Strategic Management in the Financial Crisis - Essay Example

? Reasons for failure by companies to meet pre and post-tax return on capital employed targets before the financial crisis Insert Insert Grade Course Insert Tutor’s Name Submission Date Introduction The financials crisis of 2007/8 took many listed companies by surprise. In addition, the global economy has been a subject of interest to many people and the previous and current turbulence in the economic front of nations has made this issue a subject of many debates. Many have assigned the year 2007/8 as the year of the great credit crisis that first had a toll on the United States’ financial sector before other parts of the globe had its impact. However, there are indications that the credit crisis of the stated period was just a climax of a historically influenced turbulence in the world’s financial market that began with the end of “the golden age of capitalism in 1970’s” (Kapadia and Jayadev, 2008). This may have been because of various issues of failure within companies that even made them fail to meet targets before the financial crisis period. With the resource utilization reaching the maximum limits compounded further by a relatively high wage rate, most enterprises were feeling the pinch in the reduction of their rates of return. The widening of international trade and the strengthening of global capital flows have led to a significant rise in cross-border assets and liabilities, as well as to tight real and financial linkages across countries and regions. The key implications of such developments have been a wider spread of shocks and stronger co-movements in macroeconomic variables. This paper will closely examine the issues that led to under par performance in the run up to the financial crisis. There are various issues that have been raised and a major one has been that of the failure of corporate governance as shall be discussed in the section below. Corporate Governance It is clear that good corporate governance actually operates effectively in two distinct areas which may include measures put in place to guard against opportunistic or conflicted behaviour by financial technocrats with aims of maximizing wealth. They include agents, and internal personnel in organizations. Consequently, it is observed that there is a wide gap between industrial organizations and financial sector companies. Whereas industrial and manufacturing firms will be mostly involved in the production and marketing of material goods and related services, financial organizations on the other hand, engage in activities related to relatively expedited capital or resource allocation. According to good management principles, corporate governance best practice is important and therefore essential for the protection of shareholders and other stakeholders against the often conflicting interests of dealers in the financial sector. Blundell-Wignall et al (2009) point out the need to clarify the responsibilities of regulatory institutions and to restore confidence in the integrity of financial institutions. Independent audits of financial statements provide a check against fraud, and a verified overview of financial evolution of the business. Blundell-Wignall et al (2009) also state that considerable flexibility should be envisaged as regards liquidity management. Quantitative measures and indicators should be integrated into the process in proportion to the degree that they are robust and operational. There is an overall bias in many countries' tax systems which work to encourage corporate leverage. The interface between tax, leverage and excess risk taking is complex. Blundell-Wignall et al. note that the US approach shares the risks of buying toxic assets between the taxpayers and investors creates buyer demand and prevents dumping of assets that would prolong the crisis phase, and is an open-market approach. It is important to foster corporate structures that enhance both stability and competition. The complexity of some corporate groups has been identified in both governance and risk control issues. As a result, the financial institutions should subject to a framework of firm regulation. This lack of stringent regulation by corporate governance policy makers may point to the fall of big finance institutions. Financial businesses' activities in rapidly changing markets are highly sensitive to variance. Market systems are competitive and volatile. Innovation in financial products has exceeded the capacity of risk management measurement and monitoring tools to gauge risk. Consequently, the diversity of corporate models is rooted in societal characteristics that shape the competitiveness of the different models. The issue of control-enhancing mechanisms remains the central dilemma of European corporate governance. Blundell-Wignall et al (2009) holds that the practical implementation of a corporate governance code cannot be realized by a compliance program alone. The predominant majority of European codes orientate themselves to stakeholders and the company. Wieland defines corporate governance as leadership, management, and control of a firm by formal and informal, public and private rules. Any efficient and effective governance structure needs to constrain and to enable. Monitoring and management control are embedded in a conception of the firm that sees it as a part of the society at large. Regulatory Framework There should always be proper regulatory Structures and rules that guide Corporate Governance and the Financial Markets. The risk management systems have failed in many cases due to corporate governance procedures. The importance of qualified board oversight and robust risk management is not limited to financial institutions. The companies at the period to the financial crisis had various shortcomings in risk management and incentive structures. There is also an issue of responsibility of the board and why its oversight appears to have failed in a number of cases. It is also important to stress that internal control is at best only a subset of risk management and the broader context might not have received the attention that it deserved. As a result, Dowd (2009) claims that the current financial crisis has delivered a major seismic shock to the policy landscape, and points out that moral hazard played a central role in the events leading up to the crisis that understands moral hazard is fundamental to understanding how the economy works. Inadequate control of moral hazards often leads to socially excessive risk-taking. The practice of what passes for risk management might be counterproductive. Model-based valuations do not reflect true market prices. According to Dowd (2009), the most important reasons for the failure of financial risk management to contain risk-taking are the basic economic ones. The system of managed state intervention into the financial system has failed dismally. Another issue that affected this is the claim that capital-raising tends to be sluggish: it is particularly costly for a bank to raise new capital during times of great uncertainty. As a result, the causes of the current financial crisis, and its spill over effects onto the real economy emanated from various issues. The banking sector may be a good illustration of some of the following causes. First, collateralized borrowing in the banking context tends to be very short-term in nature. Equity rising leaves a considerable fraction of the near-term adjustment to be taken up by asset liquidations. Banks may be reluctant to raise new equity when under stress. The banking crisis has roots in both bank governance and capital structure. The failure of risk management played an important role in the crisis. Kashyap (2010) explains that there are three competing hypotheses about what went wrong with risk management. First is the issue of inappropriate incentives for the chief risk officer or the officers in charge of risk management. Secondly, the companies’ top management failed to heed the warnings of the risk managers. Lastly, it is possible that there were critical mistakes in the modelling of risks within such organizations. Diversification of Markets Most companies relied on the regional financial markets instead of taking advantage of globalization opportunities. Establishing presence in foreign, mostly emerging countries, affords companies a strategic advantage by accelerating their growth in pursuit of business development outside their current markets while providing diversification benefits. Due to increased production and market globalization this has even become an imperative for maintaining competitive advantage by removing the barriers that used to protect isolated geographic locations. Complexity and risk is increased as cross-border acquisitions are challenged in their effort to succeed in a global environment of instability fuelled by ongoing financial turmoil. The upside for opportunity is increased, as well. Surveys and interviews revealed unique non-traditional strategies, new patterns in corporate diversification and creatively structured transactions in cross-border mergers and acquisitions of all size businesses. New insights offer that the financial crisis highlights the value proposition offered by cross-border acquisitions and changes the landscape of M&A to include variations on the traditional motivation, typical reasoning and standard process of mergers and acquisition. Governments can establish regionalized initiatives that increase integration where improvement in economic, political, and social relations would increase prosperity and augment the ongoing economic momentum generated by global business. This was a glaring failure and which also contributed to the collapse or underperformance in the said companies. Risk Management The companies evidently did not take into account long term risks associated with expanding markets. Sahlman (2009) argues that managers need to pay close attention to three related issues: they need to make sure they understand all aspects of a set of related trades; they need to make sure that the reported values of securities in a trade are true market prices; and they need to distinguish between economic profits and accounting profits. In Sahlman' s view, many organizations suffered from a combination of powerful, sometimes misguided incentives; inadequate control and risk management systems; misleading accounting; and low quality human capital in terms of integrity and/or competence. External auditors can play an important role in helping organizations manage risk and reward. Preserving financial flexibility should be an ongoing priority for company managers and investors. Regulators failed to understand how individual and company incentives might drive behaviour and increase systemic risk. Sahlman (2009) asserts that the underlying problems are complicated and interconnected within organizations and across them. The macroeconomic problems were the result of terrible microeconomic decisions. Erkens et al (2009) empirically examined the role of corporate governance in the disciplining of CEOs for the losses during the crisis, and its role on risk taking by financial institutions before the crisis. This was through the focus of independent boards and institutional investors on short-term profitability have led to the replacement of poorly performing CEOs during the crisis, and have encouraged risk taking of firms before the crisis. The authors claim that compensation contracts with a heavier emphasis on annual bonuses (as opposed to equity-based compensation) encourage executives to focus on short-term results. CEO replacements in financial institutions during the crisis period exceeded the norm. CEO turnover is more sensitive to shareholder losses for firms with more independent boards, larger institutional ownership, and smaller insider ownership. Firms with higher institutional ownership have higher expected default risk, while firms with more independent boards have higher equity-to-assets ratios. Erkens et al (2009) discuss their predictions on the role of corporate governance mechanisms in the credit crisis, and consider the influence of corporate governance mechanisms on risk taking by financial firms in the period leading up to the crisis. U.S. firms have significantly higher export losses in terms of write downs but significantly lower risk taking before the crisis. Firms with higher institutional ownership took more risk and experienced higher performance before the crisis. They also state that external monitoring by independent board members is important for disciplining top management for poor performance during the crisis. Independent directors pushed for higher performance and curbed risk taking as observable to market participants before the crisis. Pressure from institutional owners induced managers to focus on short-term performance. Incentive compensation per se is not associated with losses in financial firms. Conclusion The failure by companies to meet the set targets is seemingly a failure by the companies as discussed above. The financial crisis can be said to be only an indicator of such failures. The financial crisis was majorly as a result of internal rather than external factors. The impact of the crisis that has left the country struggling to make a footing of the world economic front today may have been a more historically motivated consequence than a sudden happening even though many people may like to refer to the year 2004 (Weinsenthal, 2009). It is also observable that this crisis was because of indiscipline in the banking and mortgage sector that was mostly encouraged through the effects of deregulation. The three major identifiable areas of the both internal and external push factors to this crisis after this discussion are clear. The first was the complexities of the products developed in the financial sector and the associated risks. There was also conflicting interests of market players and finally, the blatant failure by the regulatory bodies as well as the market players themselves to curb the excesses they were indulging in at that time. It is however important that the United States as well as the whole world learns from this crisis. There should be proper and relevant regulatory framework to eliminate the illegal and unethical acts of market player who only care about making an extra dollar out of every deal. Moreover, the management of corporate should understand that leaving them at the hands of self-regulation might have disastrous long-term implications on their organizations. Bibliography Blundell-Wignall, A. et al. 2009. The Financial Crisis: Reform and Exit Strategies. Paris: OECD. Dowd, K. 2009. Moral Hazard and the Financial Crisis, Cato Journal, 29(1): 141-166. Kapadia, A. and jayadev, A. 2008. Global Economic Crisis. Economic and political weekly 43, (16), pp.10-14. Kashyap, A.K. 2010. Lessons from the Financial Crisis for Risk Management, paper prepared for the Financial Crisis Inquiry Commission February 27. [Online]. Available at: http://faculty.chicagobooth.edu/anil.kashyap/research/papers/lesson_for_fcic.pdf Kirkpatrick, G. 2009. The Corporate Governance Lessons from the Financial Crisis, Financial Market Trends 1. [Online]. Available at: http://www.oecd.org/finance/financial-markets/42229620.pdf Read More