Risk-taking is about managing uncertainty. It involves making decisions and taking action in situations where the outcomes are uncertain and may have both positive and negative consequences. Risk-taking does not mean acting recklessly but understanding and navigating uncertainty by weighing the potential rewards against the risks. Effective risk management entails evaluating, prioritizing, and addressing risks to minimize negative outcomes and maximize potential gains. By embracing calculated risk-taking and incorporating strategies to mitigate potential downsides, leaders and organizations can seize new opportunities, foster innovation, and drive growth.
We know that both business and life are marked by uncertainty. It’s nothing new for aeons; uncertainty has been part of human life. To navigate this uncertainty, leaders must develop a profound comprehension of their business models, maintain a watchful eye on the repercussions of global events on their industries and businesses, evaluate their organizations' liquidity at any given moment, and ensure that risks associated with expansion or the introduction of new products or services are sufficiently hedged and safeguarded.
Effective leaders understand the occasional need for bold decisions to propel their organizations forward. Such decisions may include venturing into new markets, introducing cutting-edge products, or adopting novel technologies—all of which inherently involve risks. To address these risks, leaders must rely on data and knowledge for careful evaluation, well-informed decision-making, and the implementation of strategies to mitigate potential adverse effects.
In this light, risk-taking entails calculated risks that involve weighing potential gains against risks, making decisions grounded in a comprehensive understanding of the situation, and monitoring its progress. By merging risk-taking with risk mitigation and concentrating on enhancing the likelihood of success, leaders can foster more robust and agile organizations capable of adapting to fluctuating circumstances and capitalizing on new opportunities.
Below are some points to ponder for leaders in decision-making and risk-taking positions.
“Complacency is the Enemy of Progress.” The case of the collapse of Silicon Valley Bank (SVB).
Organizations and individuals may become complacent when things are going well, making them more susceptible to risks. In a state of complacency, people may overlook potential threats or become less vigilant in their risk management practices, leading to vulnerabilities that could have significant negative consequences. To avoid complacency, it's essential to maintain a proactive approach to risk management, continuously assessing and addressing potential risks even when things seem to be going well.
Repeatedly, we have observed that risk management remains inadequate despite the considerable governance and compliance requirements implemented after the 2008 subprime crisis. Take the case of the collapse of the Silicon Valley Bank (SVB), for example, which is widely covered by the media. Analysts attribute the collapse of the $212 billion tech lender to 1) poor risk management, 2) a rise in interest rates following a decade of low borrowing costs, 3) changes in regulations related to capital requirements and financial stability stress tests, and 4) a combination of these factors and some other reasons. However, the bottom line is that the bank's leadership could not assess the underlying risks during good times, leading to the fatal liquidity crunch and collapse. Analysts believe that a simple stress test of the on-demand assets with on-demand liabilities would have surfaced the issue in time for a correction. Worst if they knew and did nothing!
Let’s dive a bit deeper into the case. SVB financed roughly 50% of all venture-backed technology and healthcare firms in the U.S. The bank was a favourite among the tech sector because it supported startups that not all banks would accommodate due to the higher associated risks. During the 2020 pandemic, the tech industry thrived as consumers increased spending on digital services and electronics. Tech companies experienced a massive cash influx, relying on SVB's services to manage their business expenses, such as payroll.
However, when economic shifts impacted the tech sector, many bank clients withdrew funds as venture capital began diminishing. SVB lacked the available cash to fulfil these withdrawal requests since their funds were locked in long-term investments. They resorted to selling their bonds at a considerable loss, which led to distress among customers and investors. Within 48 hours of announcing the asset sale, the bank collapsed.
SVB's downfall can be attributed to its failure to respond quickly to rising interest rates, as it had invested in long-term treasury bonds without swaps or hedges. The increasing interest rates generated unrealized losses on their balance sheet, exacerbated by the difficulties faced in the tech sector, which prompted venture capitalists to withdraw funds from the bank to sustain startup operations. SVB's liquidity was insufficient to cover its liabilities, forcing them to sell securities at a loss (converting unrealized losses to real losses).
In the good times, SVB had reaped the benefits of over a decade of "zero money" interest rates as it funnelled billions into U.S. government bonds. This strategy seemed promising, but the Federal Reserve aggressively raised interest rates to combat inflation. We know that bond prices fall when interest rates rise, resulting in accumulating unrealized losses on SVB's balance sheet. The problem is not the investment in government bonds or the rising interest rates. Rather, the problem is in not assessing the impact of the rising rates on the lower bond value of the SVB portfolio and taking immediate corrective actions to mitigate the hurt.
In conclusion, as Danny Moses—an investor who foresaw the 2008 financial crisis as documented in the book and film The Big Short—said, "This isn't greed, necessarily, at the bank level. It's just bad risk management. It was complete and utter bad risk management on the part of SVB."
2. "An organization's culture is the foundation for successful risk management; it shapes how risks are identified, assessed, and addressed, ultimately determining the effectiveness of the entire process." – Anonymous
Credit Suisse rank among the 30 most important banks in the global financial system, and together with UBS, they have almost $1.7 trillion in assets. A stalwart business is being sold for $3.2 billion to UBS after a lifeline of $50 billion thrown by the Swiss central bank to shore up liquidity post the drop in share prices was not considered enough to prevent a global banking crisis.
The biggest learning from this episode is the importance of a strong culture of risk management that can identify the underlying risks in time for correction. Like crashes, a collapse is never caused by one event. It is rather, a domino of events triggered simultaneously that causes it. Analysts believe that a string of scandals over many years, top management changes, multi-billion-dollar losses and an uninspiring strategy can be blamed for the mess that the 167-year-old Swiss lender now finds itself in. The sell-off in Credit Suisse's shares began in 2021, triggered by losses associated with the collapse of investment fund Archegos and Greensill Capital. In January 2022, Antonio Horta-Osorio resigned as chairman for breaching COVID-19 rules, just eight months after he was hired to fix the ailing bank.
Finally, the statement from the SNB bank (investor in CS), the sharp share price decline, and the withdrawals by the clients were the final nail for the bank till the central bank intervened to broker the deal. Sadly, outstanding employees and leaders are affected by the mistakes of a few in not creating a culture that monitors and fosters checks and balances in risk-taking.
3. "The human tendency to follow the crowd is a powerful force that can lead us astray, but it's essential to remember that true progress often comes from challenging the status quo and charting our own course." - Anonymous
Over the past year, stock markets have experienced a decline, with the Dow falling by -6.73%, the S&P by -11.5%, and NASDAQ by -15.90%. This downturn is primarily due to rising interest rates, which impact the terminal value of cash flows, necessitating higher growth and profitability to maintain stock prices – a challenge that has yet to be met. Additionally, high-interest rates make bonds and treasuries more appealing to investors, particularly during volatile times when banks fail stress tests and tech companies lay off thousands of workers.
The crux of the matter is that companies and markets recognize that rising interest rates will lower valuations for businesses with higher costs of capital. Growth and profitability must increase to maintain share prices at these elevated interest rates; if that growth fails to materialize, stock prices will be adjusted downward. This tendency to quickly "price in" everything in the stock market contributes to volatility. For instance, during the pandemic, when the tech sector was thriving, this growth was swiftly priced in, so it was unsurprising that a combination of slowed growth and rising interest rates led to a significant decline in share prices.
Undoubtedly, companies are aware of these dynamics and likely view price adjustments as temporary reductions, focusing instead on their fundamentals. The challenge lies with less knowledgeable investors who follow a herd mentality, investing based on trends rather than fundamentals. To assess risk accurately, investors must develop a solid understanding of investment principles.
Typically, most people consult with relationship managers, who are essentially salespeople pushing bank products for profit. Their salaries and bonuses are tied to the deposits they attract and the products/services they sell, not to the clients making substantial profits. While relationship managers are simply doing their jobs like any other employee in any sector, it is crucial for investors to take the time to comprehend the risks of investing and devise strategies to mitigate them while enhancing their chances of thriving amidst volatility. Once investors understand the market, their chosen assets, and their strategy, the turbulence and volatility will not shake their long-term conviction to succeed.
4. "Accountability is the glue that ties commitment to results. It's about taking ownership of our actions, learning from mistakes, and striving to improve, ensuring that success is not a matter of chance, but a matter of choice." – Anonymous.
Frequently, we witness the rescue of companies by the Federal Reserve, governments, or central banks in an effort to avert a domino effect. Substantial interventions occurred during the 2008 subprime crisis, with some being labelled as one-time occurrences. Yet, these interventions continue to happen. In the case of Credit Suisse, merging with UBS proved beneficial for shareholders but eliminated the AT 1 bondholders. Companies receive protection or bailouts because they are deemed too big to fail, and their collapse would trigger turmoil in global finance.
Small companies and investors are often disadvantaged, as numerous smaller businesses fail without any assistance or public acknowledgement, while many large corporations with poor governance and risk management are repeatedly rescued. One can't help but wonder if, in the long run, it would be better to allow market forces to take their course and let troubled companies face liquidation. This approach might encourage other businesses to strengthen their governance more effectively than creating new regulations and oversight bodies to enforce compliance.
5. “The worth of a business is measured not by what has been put into it, but by what can be taken out of it.” Benjamin Graham.
We've observed inflated start-up valuations, particularly for tech companies with minimal profit but notable sales figures. These companies often receive millions in seed funding based on the hope that they'll become unicorns, even though only a tiny percentage actually achieve that status. Despite this, investment in tech start-ups has surged due to low-interest rates and unimpressive returns on deposits and bonds.
In recent years, lower interest rates have made tech companies' cash flows more valuable, as they're discounted at a lower rate. While some argue that start-up valuation is more art than science, it's crucial to adhere to fundamental principles in investing. Overvaluing businesses in the name of art increases risk, and it would be informative to compare the overall return on investment for start-ups versus established companies, excluding high-profile unicorns.
As interest rates rise, venture capital investments and start-up funding may decrease, with investors favouring more predictable, profitable companies over riskier business models. Low-interest rates have driven investment in growth-oriented companies, as they've been seen as having more potential for valuation gains compared to slower-growing counterparts.
Ultimately, strong fundamentals should guide investment decisions. While innovative start-ups present tremendous opportunities, investments should be based on reasonable valuations, exceptional teams, and robust risk management, with a structured approach to allocating funds.
Conclusion
In conclusion, the art of risk-taking is a complex yet essential aspect of personal and organizational growth. It requires a delicate balance between embracing opportunities and mitigating potential downsides. Key lessons to enhance our risk-taking endeavours include cultivating a strong culture, fostering accountability, avoiding complacency, and resisting the temptation to follow the crowd blindly. By embedding these principles into our decision-making processes, we can navigate the uncertainties of life and business more effectively, ensuring that our risk-taking efforts drive progress and innovation rather than leading us astray. As we forge our unique paths, embracing these lessons empowers us to create a more resilient and adaptable future where success is the result of deliberate choices and strategic action.
(In writing this article, I read lots of materials from print and digital media about Credit Suisse and SVB written and spoken by expert writers and analysts, and I would like to thank them all for spreading their knowledge.)
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