The Current Economic Crisis and Risk Management - Essay Example

SHOULD THE AUDITING PROCESS HAVE ALERTED THE WORLD OF THE LOOMING BANKING CRISIS ID 19714 Order No. 282984 [Name] [University Name] [Course Name] [Supervisor] [Any other details] 27 March 2009 Table of Contents: Table of Figures Figure No. Description and Word Hyperlink Figure 1 Interest rates increased drastically after 2005 in US, UK and Europe (www.marketoracle.co.uk/Article1694.html) Figure 2 The new Loan Approval Process involving Securitization (Murali et al. 2008) Figure 3 CDO Issuance rise (Source: http://subprimer.org/content/problem-shorting-mortgage-market) Figure 4 Growth of Piggyback loan that was one of the risky products offered as a part of CDO offerings (Office of Federal Housing Enterprise. 2008) Introduction: In the United States in past few years, banks appeared to have adopted enhancement of exposure to risks as the way of business thus putting high reliance on the competency and track record of Risk Management. This probably resulted in high risk appetite by the Banks looking into the excellent track record & innovative risk management procedures. In this process, multiple banks & financial Institutions gradually increased the exposure of their investment capital to the credit & liquidity risks to earn higher returns. They transferred the risks (apparently!!) by practising dependency on unregulated investors through mechanisms like SPVs (Special Purpose Vehicles) and SIVs (Special Investment Vehicles). The crisis is thus perceived to have occurred as the result of exposure to Market Risks due to such risk transfer mechanisms (Banks normally are never exposed to market risks because they reply on internal systems in managing the credits) that caused many loopholes in the Credit Risk Management in management of lending to Sub-Prime customers. These customers are individuals or companies who do not have clean credit history or regular source of income. The Banks & Financial Institutions preferred to lend loans to Sub-Prime customers to avail the benefits of higher interest rates at a perceived calculated exposure of the investment capital to higher risks. To facilitate this in a secured and manageable manner, the banks & financial institutions used the mechanism of "Securitization" that essentially is the mechanism of distributing the risk of the lending to the investors outside the Banking system through a process. The process of "Securitization" resulted in the boom of Credit Derivative Market and was used extensively in the US Sub-Prime Mortgage Market by increasing the number of risky products but still reduce the liabilities on their balance sheets (thus shielding the same from external auditors). The money was shown to be flowing through so called "conduits" from investors to the borrowers through the SPV and SIV system. As described by experts the primary drawbacks that occurred in this process are poor valuations of assets acquired against the credit instruments thus resulting in uncertain asset valuation & high credit risk exposure that couldn't detect the imperfections in the Credit Markets. Even the external rating agencies got trapped in this mirage and couldn't predict the Sub-Prime crisis because the Securitization Process was extremely complex and the dependency was upon scattered and unreliable data outside the core banking system. Moreover, the Bank's risk assessment didn't demonstrate due diligence in screening the sub-prime borrowers and informing the investors about the associated risks in the so called securitized products. The overall system expanded uncontrollably and the competition became very stringent resulting in loans getting sanctioned at the flash of light and there was no time for adequate risk management. The actual risks ware completely covered under hyped data and analytics about the new credit instruments which, frankly no one understood correctly - not even the external auditors and the statutory & governance system. To make the situation more worse, the securitization process gradually came out of the platter of mission critical processes of the banks and hence got outsourced to countries like India & Philippines without adequate control on how they were executed remotely [Schmitz, Michael. C and Forray, Susan J. pp28-30; Clerc, Laurent. 2008. pp1-4] In this paper, it is critically investigated if the auditing process could have alerted the world about the current financial crisis by looking beyond what was visible and specifically in-depth into the credit & risk management of banks & financial institutions. In this context, following is the research question: What should have been the role of auditors in bringing to table the underground issues that prevailed in banks and has led to the current financial crisis Could auditors have alerted the world much in advance and helped in preventing the world from the current looming banking crisis The author proposes to carry out critical review of literature and present the conclusions based on information & data gathered. The analysis shall be qualitative in nature given that the author shall focus on what and how. From the ethical perspective, the research shall be not be intended to criticise the auditing community but is targeted to bring to surface process and system level gaps that can help in improvements in auditing system and procedures. The objective of this research is to provide an academic baseline for researchers that can work on the findings further by carrying out in-depth industry surveys and then arrive at empirical generalizations that can be useful for both the academic world as well as the professional world. The Current Financial Crisis due to Sub-Prime Lending Sub-Prime lending is a process by which loans are approved for customers or companies not having regular source of income or having poor credit history. The original idea of sub-prime lending was to approve loans against better collaterals and to charge higher interest rates to such customers. The Risk Management of sub-prime cases was expected to be carried out more intensely compared to the cases of prime customers. The blame of the crisis is put on the over reliance on the Risk Management processes to develop risky products with higher returns whereby the risk management processes were not that matured to take care of the exposures. Sub-prime lending became popular in the housing mortgage markets because the additional collaterals were the houses mortgaged by Banks which were perceived as one of the most secured collaterals given the rising housing markets in the US and the UK. Moreover, the interest rates & fees for Mortgage Loans for Sub-Prime customers were higher than those for the customers with reliable track records. However, two negative phenomenons occurred almost simultaneously that seriously challenged the threat that might have been perceived of the rarest of rare case - the interest rates started to move upwards and the housing markets begin to crash. The interest rates increased gradually after 2003 in UK, 2004 in US and 2005 in Europe (see Figure 1) those made the sub-prime deals appear more lucrative for the banks and they indulged into the rush for lending to even the poorest of the customers to realise as much gain as possible. Figure 1: Interest rates increased drastically after 2005 in US, UK and Europe (www.marketoracle.co.uk/Article1694.html) A spurt of high risk products filled up the markets during this period and on the other hand the credit approval system also took new shape but neither the risk managers, nor the rating agencies nor did the Federal Government had any clues what exactly was happening. In fact the complexity of the new loan system was so complex that no-one could build the domain knowledge around the same. No one realized that the existing borrowers on the other hand that have their properties mortgaged & having adjustable interest rates are getting overstretched and gradually finding it unreasonable to repay loan against the properties that were getting devaluated gradually given that the property markets were crashing gradually. The author hereby presents the new loan approval process presented by a large Indian Outsourcing company named "Infosys" that were involved heavily in outsourced work of securitization and managing the process of SPVs, SIV and the so called "conduit" process: Figure 2: The new Loan Approval Process involving Securitization (Murali et al. 2008) Let us compare the new loan life cycle process of banks compared to the original loan life cycle. The original loan life cycle process was managed in-house completely thus requiring all the collaterals to be accounted in-house by banks and shown on the balance sheets of the bank thus allowing in-house risk assessment & monitoring of credit risks as well as liquidity risks. The traditional risk management process of credit risks & liquidity risks were very clear & tangible and based on loads of historical data and knowledge thus allowing the risk assessors to manage the exposures very confidently. All assessment factors were internal to the Bank and there were no factors that were impacting the internal risks of the Bank. The approach was cautious, data driven and analytics driven. However, the new loan life cycle process completely changed the world. The new modified loan life cycle process comprised of pooling of all loans into Special Purpose Vehicles and Special Investment Vehicles and then selling them as packaged products to external investors. The external investors were acquiring what was termed as "Collateralized Debt Obligations (CDOs)". The question is - why were the external investors interested in buying the CDOs This is because the banks had protected the investors through backup lines of credits and such other forms of guarantees. This means that the banks were never safe after selling the CDOs but presented a notion that the risk is transferred to investors thus keeping the CDOs out of the balance sheets. The money was perceived to be flowing through "conduits" directly from investors to borrowers. The risk of selling CDOs remained with the banks; rather exposed them to a new kind of risk "the CDO market risk" that the banks were never used to in the past. The risk assessment of CDOs assets required market risk assessment as well whereby the existing risk assessors didn't knew how to model this given that they were used to the traditional methodology of credit & liquidity risk management. Hence, the securitization process was never safe for the banks that made it even worse by outsourcing the same to countries like India and China where this process was not followed by the local banks and hence the entire domain knowledge of credits & derivatives was transferred from US. The CDO market grew substantially in a short span of time as presented in Figure 4 below: Figure 3: CDO Issuance rise (Source: http://subprimer.org/content/problem-shorting-mortgage-market) The rating agencies primarily focussed on market risks but didn't do well in assessing the credit and liquidity risks given that they did not possess adequate data for assessing the risks. The products were sold at such high pace that there was practically no time for them to look into the details of the risk assessments whereby the banks continued to trust their reports on the nature & sensitivity of the reports provided by the rating agencies. The complexity of valuation techniques resulted in considerable variation in fair value estimates whereby the process of "distributed transfer of risks" completely covered the actual root causes of the exposures. The actual exposures could have been detected but the new "unconventional" risk assessment processes and the backed databases had completely diverted the thought process of risk management experts. Thus it just turned out to be a large number of bubbles that had to be burst one day. The following chart shows a surge in increase of Piggy Back Loans that were offered to protect the investors of CDOs in the year 2003 to 2006: Figure 4: Growth of Piggyback loan that was one of the risky products offered as a part of CDO offerings (Office of Federal Housing Enterprise. 2008) [Murali and Srividhya et al. 2008. pp12-13; Clerc, Laurent. 2008. pp1-4] Piggy Back Loans are today perceived as one of the riskiest products that were offered to cover the exposures of the investors in the CDOs but were based on the overall formation of CDOs which again was so complex that the actual exposure was completely shielded. Such loans again gave the notion of double income for the banks - from the mortgaged loans and then from the SPVs. But no one realised what is funding these loans. These risky instruments with practically no collaterals were acquired through the Conduits by selling SPVs and SIVs and were actually backed by the Contingency Funds setup by bank to face liquidity risks. In fact the actual assets that were supporting this entire "virtual business system" were the mortgaged real state properties and perceived as safe. This is where the market risks, credit risks and liquidity risks required combined analysis that should had been carried out by the internal risk assessors with the help of external rating agencies. The home prices had already reached extremes letting the banks lending loans at premium prices and the borrowers signing loan agreements at much higher monthly mortgage payments. The increased home prices were due to speculations in the market and the gesture of the banks to lend mortgage loans rapidly. The prices couldn't be held at the extremes and they started reducing rapidly while in the mean time interest rates were growing. Hence, on one side borrowers were stretched with increased monthly mortgage payments and on the other side were squeezed due to reducing valuation of their properties. The justification of holding the loans couldn't continue for long and hence they started filing for mortgage insurance claims that was another risky product in this era. A large number of foreclosures occurred and borrowers lost their homes. But on the other hand the banks were left with huge pool of non-performing mortgages given that the home prices had reached the bottoms by this time. Reports revealed that a $500000 mortgaged property in 2005 was reduced to $300000 in 2008 at the time of foreclosure. As mentioned above, this was the only fundamental that was supporting the entire "virtual business system". Hence, the entire system collapsed and banks & financial companies were left with no cash to run operations because they had used even emergency funds to sell loan products and mortgage insurances claims caused the rest of stripping. Hence, this entire system collapsed as a result of serious credit & liquidity exposures which were caused due to market exposures. Millions of homes and other properties were left with the banks at rates much lesser than what they paid for through the mortgage system. This entire phenomenon led to the current Sub-Prime crisis that triggered a chain reaction resulting in an overall economic crash. The Federal Government showed gross negligence about this new loan cycle and the process of credit risk management and later fuelled the crash further by desperate bail-out attempts of banks that resulted in further loss of good money burnt in bad debts of the Banks. Also the banks did not raise timely alerts due to perception of losing reputation and indulged in hiding the information of the crisis till 2008 when all the bubbles had to burst automatically and the entire world witnessed the crisis. [Kneuer, Paul. 2008. pp11-12; Yuliya, Demyanyk. 2008. pp1] Credit and Liquidity Risk Management practiced by Banks - An Auditor's Perspective Having presented the sub-prime crisis in detail, the author hereby presents the procedure of banks in assessing credit risks and liquidity risks. This is presented herewith from the perspective of an auditor that views the system from outside. It is known that each bank follows their on Credit Approval System that is supported by underwriters tasked with evaluation of credit risks with the help of risk assessment team. The underwriters design the guidelines to assess the possible exposure for the bank when scrutinizing a loan application. The primary parameters need to be assessed during scrutiny of loan applications are defined by Basel-II that are: Loss Given Default (LGD), Exposure at Default (EAD), Probability of Default (PD) and Maturity (M). The Probability of Default can be assessed form the following information about the borrower and the general historical data available with the bank: (a) Credit history data of the borrower (b) Current & future ability to repay the interest & principal components of the loan (c) Sustainability of borrower's occupation (and other sources of income) (d) General economics of the region and the Nation as a whole (e) The history of defaults in the bank The Loss Given Default is related to the value & type of the collaterals that are taken into account during the loan approval process of the borrower. The collaterals acceptable by the bank are defined by the internal policies of the bank defined by the credit risk management function and the underwriters. [FMA. 2004. pp9-27] The loan application screening is an essential part of the loan approval process that is carried out by capturing relevant information & data populated in the loan application forms like age of applicant, income of applicant (or closest relative that may be working as guarantor), past employment history of the applicant, banking transactions of the applicant & guarantor of past few years, credit history of the loan applicant and the guarantor, length of time the loan applicant has stayed at an address of residence, the residence is self owned or rented, other loans & such liabilities held by the loan applicant, length of time the loan applicant has been serving the current organization, financial status of the current organization that she/he is serving, skill set of the loan applicant & its general demand in the industry (i.e., the probability of the applicant getting laid off her/his job, etc. These details are assigned weighting factors by virtue of an "internal risk rating system" of the bank that comprises of computerized risk assessment system supported by loads of historical data & analytics collated by the bank in its lifetime and from popular risk databases available in the industry. The system asks such questions about the loan applicant and the scrutinizer is required to answer the questions based on the information collected in the loan application form. Based on the information fed by the loan application scrutinizer the system either approves or rejects the loan application. If the system approves the loan automatically, then the processing of loan disbursal is triggered. However, if the system disapproves the loan then the system guides the scrutinizer by assigning reasons for rejection and guides on more information or data to be collected from the applicant. This entire computerized approval system is possible because the backend of the credit risk assessment systems of the banks are powered by loads of historical data & analytics thus supporting the decision making process through analytic capability developed over a number of years. [FMA. 2004. pp9-27] The key steps in this entire process are the applicant review, credit database review, collateral review and the corresponding Risk Assessment against the information collected from all these reviews. In Mortgage markets, the collaterals comprise of physical & tangible high value assets like homes, office buildings, plants, machineries, etc. that are mortgaged with the Bank against the Loan disbursal. In case of a default, the bank reserves the right to auction the physical & tangible assets and recover the amount owed to the bank by the borrower. Liquidity Risk Assessment is the other essential aspect of risk management framework of the banks. Liquidity is defined as the ability of the bank to meet the existing obligations, fund the increase of assets due to loan disbursements, absorb the losses incurred from non-performing assets and protect the bank from incurring of unplanned/unacceptable losses. Liquidity Risk Management is carried out by maintaining cash reserves internally as well as with the central banks of respective countries. These mechanisms are defined in detail by the Basel Committee on Banking Supervision (BCBS. 2008. pp3-5) that published 17 principles of Liquidity Risk management pertaining to: 1. Bank's accountability: Every bank is supposed to own accountability of their liquidity risks - the government or central banks can only help by maintaining cash reserves on behalf of them as per the regulatory requirements. 2. Clear articulation of liquidity risk tolerance: Every bank is supposed to clearly articulate their tolerance limits of liquidity risk (and obviously stretch within the limits) 3. Strategies, policies & practices to manage liquidity risk: The banks are expected to define their strategies, policies & practices of managing liquidity risk and ensure internal governance for compliance against them. 4. Incorporation of liquidity costs, benefits & risks in product pricings: The banks are expected to include the overall cost of liquidity risk management in the product pricings. 5. Identifying, measuring, monitoring & controlling liquidity risk: The bank should have proven and effective risk management tools & specialist people to identify, measure, monitor and control liquidity risks. 6. Management of liquidity risk exposures: The banks are supposed to establish effective mechanisms to manage their exposures against liquidity risks (and credit risks in the bigger picture) 7. Pre-established funding strategies: The banks are supposed to possess internal strategies for all funding requirements - loans, running costs, liabilities like savings accounts, fixed deposits, business accounts, etc. 8. Management of intraday liquidity positioning & risks: The banks are supposed to carry intraday liquidity risks & positioning on a daily basis. 9. Management of collateral positions: The banks are supposed to continuously assess the valuations of their collaterals and manage them effectively. 10. Conducting regular stress tests: The banks should periodically carry out stress testing to assess liquidity positioning against predefined exposures. 11. Formal contingency funding plan: Every bank is expected to have formal contingency funding plans 12. Insurance against liquidity stress scenarios: Banks should consider buying insurance against liquidity stress scenarios. 13. Regular public disclosure about soundness of liquidity position: Every bank should regularly disclose to the general public about their liquidity position. 14. Regular assessment of the overall liquidity risk management framework: The banks should regularly assess the internal framework that they use for liquidity risk management. 15. Monitoring of internal reports, prudential reports & market information: The banks are required to monitor all internal reports and compare with the information in the markets. 16. Timely intervention & timely remedial action: The banks should be prepared to timely intervene whenever problems are perceived and take remedial actions. Also, the banks are supposed to prepare and test emergency response and crisis management plans. 17. Regular internal communication as well as with public authorities: The banks should ensure that the liquidity position and risks should be communicated regularly internally as well as with public authorities. Conclusion: Should the auditing process have alerted the world about the current financial crisis The author hereby concludes that the current economic crisis is clearly due to inadequate & lack of collaborative risk management having myopic views into credit risks, liquidity risks and market risks in isolation. The older mechanism of loan life cycle management and the corresponding risk management were carried out with the help of internal historical data available with the banks that is having direct link with the internal economics & dynamics, financial position of buyers, internal cash flows, internal cash reserves and the reserves with central banks, stress tolerance, etc. These factors are clearly visible to the banks and hence risk management is very effective given that the risk assessors have support from historical data as well. The new loan cycle management system was never understood adequately by the risk management experts and the rush in markets to sell products didn't allow enough time to redesign their assessment strategies. Moreover, the fundamentals of the SPVs, SIVs and Conduits were lying outside the banking system whereby their reliability was a big question mark. The CDOs were kept outside the balance sheets with the perception that the money has transferred to the borrowers through conduits and hence the bank didn't spend money on them. This resulted in false liquidity assessments with the bank. Lastly, the exposure to market risks occurred automatically in this phenomenon that otherwise would never had happened to the traditional credit & liquidity management procedures. Hence, overall the system had already failed and was just waiting for the crisis situation to happen. These gaps apparently appear difficult for auditors but if they had targeted to audit the risk management of the banks collaboratively, it was not very difficult for them to detect the anomalies much ahead of this crisis. The focus of the auditing should have been the following: In-depth understanding of the legal & regulatory framework of the Bank from the perspective of the Board, the operations management team and the internal risk management team. In depth Assessment of the documents & records of the Bank pertaining to Statutory and Basel compliance and assess the non-compliances keeping the liquidity & credit position in view. For example, the aggressive mode of investing contingency funds could have been easily discovered by the Banks. In depth assessment of balance sheets, operating expenses, income statements, profit before & after tax payments, collaterals, assets & liabilities held by the bank, cash flows, cash & equivalent reserves, loans & advances to the customers, non-performing assets, and any other area that may be useful in identification of anomalies during the audit process. The audit should have been carried out in full on all the accounting statements and balance sheets. Critical parts of the statements pertaining to credits & liquidities should have been sampled carefully to assess compliance to internal risk management & regulatory procedures by the government & central banks. If non-compliances were evident then the auditors should have increased the sample sizes at the relevant areas. The Risk Management System of the Bank should have been assessed much in detail and all the identified risks should have been analyzed with respect to the threats & vulnerabilities (internal & market exposures) and criticality at which the risks are logged. The risk management of material misstatements in the accounting statements should have been given special emphasis as per applicable standards [for example, material statements can be assessed in accordance with ISA (UK and Ireland) 315]. In addition the auditors should have assessed the mitigation actions much in detail against the risks identified internally as well as by external consultants. If the risk assessment, application of controls & risk mitigation actions are perceived by auditors to be insufficient, the auditors have full rights to enhance the audit scope & carry out more detailed assessments of the overall risk management system. ISA (UK and Ireland) 330 has articulated this right of the auditors pertaining to the risks of material misstatement in accounting statements. The Loans & Advances to Customers should have been sampled more effectively and some loan approval cases (especially the sub-prime customers) should have been analyzed much in detail. The liabilities of the Bank totals (customer accounts, customer deposits, insurance policies, etc.), debt securities and the cash reserves should have been compared intelligently and the liquidity risk situation should have been analyzed effectively. The auditors have all the rights to question misuse of contingency funds for wrong reasons and alert the internal management of the bank. When the property markets started crashing significantly, the auditors should have focussed in-depth on the property mortgages held by the banks and reported the risk of foreclosures. The auditors should have asked for in-depth information about derivative assets and investment securities to verify how the securitization was carried out given that the sub-prime loan liabilities were disappearing from the balance sheets thus inflating the accounting statements giving wrong notions to the world that the banks are earning good revenues and profits. The collaterals pertaining to international customers (that are not natives of the country) should have been assessed more deeply by the auditors. Overall, the auditors should have asked for detailed evidences against the cash flow statements, loan approval process, non-performing assets, securitization process, mortgage process, and the process of accounting collaterals of non-UK residents. The above list presents a list of "should haves" that the auditors were required to take care of and it appears that by smart auditing and comparing various data elements, it was not difficult for the auditors to foresee the financial crisis and alert the banks about the same. As a matter of fact, given the competencies of auditors in US, UK and Europe, it is highly unlikely that these basics wouldn't have been taken care of. However, one more question arises is that was it feasible for the auditors to report these anomalies to the central banks, government and above all, the general public The job of the auditors is to report all such detected gaps to the board of directors on banks and it was the responsibility of the board to inform the anomalies to larger groups, the government and to the central banks. The auditors are not supposed to submit the reports to the government or central banks unless they are asked for it or else they witness clear evidences of fraud or foul play by the board of directors of the banks & financial institutions. In this entire episode, the intent was not the problem anywhere. The banks wanted to make maximum money which is feasible from their perspective. If they were successful doing so, no one would have questioned them and the author wouldn't have been writing this paper. It is just a system failure and the auditors must have reported the flaws from the perspective of individual banks to their board of directors. The board of the banks however were responsible for reporting to the world and if they confirm that they have done it already, the auditors wouldn't question them. Hence, auditors must have done their job already and it is unfair to expect that they are the ones to be blamed because they could have alerted the world. They did their job up to the communication channels accessible to them and it was the job of the board of directors of banks and the government to take further remedial actions. In practical world, the auditors cannot stand against the Fred Goodwin's of the banking world - they have their own limits. Reference List: Credit Approval Process and Credit Risk Management. Financial Market Authority (FMA). 2004. pp9-27. Clerc, Laurent. (2008). A Primer on the Sub-Prime crisis. Financial Stability Directorate. Occasional Papers - Banque De France. pp1-4. Kneuer, Paul. (2008). Bubbles, Cycles and Insurer's ERM - What Just Happened. Risk Management - The Current Financial Crisis, Lessons Learnt and Future Implications. Presented by Society of Actuaries, The Casualty Actuarial Society and The Canadian Institute of Actuaries. pp11-12. Murali, Thadi and Muralikrishnan, Srividhya et al. (2008). Sub Prime Crisis and Credit Risk Measurement: Lessons Learnt. Infosys Technologies Limited. pp12-13. Principles for Sound Liquidity Risk Management and Supervision. Basel Committee on Banking Supervision. Bank for International Settlements. 2008. pp3-5. Schmitz, Michael. C and Forray, Susan J. (2008). The Democratization of Risk Management. Risk Management - The Current Financial Crisis, Lessons Learnt and Future Implications. Presented by Society of Actuaries, The Casualty Actuarial Society and The Canadian Institute of Actuaries. pp28-30. Yuliya, Demyanyk. (2008). Did Credit Scores Predict the Sub-Prime Crisis. Federal Reserve Bank of St. Louis. Proquest Information and Learning. Published at The Regional Economist. 2008. pp1. End of Document Read More