Investment Risk Management of Lehman Brothers Holdings Inc - Case Study Example

Investment Risk Management Lehman Brothers Holdings Inc. used to be a worldwide financial services company. In 2008, before Lehman declared bankruptcy, it was the fourth-biggest investment bank in America offering financial services in private banking, selling ant trading fixed-income and equity, investment management, research, private equity, and investment banking. Lehman Brothers’ bankruptcy is considered to be the hugest bankruptcy case in the American history. Financial factors that contributed to the failure of Lehman Brothers and the subsequent bankruptcy include low standards and unethical behavior of top managers, the misrepresentation of financial statement, Collateralized Debt Obligations, and the complex company structure. Other causes and agents that led to the collapse of Lehman Brothers are the large debt load of US households, rating agencies, Fed’s actions, insatiable Wall Street traders, and finally the deregulation (Peterson, 2012). The Lehman Brothers’ management failed to curb the risks because unethical practices were monitored under the top managers’ watch or even exercised directly by them. In other words, they were the main participants. The top officials practiced unethical behaviors hence difficulty in realizing when they were being a threat to the organization as a whole. Because of the easy-to manipulate accounting techniques and standards in place only ‘’beautiful and healthy’’ figures were portrayed in the financial statements. There was extensive utilization of accounting manipulations (Ziemba & Ziemba, 2007). Further, Lehman refused to disclose some transactions as part of the notes accompanying the financial statements. This was negligence on the part of auditors and accountants. The beauty of the numbers might have blinded the management making them overlook the ‘’good’’ numbers despite the fact that they knew such figures were impossible given the current situation of the firm. This continued for long and eventually contributed to the bankruptcy of Lehman Brothers Holdings Inc (Peterson, 2012). The complicated company structure made it difficult for the management to identify who was responsible for what and at the end of the day there was no particular person to take any blame. Again, the management did not perform its duties in ensuring that the company had a comprehensible structure detailing duties and responsibilities for each and every employee. Therefore, there was no proper channel of communication which is a critical factor in any organization. The management was simply negligent on its duty of disclosure” while dealing with Collateralized Debt Obligations (Peterson, 2012). In the future, firms should be on the lookout for such risks. The management of any firm aiming to be successful should be independent, possess high standard morals and be ethical. With such a management, negligence is unlikely to occur in the firm, and since they are the superiors, all other employees will follow suit. If the management of Lehman Brothers Holdings Inc. was less negligent and less unethical, bankruptcy would have been unlikely. Risk management is the procedure followed in identifying, analyzing and prioritizing risks. Risk management techniques include (Ziemba & Ziemba, 2007). Risk avoidance; this means not performing any activity that could produce risk. For instance, refusing to purchase a business or property so as to avoid consequent legal liability, or avoidance of flying because the airplane might be hijacked. Risk avoidance may be ideal; however, it may not be ideal because it eliminates potential benefits (Peterson, 2012). Risk reduction; it deals with decreasing the severity of the anticipated loss or the possibility of the said loss from happening. For instance, sprinklers’ function is to put out a fire in order to decrease the risk of losses caused by fire. Sprinklers may lead to a much greater loss from the damage done by water hence unsuitable. Outsourcing is a perfect illustration of risk reduction (Etukuru, 2011). Risk sharing; this is splitting with another person the encumbrance of loss or the advantage of gain, brought about by a risk, and attempts to decrease a risk. Mistakenly, people believe that a risk can be transferred to another person via outsourcing or insurance. Practically, should the insurance firm go bankrupt the original risk reverts to the first person. Risk holding pools practically retain the risk for the entire group, while at the same time spreading it to the rest of the group members (Ziemba & Ziemba, 2007). Risk retention; this is loss acceptance, or gain benefit, from a given risk should it occur. Self insurance is an example of risk retention. Retention of Risk is a beneficial scheme for minimal risks where the insuring cost against such risks will ultimately exceed the total losses incurred over time. Any risk that is not transferred or avoided is normally kept by default. This comprises of risks that are extremely large or catastrophic such that it is impossible to insure them or the premiums figure would be impracticable. War is a good example because most risks and properties are uninsured against war; therefore, the loss caused by war is felt by the insured (Ziemba & Ziemba, 2007). In any financial investment company, the management is responsible for establishing appropriate risk management procedures for high risk investments. The management should start by evaluating these particular investments and then classify them according to the amount of risk they pose. The management, after classifying these high risk projects, may advise investing in the projects starting with the one posing the minimal risk. The Financial Firm Management is then responsible for disclosing all the risks involved in every project to the investors. In addition, the management should advise the investors accordingly describing to them which investment is most viable; likely to yield more revenue. In case the management fails to disclose any useful information or falsifies the information to make the investment look more attractive, the investor can sue for breach of contract and at the same time withdraw his investment (Peterson, 2012). The current EURO Zone debt crisis has affected the performance of foreign markets adversely. The investment risk has recently gone up and thus discouraging investors. It has made it extremely difficult or entirely impossible for a few countries within the euro area to pay back or re-finance their existing government debt unless given some assistance by third parties (Etukuru, 2011). A strategy that financial firms should adopt to reduce investment risk in these markets is diversification. The firms can spread their investments to various asset groups such as bonds, cash, and stocks. The total investment risk is effectively minimized because there is always one asset class at least performing well. For instance, if stocks fall, then interest rates go up, meaning bonds could be an appropriate investment. The federal government makes a significant contribution in regulation of investments by financial institutions through ensuring that the consumer is wholly protected from various imperfections in the market like hiked prices. Regulation is concerned with the competency and integrity of financial institutions. More often than not, regulations quicken change within a business surrounding. Normally, businesses adapt steadily to a certain set regulations. After the new regulations have been passed, businesses must switch to the new conditions as soon as possible because the old practices may no longer be legal. The businesses might be obliged to report additional information to the government concerning their activities (Chong, 2004). Consequently, fresh accounting methods and procedures should be created. Should a regulatory environment become excessively hostile for a certain business in any given country, the business tends to transfer its operations to a different location. Over the next five years, there will be self regulation. The rising need for market solutions indicates a growing role for the private regulatory bodies and self-regulation. The benefit of self-regulation is flexibility. However, failures in private regulatory may arise because of collective action crisis (Jaeger, 2005). References Chong, Y. Y. (2004). Investment Risk Management. Chichester: John Wiley & Sons. Etukuru, . R. R. (2011). Alternative investment strategies and risk management: Improve your investment portfolio's risk-reward ratio. Bloomington, IN: iUniverse Inc. Jaeger, L. (2005). The new generation of risk management for hedge funds and private equity investments. New York, NY: Institutional Investor Books. Peterson, S. P. (2012). Investment theory and risk management. Hoboken, N.J: John Wiley. Ziemba, R., & Ziemba, W. T. (2007). Scenarios for risk management and global investment strategies. Chichester, England: John Wiley & Sons. Read More