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]
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ReplyDeleteAnand Sir,good article about risk management.
I know NCDEX.com for agri market,,, not all the products (futures/forwards)available like commodity market.
There is a margin requirement also,, how can farmer learn these things.?
Interesting thing is lots of people graduated form IIM/Harvard(MBA/PGM) etc employed in BANKS those who deals finance/commerce/derivatives/currency .yet Greece(debt crises),India(Balance of payment)
Higher the risk,higher the returns,,this greed makes man to take wrong decision.
Speculation is mother of all evil.People try to forecast future based on past data.
I learned hard way during trading,,,"Size matters" even in finance :-)
Suresh, I think if those Agri futures gets sold in the APMC itself (even without a Demat account initially), idea may spread. Many farmers use smartphones these days and are on Facebook, they understand the power of information and networking. They may not take much time to learn. When the time comes, it happens quickly than we think.
DeleteAll financial crisis so far have pointed towards the need for better risk management, and the after math has led to reforms, but again people get creative enough to invent new risks. So the need for risk management is a sticky one.
ReplyDeleteI agree, Somali. They innovated new derivatives which fueled speculation than hedging which caused crisis situations. But slowly (hard way) the attitude towards risk management is changing and for good.
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