High returns on investment may be a reward of taking high risk; but taking a high risk may not always result in high returns and worst still results in a financial disaster. Whenever, a company overlooks this fundamental rule of business, then it is bound to face severe ramifications. Companies tend to forget the difference between taking a blind risk and a calculated risk.
Following the economic euphoria of low interest rates, corporations over leverage and over extended themselves. The risks taken to over borrowing and leveraging become a nightmare coming true – a systemic financial disaster. The banking and financial institutions are the first to take the hit.
Financial over-leveraging means incurring a huge debt by borrowing funds at a lower rate of interest and utilizing the excess funds in high risk investments in order to maximize returns. Many investment banks and finance companies across the world have over extended their leverage position by 40 to 70 times of their net worth. As the real estate bubble busted, it hurts the balance sheet of the banking institutions through write-downs and impairments and subsequently resulted in a systemic disaster due to loss of confidence in the market. This situation has bankrupted many financial and housing mortgage institutions. Some fortunate ones and those ‘too big to fail’ somehow managed to get bail-out packages from the respective governments of their countries. Many more unfortunate ones will be left by the wayside. This current global recession has made one thing very clear – the old rules of corporate risk have to change.
If we closely analyze the underlining factor for this systemic failure, then we can form a logical conclusion, that there was a strategic failure in the risk management planning of these companies. Some of the most famous corporate giants of the world would not have collapsed if they have earlier effectively managed the financial risks associated with their businesses. During this difficult time, the best strategy is ‘consolidation’ and ‘corporate turnaround’.
No one can exactly predict when the global economy will recover. But one thing is very clear – we need to change the old rules of corporate risk management. In future, companies need to be wary of over leverage and ‘living beyond their means’.