farmer suffering Rs.1 lakh loss due to pricing change would push him to death but the loss of Rs.100 for every contract held by 1,000 people would become a manageable loss. Total loss would not change but the risks and rewards when distributed can be managed well and absorbed without devastating effects.

The crisis our society is going through calls for a better risk management. Relief packages won’t last long. Govt. needs to spend the tax payer’s money sensibly. Banks should not relax regulations under any pressure. And there should be a forward market for all those commodities which see huge price swings. Regulator should ensure speculators do not manipulate the market. Does risk management looks like a risky business? Yes, it is when not managed well. But if we bite only what we can chew and if we have saved for a rainy day, risk would not bother us or anyone to death (financial or physical).

[Inspired by the book ‘Against the Gods’ by Peter L. Bernstein]