- 25 Marks
Question
A new commercial bank which has recently acquired license to operate as a bank in Ghana has developed a new product to position itself in the banking industry as a relevant player. It believes in a blue ocean strategy by creating its own market space to make competition irrelevant. As a marketing manager for the new bank, you have been asked to conduct a feasibility study of the new product. Management of the bank must make a decision with respect to the sales volume and ancillary resources that must be used to market this product for the ensuing year.
The least expensive decision alternative (d1) is to start selling the new product through existing sales channels and provide customer support as needed. The next alternative (d2) is to assign one full-time sales person to focus on this product. The third alternative (d3) is to have a team of six people dedicated to this product. Finally, a complete division (d4) consisting of about twelve people may be created to fully automate the product and engage in an extensive marketing campaign.
The potential profit from each decision alternative depends on the market acceptance or demand for this product which may be high, moderate or low depending on the circumstance. If market acceptance is high, each of the four decision alternatives, d1 through d4 will produce a profit of 200, 300, 600, and 900 thousand dollars respectively. If there is a moderate demand, the profits are likely to be 100, 100, 200, and 200 thousand dollars respectively. If the demand turns out to be low, then the profits will be 100, 100, -200 and -500 thousand dollars respectively. Anecdotal research in the banking industry suggests that with such products provides a probability estimate of demand to be high, moderate and low as 0.3, 0.5 and 0.2 respectively.
a) Which of the four decision alternatives should be selected by the bank and what will be the expected profit from this decision? (7 marks)
b) If a market research firm can provide perfect information about demand to the new bank (i.e. whether it will be high, moderate, or low) before a product launching decision is made, how much is that information worth to the new bank? (7 marks)
c) Define the complement rule of probability. (5 marks)
d) Discuss the implications of making decisions under conditions of uncertainty. (6 marks)
Answer
a) To determine the best decision alternative, calculate the Expected Monetary Value (EMV) for each option using the formula: EMV = (Probability of High Demand × Profit under High) + (Probability of Moderate Demand × Profit under Moderate) + (Probability of Low Demand × Profit under Low).
- For d1: EMV = (0.3 × 200) + (0.5 × 100) + (0.2 × 100) = 60 + 50 + 20 = 130 thousand dollars.
- For d2: EMV = (0.3 × 300) + (0.5 × 100) + (0.2 × 100) = 90 + 50 + 20 = 160 thousand dollars.
- For d3: EMV = (0.3 × 600) + (0.5 × 200) + (0.2 × -200) = 180 + 100 – 40 = 240 thousand dollars.
- For d4: EMV = (0.3 × 900) + (0.5 × 200) + (0.2 × -500) = 270 + 100 – 100 = 270 thousand dollars.
The highest EMV is 270 thousand dollars for d4 (creating a complete division). Thus, the bank should select d4, with an expected profit of 270 thousand dollars.
In Ghanaian banking context, such as post-2019 cleanup where banks like Access Bank Ghana invested in new digital products amid uncertainty, EMV helps prioritize resource allocation for maximum expected returns while complying with BoG’s risk management guidelines under the Capital Requirements Directive.
b) The value of perfect information (EVPI) is calculated as the Expected Value with Perfect Information (EVwPI) minus the Expected Value without Perfect Information (EVwoPI, which is the maximum EMV from part a, 270 thousand dollars).
For EVwPI, select the best alternative for each known demand state and weight by probabilities:
- High demand: Maximum profit = 900 (d4).
- Moderate demand: Maximum profit = 200 (d3 or d4).
- Low demand: Maximum profit = 100 (d1 or d2).
EVwPI = (0.3 × 900) + (0.5 × 200) + (0.2 × 100) = 270 + 100 + 20 = 390 thousand dollars.
EVPI = 390 – 270 = 120 thousand dollars.
This information is worth 120 thousand dollars. In practice, Ghanaian banks like Ecobank Ghana often engage market research firms for fintech products, weighing costs against EVPI to ensure compliance with BoG’s outsourcing regulations under Act 987, avoiding excessive risks seen in the UT Bank collapse due to poor demand forecasting.
c) The complement rule of probability states that the probability of an event not occurring (the complement) is 1 minus the probability of the event occurring. Mathematically, if P(A) is the probability of event A, then P(A’) = 1 – P(A), where A’ is the complement of A.
To arrive at this, note that the total probability of all possible outcomes in a sample space is 1. Thus, subtracting P(A) from 1 gives the probability of everything else (not A).
In banking, this is used in risk assessment, e.g., if the probability of loan default is 0.2, the probability of non-default is 0.8, aiding provisioning under BoG’s directives.
d) Making decisions under uncertainty implies lacking complete information about future outcomes, leading to potential risks and opportunities. Implications include:
- Risk of Losses: Without probabilities or outcomes known, decisions may lead to financial losses, as seen in Ghana’s 2017-2019 banking cleanup where uncertainty in asset valuations contributed to bank failures like Capital Bank.
- Reliance on Subjective Judgments: Managers may use heuristics or anecdotal evidence, increasing bias; e.g., over-optimism in product demand could violate BoG’s Corporate Governance Directive 2018 requiring prudent risk assessment.
- Need for Diversification and Contingency Planning: Banks must diversify portfolios or use scenario analysis to mitigate, aligning with Basel III adaptations in Ghana for operational resilience.
- Opportunity Costs: Choosing suboptimal alternatives due to fear of uncertainty, potentially missing profitable ventures like digital banking expansions post-DDEP.
- Ethical and Regulatory Implications: Uncertainty can lead to non-compliance if not managed, e.g., under BoG’s Liquidity Risk Management Guidelines, emphasizing stress testing.
- Use of Tools like Sensitivity Analysis: To evaluate how changes in assumptions affect outcomes, enhancing decision robustness.
In Ghana, post-DDEP recovery (2022-2024) highlighted how uncertainty in government debt restructuring forced banks to recapitalize under BoG Notice BG/GOV/SEC/2023/05, underscoring the need for probabilistic models like EMV for ethical, profitable practices.
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