Risk Management for Finance Sector Enterprises - Essay Example

? Risk Management for Finance Sector Enterprises Question Barings Bank has remained one of the oldest mercantile banks in UK until its downfall in February 26, 1995. The measurement and management of risk is what stands as a major challenge for today’s financial sector, and failure to properly handle this can entail disasters, as happened in this case. The main cause of the downfall of Baring Bank in the unfair practices of one of its dealers named Nick Leeson who misappropriated funds to the tune of “1.4 billion” (Barings Bank and Nick Leeson n.d., p. 1). Barings Bank has faced several market risks including concentration of power in a single hand, monitoring of the daily activities, funding allocation, hedging of the position of the bank in the market and checking of the closing position and trading limits. (Article called Barings Bank and Nick Leeson) These risks affected the Bank after the merging of banking and securities business. The failure to manage these risks appropriately lasted to the collapse of the bank. “The failure of Barnings in early 1995 and the circumstances surrounding the discovery of large trading losses at Daiwa in New York in that year, as well as the more recent experiences of losses at Sumitomo, show that risk management must be made  to work in practice as well as theory” (Managing Market Risk in Banks 1996, p. 6). The circumstances that led to the collapse of Barings bank are mainly the failure in managing the market risks. The power to manage the activities of the bank in Singapore has remained concentrated in the hands of Nick Leeson, who worked in the Singapore stock market and was able to deal from both sides. Leeson appointed only few staffs in his office at Singapore due to the fact that it will offer him the leeway for making the forgery. With this motive in mind, he projected a false impression of the market situation by the use of cross-trade technique and created a profit of 50% during 1994. He started the forgery by creating to a false account and by the end of 1994 the actual state of affairs came into notice and the bank authorities realized that they have sustained a loss of “$296 million” (Yeung et al. n.d.). By 1995, the collapse occurred with its full impact. Market risk of the financial sector enterprises may arise from variations in market prices, consisting of alternative volatilities, change in interest rates, product costs and foreign exchange rates. Generally, the higher the cost volatility in any marketplace the greater the possible markets risk. According to Richard J. Herring in his article called BCCI & Barings: Bank Resolutions Complicated by Fraud and Global Corporate Structure, talks about the Leeson’s intention of defrauding the bank. He says that his intention (Herring n.d.) has become successful mainly due to the lack of monitoring of the daily internal activities. The bank over relied on its staffs and gave them freedom which enabled Leeson to misappropriate the money. An internal assessment of the Bank would have prevented the possibility of manipulation and the subsequent collapse. Inadequate allocation of funds was another failure in managing the market risk and this encouraged Leeson to continue his corruption. Adequate hedging the position was another market risk faced by the bank and it utterly failed in managing this risk. The position of Barings Bank in the stock market was also manipulated in the beginning of 1994, which prevented the bank from taking necessary action. The final market risk faced by the bank was the checking of the closing position and trading limits. The management of the dealings in stock market and of the dealing limits is an important function of a bank. However, the bank failed to manage this risk as Leeson controlled the activities of the bank in the stock market and the bank relied blindly on him. Thus, Barings Bank finally bore the brunt in terms of its eventual collapse. Due to the unsuccessful management of risks relating to internal controls, an employee of the bank was able to tamper with the bank accounts and thereby carried out the process of forging, which resulted in the collapse of the bank. Inadequate allocation of funds, mainly due to lack of knowledge about the market, and the credit risk was accompanied by a fall in the market price of the bank’s shares. Poor monitoring of the closing position of the bank in the stock market prevented it from realizing the upcoming threats. In short, the internal control deficiencies and failure in managing risk had a great impact on the bank, which eventually led to its collapse. (Managing internal audit conflicts by Robert D. Allen) Besides market risks, other risks which contributed to the collapse of Barings Bank were financial risk, interest rate risk and other generic risk faced by the institution. The financial risk is mainly associated with share market and it arises while trading in share market. The financial risk mainly consists of derivative risk and equity risk. In the case of Barings Bank, the derivative and equity risk came into being mainly due to the lack of knowledge about the market dealings. The most significant general risk faced by Barings bank was the “earthquake in Kobe” (Chua-Eoan 1995). The enduring task of the bank’s administration system as well as its supervisors is to guarantee that the implicated risk management actions are prepared to compensate for insufficiencies and act spontaneously to rectify any existing risk.  Question 2 a. Explain how Credit Rating Agencies (CRAs) created risks relating to sub-prime home loans in the US that contributed to the global financial crisis.       Credit rating agencies (CRAs) perform an important intermediary function in the global financial market. A Credit rating agency is a company that assigns credit ratings for issuers who provide or issue debt obligations and debt instruments. Moody’s Investor Service, Fitch Ratings and Standard & Poor’s are the three major credit rating agencies. These agencies played a very crucial role in the origin and spreading of the sub prime crisis. The report from Financial Crisis Inquiry Commission stated that the key enablers behind the global financial crisis were these three credit rating agencies. According to the report, the unlimited marketing and sales of the mortgage-related securities at the time of crisis would not have done without the approval of these credit rating agencies. As a matter of fact investors as well as borrowers and banks who relied and used the rating blindly were badly affected, which only added to atrocities of the crisis.          The credit rating agencies failed to respond to the new phenomenon in the financial market. These big agencies reacted to the crisis by downgrading a few hundred securities in July 2007. But by then, the plight had started to spread and it became uncontrollable. b. On 15 December 2009 the National Consumer Credit Protection Act 2009 (Cth) came into law, and required that CRAs should hold an Australian Financial Services License (AFSL). Describe two ways in which this requirement will reduce credit risk for finance sector enterprises. After the global financial crisis, a law was passed in Australia, which made necessary for the CRAs to hold the AFSL to function in the country. The act may help in reducing credit risk in different ways. This law gave ASIC direct supervision of the adequacy of the assets of CRAs. One of the biggest advantages is that credit quality of assets gets ensured through the licensing process. The ratings of all licensed CRAs will be viewed and recognized by the Australian Ratings based on the equivalency scale. In the case of multiple CRAs, the suitability of the rating to a security is determined using the median of ratings.       Secondly, credit risk can be reduced through Australian Securities and Investments Commission (ASIC) by imposing conditions that apply specifically to CRAs. The credit risk can be mitigated through diversification process. The law gives ASIC the right to look across the portfolio with a view to measure risk from industry, risk due to geographic factors or other correlated risks. Therefore, the ASIC can reduce credit risk faced by the investors and enterprises as it has the right to impose circumstances specific to CRAs in favor of the investors. Question 3 A detailed analysis of the potential corporate and sovereign risks associated with the two investment alternatives can be evaluated by analyzing the following questions and answers. There are two types of borrowers, namely: 1) Corporate borrower and 2) Sovereign borrower a) Two factors to assess the creditworthiness of a corporate borrower There are a number of factors used to assess the creditworthiness of a corporate borrower, such as the degree of collateral and liquidity in the organization, the conversion rates of accounts receivables into liquid form like cash and the relative liquidity, which is found out by calculating the proportion of current assets and liabilities. The two important factors to assess the creditworthiness of a corporate borrower are the subsistence and the amount of liquidity and collateral that is available in the business. The balance sheet of the firm is a documentary proof of the two conditions that test the creditworthiness of the borrowers, like the collateral and the liquidity of the firm. Collateral assets- these are mainly the assets that the firm owns and is guaranteed to the lender in return for providing a credit. The amount of collateral assets that the firm has determines the amount which can be borrowed by the firm. A corporate borrower is assessed in terms of his ability to repay the debt which is adjudged by the collateral assets that is owned by the corporate borrower. Liquidity – the lenders are always concerned over whether the borrowers will be able to pay within the stipulated time or not. Liquidity means the availability of cash in liquid form used to pay off the debts. For a corporate borrower, liquidity is very important because if a firm has strong liquidity then it can pay off its debts quickly. b) The two factors to assess the creditworthiness of a sovereign borrower When government is the borrower then its creditworthiness can be assessed through sovereign risk. Sovereign risk is of two types, that is, economic and political risks. The economic risk factor includes factors like price stability, the economic growth prospects of the country, the fiscal flexibility etc. while the political risk factor includes the degree of political consensus in the state, the internal as well as the external security risk associated with the organization. There are a number of factors to assess the creditworthiness of a sovereign borrower or the firm that is borrowing. This creditworthiness depends upon not only the borrower’s ability to pay, but also his willingness to pay. Economic development – the economic development of a country is calculated by its Gross Domestic Product (GDP). The GDP of a country has a negative relation to the country’s default risk, which is because a country that has high GDP is bound to pay off its debts quickly, whereas a country with a low GDP will be able to settle off its debts taking more time. The degree of political consensus – the degree of political consensus in the state is one of the important factors that determine the creditworthiness of a sovereign borrower. A politically stable country can pay off its debts quicker and in an easier way as when compared to a firm with an unstable political condition. “sovereign nations rarely come with security” (Risk Management for Finance Sector Enterprises 2011, p. 132 sec. 6.14) Sovereign debts have uncertainty associated with them with respect to political instability in the nation. c) An example of the default of a sovereign borrower The assets of the firm serve as collateral for its debts. When a corporate house defaults on its debts then its creditors can ask for liquidation of the business in order to pay off those debts. There are many examples of how countries, due to the latest economic recession, have fallen prey to defaults as sovereign borrowers. A very significant example of a country that faced enormous credit default is North Korea, which had defaulted on some of its loans in 1987. Similarly, in one of the recent cases, Argentina defaulted on its debt payment to the World Bank for an amount of $ 1 billion. d) An example of the default of a corporate borrower There have been many examples of default corporate borrowers but one of the latest, which has splurged the economic recession of 2007, was the credit default swaps associated with the Merrill and Lynch firm in 2008. Merrill and Lynch were sued by a number of firms to whom they had to pay, that is, from whom they had borrowed. The firm, due to the borrowing pressure, had to go into liquidation in order to partially pay off its debts. e) Recommendations and their reasons It is recommended that the firm invest in a private institution rather than going for a sovereign debt in Sweden, which is because a corporate firm can pay off its debt by going into liquidation. This can be enforced on the firm from court pressures too, but, it is not so in the case of a sovereign debt. A sovereign debt is not secured by specific collateral, but by the penalties that creditors may impose on defaulting debtors, which is in the form of a country’s reduced access in the worldwide economic system. Sovereign debtors keep a high fraction of their income when they default and they cannot be forced to sacrifice their control like in the case of corporate borrowers. The negotiation position of sovereign debtors is better than the latter. “The sovereigns are more vulnerable than corporations to capital flight, exchange rate and banking crises. It is these risks, more than creditors’ debt collection efforts that threaten the going-concern value of the sovereign” (Calvo et al. 2003, p.58). Considering a corporate borrower, there is no special body like IMF to postpone or restructure debt by special granting programs. The IMF has information about the creditworthiness of the sovereign and, therefore, it can avoid or postpone debt restructuring. Question 4 a. (i) Analyze the payment process in the given chart and identify six ways in which internal fraud can be committed.       Internal fraud is an act by the employee to deceive or cheat the employer, in terms of achieving various goals. It could be committed in each and every stage of this payment process in different ways. Some of the possibilities are as follows: 1. False or manipulated invoice of services or transactions can be submitted and with the cooperation of other employees, the act of fraud can be carried out as the copy of invoice is not actually requested from the supplier. 2. In the process of scanning invoice, possibility of occurrence of fraud is high. In this case, the need of scanning automatically increases the chances of fraudulent practices. 3. Raising and authorization of purchase order can be manipulated in order to make it seem balanced with the invoice. 4. Fraud also takes place if the invoice is created as an exact match of the purchase order. 5. Showing more number of cheques than really required can also lay foundation for frauds. 6. In the process of signing checks, the fraudulent act of using fake signatures can fool anyone. (ii) Describe six mechanisms that could be put in place to prevent the potential for fraud you identified in part (i).       The mechanisms to prevent the possibility of fraud are different in the case of internal and external frauds. In this case, the mechanisms to check the potential for fraud can be identified as follows: 1. Provision for receipts and acknowledgment of transactions should be made compulsory. 2. To avoid fraud at the stage of scanning of invoice, a regular and random auditing of all the stages should be conducted with the help of an efficient auditing department. 3. For avoiding the wrongdoing with contents of the register, the registers should be kept closed unless in use. 4. To prevent fraudulent acts in the case of overpayment, the wages and salaries as well as the allowances paid by the organization should be randomly checked. 5. For preventing the case of showing increased number of checks, the floating of money should be pre-determined. 6. The problem of fake signatures on checks can be solved by using the process of dual signature. b. Document a SWOT analysis for a financial services enterprise (or a department within one) that you are familiar with. Each quadrant should contain at least three (3) points. Present your answer in the table format as shown below. Note: State the type of enterprise (or department) that your analysis relates to. You do not need to name the company.       The SWOT analysis is of a financial service enterprise, which is a public bank with many branches in several locations. Strengths The strong network of regional and international correspondent. Approval of loans is faster. Highly improved technology helps in the smooth functioning of customer service from any point within the state. Weakness Lack of experienced and technically able staff in comparison to our competitors mainly as a result of poor customer mix. Reliable on competitors to conduct its foreign exchange business. Competitors to stay buoyant because of strong research department and qualified staff. Opportunities The modern technology opened opportunity to improve the bank’s international business. New areas of investment opened up as a result of improvement and development of various industries. A strong workforce to make the industry rise to the top. Threats Customers prefer to deal with other bank mainly because of the local status of our bank. Competition with other banks and financial institutions. The terrorist attack has resulted in a setback in the tourism industry and thereby affected the business of the bank. c. For one of the quadrants in part (b) above, explain any three points in detail. 1. In the case of foreign exchange business, the relationship with regional and international correspondents has given the bank an advantageous position. 2. The local board helps in a faster approval of loans, which would prove to be beneficial for the bank. 3. The better network of branches and other outlets together with the accessibility of the computer mainframe from all branches helps to provide better customer service from any part of the state. Question 5: The legal and reputational consequences of the failure of Opes Prime stock broking (including the effects on ANZ and Merrill Lynch): Opes prime stock broking ltd providing equity financing services and securities lending to sophisticated market players, as well as fund managers, other stock brokers, individuals and corporations. Opes prime has offices in Singapore, Melbourne and Sidney. The main reason for the collapse of the Opes Prime Stock Broking is decrease in share prices. “The company's downfall was revealed on March 28, 2008 when the Australian Securities and Investment Commission (ASIC) announced it was launching an investigation into Opes Prime Stock broking, and that the company had gone into administrative receivership the previous day, with Deloitte Touche Tohmatsu appointed as receivers and Ferrier Hodgson as administrators. Opes Prime's secured debt is believed to be over AU$1 billion, with its major secured creditors including the ANZ Banking Group (owed around $650 million), and Merrill Lynch” (Opes Prime 2008, par. 2). Legal and reputational effects of the breakdown of Opes Prime stock broking consists company financial losses, the adequacy and accuracy of disclosure, impact of consumers and APRA or ASIC and government effects for the organization. “Reputation is the faith that those who contract with a group have in that group. Faith, as in all parts of life, takes a long time to develop and strengthen. It can be ruined with a single action. There are several factors that relate to reputational risk. These comprise the diversity of risk groups to be handled, the crash on persons and the elements of globalization” (Risk Management for Finance Sector Enterprises 2011). According to Robert W. Kolb in his book called ‘lessons from the financial crisis, consequences and our economic future’ says that troubles with investor protection arrangements and margin lending were tainted by the collapse of the stock broking firm Opes prime, whose margin loan consumers misplaced title to their reserves, and whose breakdown reasoned important reputational damage to the main banks giving its funding. Major Banks again endured reputation damage due to their funding planning with the company. (Kolb 2010, p. 539). Movements of share market let to decrease in share prices. This brought about instability in the share price of the bank. This is also effected the ANZ and Merrill Lynch financial transactions. Opes prime stock broking transactions offered customers a service for margin investment. Clients positioned their shares with Opes prime as safety for a loan with which to invest for additional shares in the market. At times when the share prices of these fresh shares went up, the cost of savings augmented. When the share market fell, savers were called upon to give further funds to cover the margin among the earlier price of the shares and the recent value. The adequacy of financial statement means that the financial statement should be complete. Some companies represent their annual accounts in the form of only balance sheet or profit and loss account statement. But these financial statements like cash flow statement, fund flow statement, director’s report and proper assumptions that a firm has taken while preparing the financial accounts should be disclosed. According to the article called ‘how does the stock market affect the economy’ published in the journal Economics says that, (How Does the Stock Market Effect The Economy? n.d.). The major financial influences of consumers in Opes prime stock broking are wealth effect, which includes effect on pensions. This effect causes consumers with shares to observe a drop in their wealth. If the drop is important, it will affect their economic outlook. If they lose cash on shares, they become more hesitant to use money; this can lead to a drop in consumer spending. Effect on pensions is another impact of consumers in stock broking. Pension funds invest an important division of the resources on the stock market. So, if there is a serious drop in share prices, it results in reduction in the price of pension funds. It also affects the consumers of the company’s financial position. Financial and Banking industries are subject to rule by the Australian Prudential Regulation Authority. It ensures that all financial and banking institutions, categorized as sanctioned deposit-taking organizations. ASIC noted that the equity financing business and securities lending managed by Opes Prime was founded on a model utilized in the wholesale market in which the members are more complicated and have a clear understanding of their privileges and obligations. ASIC assumed the Opes Prime production model may have been a MIS as it involved: The provisions of stock lending services and equity finance to investors. The aggregation of securities and cash acquired from investors. Collateral is acquired in the wholesale market with special orientation on the pool of assets for the purpose of investors. ASIC’s learnt into the Opes Prime business model considered two issues. The first being whether both Merrill Lynch and ANZ had real knowledge of Opes Prime’s potential flouting of the provisions about the business of unregistered methods and the second being whether the MIS could have operated without the contribution of Merrill Lynch and ANZ. ASIC understood that by bringing this claim, if it succeeded, would have the potential to give payment for the shareholders. ASIC also identified that there was a public importance in testing the handled savings scheme condition, which gave authorized securities to retail shareholders, where a wholesale manufactured goods was bought or sold into the retail market by them. ASIC made it clear that the shortages influenced ANZ’s ability to meet its requirements as an Australian monetary facility licensee under the Act. ANZ Nominees Ltd, an authorized representative and a totally owned subsidiary of ANZ, owns assets on behalf of ANZ and its customers, is also a party to the enforceable undertaking. ASIC has moved quickly since the downfall of Opes Prime stock broking in March 2008 and this in huge assess has been due to its fresh approach and possessions dedicated to many important examinations and its preparedness to use all regulatory implements at its disposal. Consumers are the main part of all profit making organizations and it is evident that every stock broking company makes its profits with the help of its consumers. The impact on consumers is one of the main points of failure of the Opes Prime Group Ltd .It is very complex to understand the main reasons of failure and the important effects it has on unsecured creditors. Conclusion: This essay provides legal and reputational consequences of the failure of Opes prime stock broking. The causes for the collapse of Opes Prime stock broking and the important result on unsecured creditors are contested and difficult. Increasing numbers of company and economic Slow Down and possessions developer breakdowns were reasoning bank loan losses to increase. The legal and reputational consequences of the failure of Opes prime stock broking exposed corporate financial losses, crash on customers and resulted in the reputational damage to the organization and the activities of APRA or ASIC and the government, with consequences for the related people as well as the organization. Question 6. a) 1) Basel III is a newly adopted standard on capital adequacy and liquidity, which was agreed upon by the Basel committee. The Basel III strengthens the requirements of bank capital and liquidity. The summary of proposed change in Basel III is in terms of reliability, quality and clearness of the capital basis. It also requires that the risk coverage of the capital framework is to be strengthened further. One of the important proposed changes in the Basel III committee report is to introduce such a leverage ratio, which would prove to be a supplementary measure as stated in the Basel II risk based framework. 2) The Australian financial system consists of commercial banks and a large number of financial intermediaries. The proposed changes in Basel III will reduce risks in the Australian banking system with respect to quality, consistency and transparency in the capital base. After adopting the Basel III committee, the Australian banking system will be strengthened even more. The banking systems will become more liquid with the adoption of these newly taken up policies. b) 1) The operational risk regulatory capital for retail banking can be calculated by first finding out the final six successive half yearly balances of advances for the business and total gross outstanding loans and then multiplying it by 3.5 % of the advances at remark point and total gross outstanding loans by a factor of 12% and finally determining an average result. =27954+28687+32217+21629+29539+28425 = 168451 = 168451*3.5%*15% = 884.36 = 884.36 / 6 = 147.3. = 18406+16218+17050+19693+21032+19841 = 112240 The ORRC for commercial banking can be calculated by taking last consecutive 6 half yearly balances of outstanding loans and advances and then multiplying it by 3.5% at the remark point by an aspect of 15% to produce a result for each observation and then determine the average result. = 112240*3.5%*15% = 589.26 = 589.26 / 6 = 98.2. The ORCC for all other business line is calculated by taking the last 6 half yearly amounts of gross income earned over a span of six months and then multiplying it by 18% so as to determine an average full year result. = 2014+2808+2363+2742-729+1521 = 10719 = 10719 * 18% = 1929.42 = 643.1 2) The risk weightage for assets is zero while for loans, it is found to be 100%. Question 7 a) Mention any four weaknesses involved with bank approaches to stress testing: Stress testing is a tool that enhances risk management and its efficiency has been highlighted during the period of economic and financial crisis. Stress testing plays an important role in the credit crisis and the financial meltdown, which usually results in economic recessions. The four weaknesses involved in several bank approaches to stress testing are as follows: Stress testing practices are necessary in banks as “the stress testing procedure is a part of capital adequacy assessment and planning process within a bank” (Oracle Is The Information Company 2009, p. 2). It is often difficult for banks to determine their capital adequacy rate and this needs continuous assessment. In such a condition, it becomes a weakness for banks to implement stress testing techniques. Stress tests were carried out by detached units, which focused on particular business lines or risk types that led to organizational barriers. Stress testing frameworks, especially, were not flexible enough to respond quickly during the period of crisis. The methodologies, which were used in conducting stress tests were complex as well as sensitive and, therefore, it was difficult to make an appropriate conclusion. b) Two ways that can help banks to improve their approach to stress testing: Banks should adopt stress tests so that they capture the extreme and appropriate present market events that are needed for various analyses. Particular risks should be covered in detail so that the stress test becomes specific, in order to make the risk management more efficient. Reference List Barings Bank and Nick Leeson. n.d. Available at Calvo, et al. 2003, IMF Third Annual Research Conference. International Monetary Fund: ISBN. Available at Chua-Eoan, H. 1995, Crimes of the Century: The Collapse of Barings Bank. Available at Herring, RJ. n.d. BCCI & Barings: Bank Resolutions Complicated by Fraud and Global Corporate Structure. Available at How Does the Stock Market Effect The Economy?. n.d. Economics Blog. Available at http://www.economicshelp.org/blog/stock-market/how-does-the-stock-market-effect-the-economy/ Kolb, RW. 2010. Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future. John Wiley & Sons Inc. Available at Managing Market Risk in Banks. 1996. Reserve Bank of Australia Bulletin. Available at Oracle Is The Information Company. 2009. Oracle and/or its affiliates. Available at Opes Prime. 2008. eNotes.com. Available at Risk Management for Finance Sector Enterprises. 2011. Kaplan Higher Education. Print. Yeung et al. n.d. The Collapse of Barings. Finance 443: International Finance. Available at Read More