Causes of the Financial Crisis and Do Credit Derivatives Increase Bank Risk - Research Paper Example

?Credit and Market Risk Introduction The 2008 financial crisis is responsible for bankruptcy and closedown of various reputed companies. The developed nations were the major victims. Basel II set for banking supervision has been blamed for occurrence of such a crisis. Criticisms have been against Basel II and its inability to set required standards for banking sectors globally (Lall, 2009). The long drafting process that has been adopted by Basel II has failed in managing risks and has such an inability has led to financial crisis with increased risks (Cornford, 2010). Failure of Basel II was claimed chiefly due to maintenance of inappropriate standards for the banking sector as a whole. It failed to bring about strict regulatory control and hence most of the international banks were able to mould the rules in accordance to their interests. Basel II was absolutely a failure in terms of financial stability (Lall, 2009). The main culprit of financial crisis has been the risks. Banks indulged themselves in various activities of capital markets without having sufficient capital to do so. Linking of Variable Interest Entities (VIE) with banks was completely absent for capital regulations under Basel II (Blundell-Wignall and Atkinson, 2010). The Basel II regulations were unable to trace out this integration between market and credit risk that led to liquidity reduction. More significant regulations were required for liquidity management. This increased risks and capital market activities of banks led to significant reduction of liquidity (Madigan, 2010) .This made the drafters and regulators introduce Basel III which was expected to bring about stricter regulation across the banking sector by setting higher capital standards and requiring the international banking system to maintain a higher amount of minimal capital ratios. Overall liquidity requirements experienced a hike under Basel III. These reforms were made to achieve upgradation in the standards of international banking system through better management of liquidity and infrastructure (Basel III- What is it? How will it concern you?, n.d). Thus integration of markets and credit risks and failure of Basel II for banking supervision were the major causes for financial crisis. The current paper tends to address this issue through various findings. The financial crisis had been the major cause of homelessness and unemployment particularly for the world’s major economies. The financial crisis became a concern for regulators and they began to alter rules and regulations under Basel II. The need for better risk management and liquidity management had forced the regulators to introduce Basel III, stricter guidelines in order to set up a crisis resistant international banking system and plug in the loopholes of previous banking supervision regulations that had led to the crisis. Credit risks Financial management is concerned with increasing rates of return for a specified exposure to risks. For tracing out the magnitude of credit risk an individual should refer to the asset involved which is termed as credit risky (Banks, Glantz and Siegel, 2007, p.17). The financial crisis had already proved that increased risks on credit for asset portfolios had dragged the banks towards bankruptcy. The move towards securitization of markets proved o be wrong. This is because it harmed consumers’ protection in loan market although they were over extended (Kiff and Mills, 2007). When risks, both idiosyncratic and for sectoral factors are imperfectly diversified, it gives less support to capital computations under approaches related to IRB. Presence of immense concentration of risks may violate The Asymptotic Single risk factor model. The previous credit risk measures were unable to perform full synchronization of underlying default risks to all the sectors of business which led to diversion from elementary IRB model for risk management. Post crisis computation of credit risks for portfolios related to credit has been termed extremely important to detect the link between banks and the asset markets (Studies on Credit Risk Concentration, 2006). The recent years had seen a considerable increase in credit risk transfer particularly adopting the form of credit derivatives (Credit Risk Transfer, 2004). Only with sufficient knowledge of credit risks the credit derivatives can be effectively used to minimize underlying risks. Banks have also instructed usage of credit derivative instruments only for those organizations that has the ability to realize and manage credit and its underlying risks. It has been seen that banks were facing problems to manage risks with old credit risk measures mainly because of poor management of credit portfolios and negligible standards of credit. These credit measures have also ignored those economic conditions that led to decline of credit abilities of the banking system (Banks, Glantz and Siegel, 2007, p.17). The credit measures of banks have failed largely primarily due to insufficient credit information. Lack of access to information made the situation worse for banks because it had to model those events of credit that were totally unobservable. This made clear understanding of risks and thereby its mitigation really problematic. Missing data had mainly led invalid risk models using old credit measures (Bessis, 2010, p.522). The roots of financial crisis were beneath the old credit measures using the global financial instruments which reduced transparency in transactions and increased exposure to risks. It had clearly increased systematic risks. The instrument that was used to spread out and mitigate risks had instead increased the magnitude of underlying credit risks. During this due to banks engagement in capital market activities, the role of capital markets had increased tremendously in the financial transaction processes. These flaws of the old credit risk measures had culminated into crisis by transferring risk effects into other financial market products (Watson, McCreevy and Daianu, 2008). Basel II for banking supervision had failed largely due to improper and less strict regulations that led the banks create a crisis situation failing to manage risks. The Basel Committee post crisis introduced Basel III guidelines that had set new and stricter standards for minimal capital requirements and liquidity ratios. Basel III is expected to establish better standards for international banking system with respect to high quality liquidity and meet required capital adequacy standards. Systematic risks have been listed on top of the agenda for making decision on regulations. Such rules will help to increase transparency and thereby reduce risks (What Basel III means to us, 2011). Market participants have stressed upon considerable attention towards proper credit and credit derivatives for counterparty risks in order to make risk transfers transparent. Industry standards documents are deemed necessary for removing legal uncertainties for credit default swaps (Credit Risk Transfer, 2004). The rules proposed under Basel III aims to achieve global financial stability. The guidelines have been established keeping in mind the small and medium sized enterprises. More strict regulations have been adopted for developed nations like UK and US that were major victims of global financial crisis. Basel III has clearly increased the role of non banking financial institutions which includes investment banks and also hedge funds. But at the same time these sectors will be exposed to more risks. The new regulations for financing trade under Basel III have strict conditions attached to trade credit. This has been done to increase availability of risk information for respective countries. With such amendments multinational companies will need to have a clear knowledge of country risk information (The Business Impact of Basel III, 2010). Basel III has been established with the goal of eliminating the possibilities of crisis. Under Basel III there has been a hike in minimum capital adequacy requirements through increase in minimum capital adequacy ratios. The standards for inclusion into capital also have been raised. In addition it now requires maintaining common equity capital which may include common shares and earnings that has been retained for risk assets. The preferred shares needs to be convertible into common equity under issuance terms for getting included as capital under Basel III (Nomura Announces Proposals for Amendments to Articles of Incorporation, 2011). Market risks The Basel Committee made an amendment in 1996 after which financial institutions were required to hold capital for risk coverage. The underlying risks included both market risks and credit risks. This amendment led to separation of trading book and banking book. A capital charge was imposed on trading book items which included derivative instruments, stocks, bonds, swaps etc. This act first considered a standard approach for measuring market risks. This first led derivative dealers to measure market risk using VAR approach (Hull, 2007, p.192). Market risks are generally associated with trading portfolios. The old market risk measures are all concerned with modeling value added risks (VAR) which considers irrational movement of the value of trading portfolio. VAR model assumes normal returns for the liquidity period. The sensitivities are also assumed to be constant. The variance covariance matrix which shows the input values highlighting risk factors dependency requires regular updating. The disadvantage of this model is that does not follow normal distribution. It has to be content with only first two moments since it follows a non parametric distribution (Bessis, 2010, p.474). The Basel Committee allowed banks to use VAR approach in 1995 to calculate the underlying market risks. What has remained as the main disadvantage of VAR is that it is merely a statistical measure for computing market risks. Its practical implications are very much limited. Usage of such market risk measures have mainly been used by senior management. Others have replaced it by stress analysis. Moreover identifying factors influencing markets and estimating dependency using risk mapping under variance covariance methods involves an explicit process (Linsmeier and Pearson, 1996). Derivation of probability distributions is really difficult under the variance-covariance method. With large number of extreme values the VAR model loses effectiveness and underestimates the actual value at risk. The VAR model breaks down when the variances across assets changes with time. Thus the model gives inaccurate risk prediction when the variable varies with respect to time (Value at Risk, n.d). The crisis situation had experienced a dramatic increase in underlying risks in equity markets. Easy financing operations had in turn increased liquidity to a great extent. As a result there was a steady decline in the capital base of the firm which culminated into liquidity freeze and ultimately into financial crisis. The problem that was faced with old market risk measures was that correlation and variances were not found to be stationary in accordance to their expectations. Under the situation of volatility low correlated factors exhibited high correlation. The changes undergone in risk premium and liquidity could not be captured by the model. As a result it gave inaccurate measures regarding volatility of asset markets and this led to more exposure towards risks (Scholes, 1998). It has been found that risk premiums rise more than proportion due to high rates of inflation and vice versa. But market risk measures found inflation and equity risk premiums to be uncorrelated. Thus it exposed markets more towards risks (Damodaran, 2011). The new measures that are proposed for Basel III setting higher standards for trading and large sales of derivatives are surely to have a huge impact on the derivatives market. The new suggested measures are directed to increase capital charges for trading books. It has suggested upgradation of VAR models that was previously used as market risks measures through Credit Value Adjustments. Under this circumstances stress analysis has been suggested to measure market risks. Its relative merit lies in the fact that it can compute the losses incurred even beyond two years (Basel III Proposal to Increase Capital Requirements for Counterparty Credit Risk May Significantly Affect Derivatives Trading, 2010). To deal with the problems related to capital ratio requirements Basel III has introduced capital buffers. The usage of stricter parameters has been instructed to compute credit value adjustments for counterparty risks (Nakagawa, 2011, p.270) Stress tests analyze a number of stress events and predetermined scenarios. Such an analysis is useful to provide necessary information of past crisis related events. The past experiences help to realize the underlying risks for trading portfolios. A clear understanding of risks can be developed from the two independent reports under stress testing- the VAR based reports and risk reports on the basis of stress testing. The introduction of this model may be helpful for identifying movements within the assets. Such identification of risks that are directed towards assets is termed as extremely important for financial institutions. Here the stress tests may be helpful to prevent crisis situations. However the errors that occur during pricing computations leads to inaccuracy in risk prediction (Allen, Boudoukh and Saunders, 2004, p.106). MoteCarlo VAR is capable of handling scenarios containing large losses. The VAR is derived here using the normality assumption. This structured has special abilities of estimating the risk values of nonlinear derivatives. In this sense it is superior to the previous VAR models and can be used significantly to reduce risk exposure. Bu it does generates problems for future forecasts although it can analyze larger number of values (Allen, Boudoukh and Saunders, 2004, p.101). Credit Value Adjustment (CVA) provides the opportunity to convert counterpart risks related to credit into new trading opportunities. Such an adjustment has changed the scenario for pricing and counterparty risk management. Post crisis many firms are adopting new measure for reducing market risks. They have used CVA for pricing and adjusting it into trades. Collateral requirements have been regulated to facilitate better handling. With its capability to capture almost all kinds of product there has been improvisation of management of counterparty risk. Such better management of risks could certainly help the banking system to avoid another crisis situation. Such methods can also be used for pricing counterparty risks for the company’s own default. Financial crisis had emphasized on the need to divert attention and better management of counterparty risks to avoid another crisis situation. This is what is exactly done by credit value adjustment (Credit Value Adjustment, n.d). Conclusion The financial crisis was undoubtedly an outcome of integration of market and credit risks and banks engagement in capital market activities. The role of capital markets increased drastically during this time. However Basel II for banking supervision is responsible for such a crisis since it could not control the activities of the banks through its regulations. The Basel Committee had formulated a set of regulations called the Basel II norms for the commercial credit-lending institutions. These rules directed the banks to hold a part of their capital assets as the support to the loans issued by them. This regulation was similar to that of most national banking regulatory authorities which always advise the commercial banks to secure the resources lent by them. Being similar to earlier laws followed by them, the financial institutions were not expected to have any problems abiding by the new norms. However, the studies showed that the international regulatory authorities were not serious about enforcing the Basel II norms. The commercial banks took advantage of this situation and flouted the new regulations at their will. This trend was observed to have been prevalent for a considerable period of time. This was indeed an astonishing revealation. The international financial market is characterized by the presence of a large number of reputed organizations. The global market has provided the basis for widespread banking and financial activities for a considerable period of time. It seemed alarming that this industry was subject to such unlawful operations by the participating institutions. Thus, it was not surprising that the dishonest operations of the financial institutions ultimately snowballed into the huge financial crisis of 2008. The capital requirements for setting standards for international banking system were also found to be inappropriate. Moreover the credit risk instruments that were used before crisis were not significant to mitigate risks. This was mainly because of poor portfolio management. The most significant regulation under Basel III was separation of trading book and banking book. This is expected to help the separation of market and credit risk integration which is necessary to avoid crisis situation. The VAR approach to mitigate market risks did not yield desired outcomes since they were unable to capture the effects of non-stationary variables. Following a parametric distribution it also led to underestimate values that were at risk. This led to more exposure towards risks. Basel III suggested upgradation of VAR models using CVA. CVA has been useful for converting counterparty risks into trade derivates. It has improved management of counterparty risk to a great extent which led to financial crisis. Stress testing of VAR had helped to identify asset related risks and MoteCarlo VAR can calculate risk values even for nonlinear derivatives. Hence this new market risk measures are considered to be quite superior than the old ones and can be helpful to avoid another crisis situation. Part Two An account of the Seminar Activity 5 The seminar topic “Risk and Hedging: Do credit derivatives increase bank risk?” by Norman Istefjord was chosen as a suitable subject of research. The knowledge of credit derivatives and their impact on the risk exposure of financial institutions is an important research area in the financial market. This knowledge can also be applied to various practical situations to understand their significance. Keeping in mind these factors, this topic was selected as a suitable subject of the project A thorough evaluation of the paper revealed that modern commercial banks are actively engaged in the trading of a new kind of securities called the credit derivatives. This kind of trading is lucrative since it has the potential for generating higher profits for the banks. The seminar revealed that the commercial banks have always tried to justify their trading in credit derivatives by declaring that this was an efficient method for hedging and ensuring the securitization of credit risks. The banks state that trading was an effective way of diversifying the risks associated with normal credit. However, financial analysts have been concerned about these practices predicting that they might have a destabilizing effect on the overall banking sector. Thus, banks should be careful while engaging in such trading practices. As with any serious issue, the trading in credit derivatives also involved two alternative viewpoints: one supporting it and the other presenting a counter argument to such activities. This undoubtedly, made the seminar topic very interesting. The attendants were keen to know the results of the study. Financial institutions all over the world have played significant role in encouraging trading in different types of securities and funds. However, the credit derivatives represent an innovative kind of securities in the financial market and its trading practices have gradually gained acceptance among people. Any person having a fair amount of knowledge in the financial markets has definitely been exposed to the concept of credit derivatives and the resultant speculative activities of the commercial banks. However, in real life one does not have the opportunity of making an evaluation of such common financial activities. The seminar presented an attractive chance to gain knowledge about this sector of the economy. After acquainting oneself with the background of the seminar, one felt excited at the prospect of discovering a significant finding related to the contemporary international financial market. The seminar proceeded to evaluate the overall impact of credit derivatives with the help of economic and financial tools. It used a simple model which was modeled on the costs involved in situation of financial crisis. The investigation process also proved to be a valuable learning experience. It provided an example of how the economic and financial tools of analysis are used in dealing with a real life situation. A model is actually a simplified version of reality which is utilized to study important effects of the economy. The seminar used such a model to derive a conclusion about the subject of study. The findings of the seminar suggested that the trading activities of the commercial banks conducted via the credit derivatives have a two-pronged effect. It is capable of generating beneficial as well as adverse impacts on the financial sector. Trading in credit derivatives helps to distribute the risks associated with the credit loans. This advantageous effect is often called the hedging argument of credit derivatives. However, the results of the seminar further revealed that as the commercial banks engage in widespread trading in credit derivatives, this had a magnifying effect in the financial sector. Increased speculative activities rendered the credit derivative securities to be more attractive to the common people who wanted to bear a greater amount of risk by enhancing their invested amount in these derivatives. This was definitely an adverse effect as it could destabilize the entire banking sector. The results of the seminar were in conformity with the postulation of the research argument. As the postulate contained two alternative viewpoints of the subject and the findings confirmed the existence of both these possibilities. Overall, the entire seminar proved to be an invaluable learning experience. The chosen subject was very relevant in the context of the present financial markets. The whole procedure exhibited the process of conducting a research on a chosen subject right from forming an argument, through to the evaluation method and finally discovering the results. The knowledge gained of the seminar subject and the procedure will prove to be of great value in further pursuits of the same nature. References: 1. Allen, L, Boudoukh, J and Saunders, A. (2004) Understanding market, credit, and operational risk: the value at risk approach, UK: Blackwell Publishing 2. 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