Money Matters-Risk rewards and punishes too

Effectively managing risk is a sure way for businesses and individuals to survive

In the past, few weeks we have all had to pore over pages in the financial newspapers to get a sense of what the public perception of the financial sector is.

This unintended academic exercise, l think, will continue for a lot longer simply because of the impact of finance in the world in which we live today.

Financial matters dominate everything - unfortunately. To pay school fees is not about how much noise you can make by shouting from the rooftop or how convincing you are with your arguments but mainly about how much you have in the bank account that can support such an obligation.

Finance matters affect what we do, every day. Waking up in the morning and driving through the heavy traffic that has become a feature of morning life in Accra is motivated by factors that include how the intended activity could impact on the pocket, ultimately.

It is therefore understandable to find people concerned about unacceptable behaviour on the part of institutions and individuals who have been entrusted with public funds or even private funds that are to be paid back on demand.

So, to get you to appreciate the normal cycle that plays out in the finance world, let me explain, in lay terms, the risk and return relationship that influence financial decisions always.

As l have always stated in this column, risk pervades finance much the same way that gravity pervades physics. This, therefore, means that there are some risks involved in every financial decision that you make.

For instance, even if you make the decision not to invest your money, there is that risk of losing likely interest if you had put it in some “risk-free” assets, such as Treasury Bills and other government issued notes.

On the other hand, too are the risks involved when you take the decision to invest; the real risk of losing the money entirely, which will depend on the instrument that you invest in, and the opportunity cost, that is, the next best alternative that had to be given up because of the final decision that you had to make between alternatives.

Because opportunity cost is so important in understanding your daily decisions, let me spend some more time explaining that.

Take the case of having about 100 cedis to spend in a week. If you have two items, each costing 100 cedis to choose from – items A and B - and you decide to go for B, the opportunity cost of having B is that you had to forgo A.

The actual cost of the item is the 100 cedis that you will pay for it. I hope you have followed the drift on opportunity cost thus far? Great!

This concept is so important in economics for the basic reason that we cannot always satisfy all our needs. Whereas we have the penchant to own several items that we come by daily, we are limited by the resources that we have and therefore cannot easily fulfill that desire.

This then forces us to make the decision between A and B as explained above. Scarce resources indeed force us to make a choice at every given point in life.

It is very easy to appreciate risk too. Because we cannot easily wish away risk, there are several risks mitigating tools that one can employ to control risk.

I am sure you have once wondered, just as a l did as a little boy growing up, why planes could fly and humans were extremely limited in that activity. The explanation falls in step with what one can do to mitigate the force of gravity because you cannot just wish gravity away and do whatever you like.

In the same vein, that is what happens when financial institutions do not treat risk management issues with the seriousness they deserve, recognizing that they cannot just wish risk away and do whatever they like.

In the finance world, where risk management issues are not fully embedded in the operational activities of the company to forestall potential problems, the company runs aground.

Let me give a little teaser here. We are all aware of recent reports in the various newspapers about some banks having high non-performing loans, meaning that the banks do have what has been classified as asset in possibly their interest income account and yet these assets do not have the possible income stream to go with it.

In plain truth, those who owe the banks are not paying and that non-payment has gone on for a considerable number of days, even months. There are indicators that are used to annotate what should be classified in that category of non-performing.

The catch is this. Most loans go through a credit assessment cycle that may even involve Board approval, depending on the amount involved.

The Credit Committee of licensed and regulated financial institutions will take recommendations from credit officers and relationship managers on an application for a credit facility, following which the Committee will either approve or decline the application.

Here, it is the credit risk situation which must be properly assessed to ensure that all risks that can be estimated within that category of risk are carefully and schematically warded off. Failing this can lead to non-performing loans of alarming proportions and spell doom for the institution concerned.

I’m sure that now you appreciate why some financial institutions may have severe challenges and others are doing well.

It is surely not the case of “all financial institutions are bad” but rather the case that some may end up in a spot of bother which could be due to a number of dislocations in operations, including poor risk management.

(botabil@gmail.com)