I am doing research for an upcoming article I am writing on Business Model risk. I would be interesting in hearing members' thoughts on the following:
1. Is this an activity that should only be confined to the Strategic Planning phase or is it a core activity of Risk Management ?
2. How do you identify businesses that are performing strongly but that may have a Business Model that is fundamentally flawed ?
3. What types of action can be taken to have Business Model risk debated. The rise of subprime products in retail and investment banking is of course one of the best Business Model risk case studies I can think of.
Comments
For those that commented or viewed this link - the article is now completed. It is under the Insights page of Alma Grove Consulting's website www.almagrove.com.au I have also posted the link on the main discussion page. Thanks again for everyone's feedback/input.
I agree with most of the comments here, Anna’s particularly detailed response is ideal step-by-step methodology – this is a model answer!
“Are risk adjusted returns from the business or a product or business line significantly higher than for peers or compared to long term trends? What are the components of the risk adjusted return - leverage, return on assets, operating margin and related components - (effectively Du Pont Analysis on a risk adjusted basis)? Another way of putting it is, are the assumptions behind the success of the business model and business plans realistic and robust?”
Fantastic ...
I would like to add a couple of other activities I would include to this list:
1) Due diligence - firms need to do due diligence on the business strategy. This is a separate exercise.
2) Back Test Assumptions – Strategic planning models rarely back test or smooth their EBIT multiple growth estimates. The comment how did you generate those projected revenues which is followed with I dragged the numbers out in Excel makes me cringe.
3) Strategic planning needs to also value using real option breaks or scenario based (Monte Carlo) and show the Net Present Value at each break, why? The future is unknown and projected cash flows should be probability based not deterministic.
4) The additional benefits to item 3 are
a) You know the value at each Net Present Value Break Point for good and bad performance
b) You will be able to plan what to do at each break.
5) Workout the margin spreads between operating costs and revenues in line with projections and in line with other business models that are published in the market place.
Why? Well you can identify how much leverage to take on firstly but you can also confirm whether your model is real.
I could list another twenty points for strategic planning but I finish with this, All strategic planning teams need to be on top of discounted cash flow.
Hello Peter:
The best catalyst for debating Business Model Risk is to establish a risk self assessment on the model itself. This self assessment will not only identify the risk inherent in the model but will outline what controls in place to mitigate such risks. Of course, the best risk self assessments will also identify gaps which highlight controls that are somewhat lacking in their ability to manage and mitigate risks.
If you're interested, I could further flesh out some thoughts for you.
Peter
This is a topic I’m very interested in and would be keen to see your completed article.
1. Is this an activity that should only be confined to the Strategic Planning phase or is it a core activity of Risk Management?
As well as being an integral part of the strategic planning phase, firms should incorporate business model risk into their overall risk management. The firm should be aware of the assumptions regarding its external environment (economic conditions, access and cost of inputs, competitor behaviour, etc) that underlie its business model and should have tools and systems in place to monitor and react to possible changes in the external environment that could lead to their not meeting their earnings expectations and potentially affecting the solvency of the firm. Such tools and systems can vary from dashboards of key external factors provided to management to mechanisms where front line staff can provide information on up to date changes in demand, supply, pricing, etc to management.
2. How do you identify businesses that are performing strongly but that may have a Business Model that is fundamentally flawed?
Identifying businesses that are performing strongly but that may have a business model (or business line) that is fundamentally flawed is not the most straightforward. Some of it is probably down to seeing things that are too good to be true or that deviate significantly from the long term norm. Are risk adjusted returns from the business or a product or business line significantly higher than for peers or compared to long term trends? What are the components of the risk adjusted return - leverage, return on assets, operating margin and related components - (effectively Du Pont Analysis on a risk adjusted basis)? Another way of putting it is, are the assumptions behind the success of the business model and business plans realistic and robust?
For example, some European residential mortgage markets in the lead up to the crisis saw significant competition as banks tried to maintain or gain market share in competition with each other and non-bank competitors. Low interest rates and the search for yield opened up securitisation markets and covered bond markets, which brought down the cost of funding (but did not in all cases remove the mortgage risk from the balance sheet), while low risk aversion saw banks pay very low rates for secured and unsecured wholesale funding generally. In addition, credit quality was very positive for an extended period of time due to strong economic conditions. Some banks relied increasingly on cheap and ready access to wholesale funding (leading to rising loan to deposit ratios), assumed a continuation in benign credit conditions, assumed a lower capital requirement for residential mortgages under Basel II and undertook to maintain or gain market share. This lead to downward pressure on pricing and a loosening of credit conditions such as higher loan to value amounts, longer maturities and higher loan to borrower income.
Over the short term this was justified by good returns on capital, but a look at the assumptions underlying the pricing decisions and market share targets should have easily identified flaws in this model. For instance – a return to more normal funding costs, a period of stress in asset markets (which was not unlikely given steep price climbs in previous years) and less favourable economic conditions and, therefore credit quality, should have rung alarm bells. There is ample historic evidence of steep house price falls and of rises in unemployment and, therefore, ability to repay due to recession. On a more prudent basis, apart from higher funding costs, some reduction in access could also have been considered. If viewed in a longer term view and considering very possible risks to underlying assumptions, a reasonable management and board would have p
One example I have looked at, and used in workshops/courses is the business model of Northern Rock. At the time, when there was a run on that organisation, there was a lot in the papers about their dangerous business model but while it may have been a high risk model, I would not have called it dangerous.... I think this might be an interesting potential case study.
Hello Peter, interesting you
ask these questions. I would be very interested in keeping in touch regarding
your research. I have almost completed an article about risk appetite and it's
role in the strategic planning process. In this paper I touch on the organisational
business model. I make the point that different business models have different inherent
risk characterises and therefore the board should be clear about their appetite
before selecting one business model over another.
I am probably a week away from having this paper completed. Drop me an email if you would like a copy - andrew[dot]smart[at]manigent[dot]com
I do not think subprime products in retail and investment banking was a case of flawed business model. The business model was just fine. They went wrong when they extended credit to borrowers with low credit appetite and repayment ability in the hope that the growth rate (salary, housing price & job ) will continue to grow. It was also a case of high financial leverage.
Busines model risk should be considered while investing in a business. For e.g you have a lease to occupy land for say 40 years and the cashinflow from the businesss are not good enough to cover the present value (discounted at market rate) of cashoutflows for lease committment. Businesses may only look at first ten or twenty years where the cashflows could be very positive and may have ignored the last 20 years where the business is not even generating enough to cover the lease payment. In such a scenario there is a risk that the business model may be flawed and the terms of engagement needs to be revised.
A regular review of business model risk will bring out risks that may have come to exist subsequent to intital risk assessment and may indicate a revision of business terms.
Hope the views may be helpful
Aamir
I would welcome a thoughtful discussion on this subject ... because starting next Monday I will conduct such "project" ... where we will think though a business concept covering all of Europe ... with huge conglomerates based out of Asia & North American as partners. In fact, I will need to present preliminary findings in about a month.
What is fundamentally different for me is the size of the risk. I have personally been involved in small ventures as the decision maker ... now I would have to think through (albeit not alone) the structure, finance, legal, etc ...
And while (names/products/entities) must remain anonymous ... I could bring forth questions, which is the "collective" would like to entertain their thought muscle ... could be fun for some ... and others would point to the fact that I am trying to get something for free when there are many who would love to consult.
Question No. 1
If you were to design a business which has head quarters in one country within EU, which kind of business model might work? Capital is not unlimited, but sufficient. Organization is lacking but few key people are in place. Manufacturing & Quality has been dealt with by partner. A new brand with proper trademarks to cover EU is not an issue. In other words, if we were to wake up tomorrow with plenty of product which we own ... how would we cover Europe with the products?
Models have risks! Risk is tolerated, but at medium pace. That is based on partner wanting to move fast and EU partners wanting to move slower, thus ending up in the middle.
There are plenty of countries in EU ... distributor network? if is safe, cheapest, but has some downsides. Maintain ownership at each EU country? very costly and requires a large organization which brings about it's own problems.
OK ... I will leave this now and lets see if anyone wants to comment ... if not, Thank You anyways.