03 Dec Risk Discovery and the Cost of Complacency
Most of us in business think of risk as a threat – something needed to be removed or minimised. If the cost of complacency is larger than the cost of removing or minimising the threat, then this necessitates action. By mitigating risk, we make assessments of its likelihood, the costs of its management, and the potential costs of being complacent by doing little or nothing about it.
If the risk can’t be measured or managed internally, you can outsource its management and see it as a cost of production to reduce an even bigger potential cost. Rarely do we measure the cost of complacency as an opportunity cost by not recognising the risk, and the potential value that can be created by understanding it.
When we think about financial risk in business, we immediately think about the ability to service debt, the impact of interest rates, and the business risks impacting revenue and costs. We think of the risks affecting the bottom line, but rarely do we give much thought to risk exposed on our financial suppliers and their ability to compete cost effectively because pricing for risk is rarely a competing factor.
However, in supply of credit, risk is a large component to the cost of funds. Business owners can be forgiven for believing that a fair deal is adequately managed through loyalty and competition. This can be easily understood when considering residential home loans in Australia and how the high adoption of brokers has improved lending margins by 150 basis points. The majority of consumers with home loans are reasonably aware of the competition between lenders and how and they are positioned in the market.
Unfortunately, the same can’t be always said in business lending, as many businesses pay (a hidden) premium instead of commercial rates. Through their lack of understanding of bank pricing, business owners that choose to negotiate alone may ultimately pay higher rates than they would have paid if they utilised the services of a professional that possess the intimate knowledge of lending price discovery.
An experienced qualified professional understands risk assessment and the calculation of risk margins can accurately determine what can be expected in the market.
As an example, Debt Capital Markets (DCM) specialists evaluate risk within the parameters of each lender and can then determine competitive margins against the cost of capital and calculate an overall interest rate. Knowing what can be achieved in the market and what is a fair deal is dependent on knowledge of the negotiator.
So why coin risk discovery and the cost of complacency as a missed opportunity? Because by not understanding price discovery and lending risk, it can be more costly than it should be. And, without knowing these risks and what can be achieved in the market, little room is left to negotiate.