Tempering the Pursuit of Profit

Speakers at an ACCA and Echelon hosted event paint an alarming picture about the cavalier disregard of many Sri Lankan firms in managing risk

By Shamindra Kulamannage.

Published on February 19, 2013 with No Comments

ACCA-RISK-FORUM

(In the picture from left: Adrian Perera, Dilshan Rodrigo, Mukhlis Ismail, Suren Rajakarier, Surana Fernando)

In firms that have not lost their entrepreneurial touch, risk takers are often highly rewarded and also often get the benefit of the doubt in decision making. After all, risk is central to profit. It’s also the factor that defines business around the world. Despite risk’s central role in mature businesses sometimes it can be hard to spot. Risk managers at the largest global banks who had unparalleled resources compared to their predecessors, failed miserably to spot the debilitating impacts a bursting US property bubble would have on their balance sheets.

They were lulled by historically low levels of volatility, low interest rates and low mortgage default rates. On top of that the big banks held top rated Collateralized-debt obligations (asset backed pools of securities, mostly mortgages). The highest rated pools were retained in the banks while the riskier lower rated ones were often packaged in to more CDOs’ and sold off, a seemingly riskless strategy. 

Among these were mortgages given to sub-prime customers, but categorized investment grade by rating agencies because of the ways in which CDOs were structured. However when house prices tanked even the investments deemed the safest, because of their triple A credit ratings had no buyers, so liquidity dried up. Soon enough it became apparent that liquidity wasn’t the biggest challenge because defaults in subprime mortgages were even impacting triple A rated paper.

A crisis rarely comes out of the blues. Even in the US, few risk managers reacted to the first signs of trouble in the mortgage market. From a practical point of view it means identifying events however improbable, says Dilshan Rodrigo, HNB’s former head of risk management. “If the impact is going to be high, then start putting risk mitigation tools in place,” he said during a panel discussion organized by accounting body ACCA and Echelon magazine.

Events of which the impact is high but impossible to predict, commonly now referred to as Black Swan events borrowed from the book title of Nassim Taleb who popularized the theory, are easily missed. For companies seeking greater risk awareness this is where perhaps the greatest danger lies, getting a handle on rarely occurring but high impact events.

Rodrigo points out firms often successfully identify the high probability and high impact risks, and put in place risk mitigating measures. However at HNB, a bank, management has insured against losses from not just the most probable but also against rare and almost unlikely occurrences. “The head office building is insured for earthquakes although the probability is remote. If one does take place, the impact on the organization is so tremendous”, he explains of the rationale. Although HNB owns many buildings, 85% of balance sheet real asset value is accounted for by its head office. An earthquake would be an operational risk for a bank, one that is hard to predict and not easy to manage. They also have to deal in addition with lending and trading risks.

HNB is perhaps among a minority of Sri Lankan firms where the board and senior management equipped a team of professionals. In the vast majority of firms here it’s not seen as a useful enough function.
Risk management in Sri Lanka is usually seen as a function of the board and senior management. Few companies have institutionalized risk management in Sri Lanka, and not surprisingly, because many were until recently too small to have a bunch of high IQ misfits telling the rest of the organization which risks are a step too far. However capitalizations of listed companies are far higher now and more is at stake. “Unlike 10 years ago, companies are much larger and challenges are equally significant, so a formal risk management process is crucial,” argued accounting firm KPMG’s partner Suren Rajakarier at the forum.

Auditors, like Rajakarier, have been more at the forefront of assessing risk at firms they audit than the firms themselves. However it’s fraught with challenges when firms, often ignorantly, run high risks. When an auditor questions the commercial sense of an excessive property revaluation, directors are known to retort, “Yeah you are the auditor, we have more commercial sense than the auditor,” Rajakarier points out. Auditors are trained to be sticklers about things that can go wrong whether it be inadequate provisioning or dividends being declared out of revaluation reserves.

It’s like driving looking at the rear view mirror Rajakarier points out. “If we point out anything, they will say, ‘it hasn’t happened in the last five years’,” he says. “That’s the fundamental problem we face as auditors, every single aspect that could go wrong is raised during an audit with the CFO and in management letters to the audit committee. They don’t give a …..” External auditors, like risk managers, are sometimes seen as obstructing the overarching selfish aim of enriching the controlling shareholders in some firms.

Risk managers rely on models which sometimes can be at odds with the trading arts and gut feel of boards and senior management. This is also a reason why some entrepreneurs and company boards favoring gut feel decisions on a quick analysis of the environment may feel uncomfortable with the straightjacket of risk management.

Risks aren’t always the result of dysfunctional behavior. Sometimes they can arise out of a series of seemingly innocuous actions. Risk managers often pride themselves in their quantitative skills; however with difficult to predict risks it can as much be art as it is science.

Risk managers, who report to a main board committee in well structured organizations, have the power to turn down transactions. This ability to prevent business from being done could be seen as a hindrance and obstruction. Unless the risk department is very accommodative the relationship with other business units can be strained. Two things impact how much risk an organization takes. The first is the culture.

“The tone at the top is very important,” emphasizes Mukhlis Ismail who headed risk management at conglomerate JKH. “We identified risk champions and risk owners at a business unit level and operational level and they took ownership of risk.” At JKH the group risk management office manager was the facilitator and consulting partner to over 50 business units helping each one to identify risks and put in place a risk mitigation plan. “Identifying the risks themselves is a key element. If we had gone and said these are your risks, there would be no ownership”. This integrated approach to risk management took nine months to implement at JKH. The firm picked risk owners at business unit level and also operations level.

“At the board level you very clearly articulate what is the risk appetite and measure that risk appetite against performance,” says Rodrigo. Banks are usually paranoid about risk because their business is funded mostly by deposits. Their loans might not be paid back and bets on the bond market or currencies can go sour. So they try hard to quantify the risks involved in lending and trading. At HNB the risk team of around 30 individuals is backed by IT systems for analytics so that performance is always comparable against risk appetite.

For banks the upside of a lending risk is limited but the downside can be catastrophic. HNB, where the loan book now exceeds Rs 300 billion, has managed to reduce the dud loans to 3.4% of total lending from as high as 8.7% a few years ago by focusing on its weakest links. “On a good loan we make a 5% margin and on a bad loan we lose 100%. So every bad loan is equivalent to 20 good loans” explains Rodrigo of why banks in particular have been early adopters of the best risk management practices.

Rajakarier believes even banks follow regulations in the breach. There is a regulatory direction from the Central Bank to have a proper integrated risk management framework in banks, he says. “With probably 95% confidence, I can say not all banks have achieved that level of compliance though the regulation was issued one and half years ago.”

The second factor is ethics. A weak and unsound ethical base promoting greed and self interest increases the scale of risky bets. In these circumstances the rewards for punting are huge and penalties for reckless behavior small. The impact of a weak ethical base and the resulting elevation of risks were obvious in 2011, on company balance sheets, when stock prices collapsed. Credit ratings agency RAM raised a red flag to firms that were punting in the stock market, especially to financial institutions. “At that point some clients told us, ‘look we know the market better than you’,” recalls RAM’s Lankan unit Chief Executive Adrian Perera. Punting with abandon was encouraged in some groups and the more money these firms were able to make the bolder their bets became.

However when stock prices tanked, unwinding these bets simultaneously became impossible because liquidity dried up. Firms that had reported a billion in profits had seen earnings drop to 50 million rupees and the published accounts of some firms have been qualified by auditors. “With the credit squeeze the bottom-line and liquidity were wiped out,” Perera explains. Firms went on a leveraged acquisition spree, encouraged by the relatively low interest rates. “In the long term you are not going to get short-term interest rates; that’s the market reality.”

Perera recalled how a client with over five billion rupees in short term debt dismissed his advice to float a long term bond to retire the short tenure borrowing. “They didn’t raise a bond because bank money was at 7 to 8%. But in February 2012 they asked, ‘can you raise the bond?’, but rates had gone up by then.”
Perera thinks that firms perusing diversification on top of short term leverage are running even higher risks of going the same path that Ceylinco and Vanik took.

He argues that diversification is good only as long as it’s done with shareholder money and not borrowed money. Allowing expansion on short term leverage is as much the fault of the banking sector as it is of CFOs’, argues Perera.

Change is difficult, even when it can potentially lead to a better handle on risks facing a business. Sri Lanka’s securities regulator which implements and introduces rules that govern the capital market has firsthand experience of this. “Often the response we get is that it’s too much, we are a small country and the economy is small,” explains Surana Fernando, SEC’s Director of Supervision who was also a panelist at the ACCA Echelon forum on risk.

Some Sri Lankan companies, often ones that are undercapitalized, resist greater regulatory oversight for obvious reasons. “We see dividends being declared when actually there are no profits but out of reserves. We don’t see this being raised by minority shareholders,” points out RAM’s Adrian Perera. While the practice isn’t illegal he questions if it’s the right thing to do. “Usually it’s done by the major shareholder because they want to take out the money.”

Investors would usually be weary of companies that take outright punts in the market, making it difficult for these businesses to raise equity. However in Sri Lanka the opposite happened during the market boom. Companies making the riskiest punts were rewarded by fantastic valuation in their IPO’s and in the secondary market, which emboldened them further.

The Colombo Stock Exchange has regulated that risk management processes should be disclosed in annual reports Rajakarier points out, while advocating such regulations be given teeth. “Nobody goes beyond to see if what is disclosed is adequate, appropriate and meets the purposes,” he says.

Perera, who due to his job often is privy to how companies make decisions, attests that often the risk management processes discussed in the annual reports and reality are worlds apart. “When we meet a company they usually give us an annual report. But we all know annual reports are done by ad agencies, and when we go through the board minutes there is nothing, when you go down to the reports there is nothing. What do sometimes profits come from?” he asked rhetorically at the ACCA Echelon forum, “from property revaluation, sometimes it now comes also from negative goodwill, that’s also happening.” Negative goodwill arises when an acquisition is made for less than the net asset value.

Rodrigo concluded the conversation pointing out that “it’s important to be fearless and do the right thing, which is why even in ACCA there is an inordinate amount of focus on ethics and values.”

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Trackbacks & Pingbacks

  1. ACCA breakfast discussion http://www.echelon.lk/home/tempering-the-pursuit-of-profit/ | Suren Rajakarier/ Governance
  2. ACCA- Echelon event Jan 2013 | Suren Rajakarier/ Governance

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