Company versus individual

In the May 7, 2022 edition of this column, I wrote about how the paradigm shift in finance is influencing market activities at all levels.

In that edition, I wrote that the “fundamental shift in the world of investing,” has “gradually brought in the link-effect of finance, investments and pensions”. In the main, the article was about responsible investing, and how corporations are now looking at ways of mitigating the negative impact of business decisions on the environment, society and governance.

And what is happening at the individual front in this paradigm shift?
Well, today, I have another view on the paradigm shift in finance, and this calls for the need for us to get back to the basics of investment lessons. Let me just say, at this point, that I have been largely influenced by events in the past few weeks regarding this week’s article.

To set off, let us consider the US banking problem. First was the incident regarding the collapse of Silicon Valley Bank (SVB), the second biggest bank failure in US history. Undoubtedly, the collapse of SVB has brought major knocks to the global financial system. Available literature speaks to how SVB’s seemingly liquidity challenges brought it down on its knees because red flags were raised about its falling franchise value. Investors (depositors) who had sensed trouble decided to go for the exit by way of seeking to withdraw their money from the bank. The fact is, bank withdrawals must always be a systematic and orderly process because by the operations of a bank, it cannot sit just waiting for all depositors to withdraw their money at a go. No.

Bank plans

The bank plans its cash handling activities based on a defined structure that ensures that there is enough money in the vault to pay the estimated cash withdrawals in a day or over a period (of course with some projections on deposits too).
So, normally the vault cash planning structure of a bank is highly scientific or must be scientific, based on data analysed over a period of time. In fact, no bank would want to hold more cash than the insurance cover limit that it has for cash-handling activities.

SVB, described by many as a highly conservative bank, by records available, with some seasoned finance gurus in top management positions and on the Board, did all the planning, investing in government gilts and technology companies, with less holding in “risky” assets. Yet, having followed all these pragmatic steps, textbook-like prescriptions, it could still not help itself out of trouble. Many analysts and market observers have various reasons for this unfortunate development.

Risk

I would rather stay on the straight and narrow, and look at the dominant factor in business and finance risk.
Risk is a fundamental issue in finance. For this reason, I have repeated it several times in this column that so long as risk pervades finance much the same way as gravity pervades physics you should never take it for granted. A zero-rated risk asset is a risk!

As I explained in the August 20, 2022 edition, when it comes to risk, there are no ifs and no buts, so you must take a look before the deep dive with your investment decisions.

Take the case of bitcoin, for example. As the signature crypto asset, bitcoin has enjoyed a lot of attention, and many have invested in it. But at some point in 2021, it lost 70 per cent of its value, and the cascading effect of the losses brought instability in the crypto markets, exacerbating macroeconomic challenges.

In fact, to deal with the broad nature of corporate failure, you have to look at a number of factors. Companies, just like individuals, run into liquidity challenges. In simple terms, if you are not able to cover key obligations when they fall due, it could be a sign of some cash problem, a recipe for failure too. It means that you are not “liquid” enough to meet your obligations.

For instance, if the school fees are due, and you are not liquid enough to cover the expense, it becomes a challenge, doesn’t it? Well, economic agents act in similar ways, even though the magnitude of the challenge differs. Or the weight of the problem is not the same.

Here is the lesson: companies may experience liquidity challenges when they are not able to meet their obligations due to a lack of cash and other liquid assets (near cash). Just like the case of the company, you may be asset-rich but cash-poor!

In other words, you may not be able to meet your obligations because you don’t have the cash immediately to pay, but you may have assets even far in excess of what you are struggling to pay. Sounds SVB-like!

The trouble here is that these assets are not cash or “near cash” and, therefore, you cannot easily convert them into cash to meet your obligations. That situation could be temporary, though, possibly triggered by some mismatches within your financial planning cycle. But it could also persist or become chronic when the decisive action is not taken to address the short-term liquidity risks.

Corporate failure and individual

In effect, if you wallow in debt for too long, that is, persistently experience liquidity challenges, you are most likely going to be bankrupt because you will become insolvent. That is a certainty, and a major cause of corporate failure- and individual failure too.

One other thing that you need to know is that it is not always that a company would collapse because it was not well managed. No. Liquidity crises can be triggered by large, negative economic shocks or by normal cyclical changes in the economy. I am sure the “large, negative economic shocks” ring a bell in your ears!