How to Manage the Risk - Essay Example

How to Manage The Risk Introduction Lehman Brothers Holdings Inc was an internationally renowned financial service providing firm. The company ranked fourth largest as an investment bank in USA. It had its business related to investment banking, private banking, equity sales, trading research, private banking. On 15th September 2008, Lehman Brothers declared the company as bankrupted. It was the largest bankruptcy in history with $639 billion in assets and debt of $619 billion. Demise of Lehman Brothers had intensified the global financial crisis of 2008. Nearly $10 trillion was swept away from global equity market. It was recorded as the biggest decline in financial market. With the real estate pricing bubble in 2003 and 2004, the company acquired mortgage lenders who were specialized in loans which were given to borrowers without proper documentation. The company secured $146 billion of mortgage securities in 2006 with a growth rate of 10% from 2005. It had earned record amount of profit from 2005-2007. In the year 2007 it had earned net income of $4.2 billion and in the month of February its stock reached a higher record of $86.18 and a market capitalization of $60 billion. With the rising house market delinquencies, on March 14 of 2007 the company faced its biggest one day drop in last five years. After one year on 15th September 2008 the global financial market suffered one of the biggest falls due to the biggest bankruptcy of Lehman Brothers on Sunday 14th September. Dow Jones Industrial index had a fall of 504 points and FTSE 100 index went 9.9% down in just four days. Reasons behind failure of Lehman Brothers Although the main reasons for failure of Lehman Brothers are defaulting of housing price bubble and liquidity crunch inside the investment bank, still there may be different reasons according to different people. Some blame the CEO of the company for his overconfidence and failure in understanding about the crisis. Many others have different opinion about Bank of America and Barclays Plc. However the most relevant factors behind the failure of Lehman Brothers are as follows Leverage When the economic condition is good then returns can be multiplied by borrowing money with low interest rates and to invest it in assets such as real estate where prices are rising. This will leverage the returns. But as the economy goes downwards, assets prices also tend to go downward and it magnifies the loss. Same was happened in the case of Lehman Brothers. They invested in Mortgage backed securities and when the housing price bubble started to default the investments became illiquid. Assume that a well managed retail bank might have a leverage of 12 times which means for every 1 pound it can lend 12 pound. But in the year 2004, Lehman had a leverage of 20 and then it increased to 44 in 2007. But then the assets prices had started to move downside. The situation had become like with 10000 pound someone was buying a property using 440000 pound mortgage and the borrower of the bank became insolvent and thus the bank. Inconsistent management decisions are responsible for it. Management should have thought again before investing in subprime mortgages. Liquidity Businesses mainly fail not because of lack of profits, but it fails because of liquidity crunch. Lehman Brothers had its assets and liabilities based on a small amount of liquidity. In other words it didn’t have enough ready cash or liquid assets to face the crisis. When market fell, other commercial banks started to protect own selves by using Lehman’s base of credits. It means that Lehman was losing it liquidity t a very fast pace and by seen that other banks refused to trade with the company and market lost its confidence over the investment bank which was the final nail in the coffin of Lehman. The bank became totally insolvent. Overconfidence of the management that it will earn liquidity in proper time was the most vulnerable decision for the bank. Losses After the devastation of twin towers in USA in 2001, interest rates started to crash down causing a boom in real estate prices for a period of five years. Lehman Brothers was totally open to the elements of real estate market in USA by being the largest sponsor of real estate loans in 2007. It had more than $60 billion subprime mortgages in US market which were lent to risky borrowers. When the property prices started to crash in US market, the company got stuck in storm. In the third quarter result of 2007 it had written down a loss of $2.5 billion and in 2008 that rises to $6.5 billion. Here also the management is responsible for the losses of Lehman brothers because they had invested their total amount in risky subprime loans. Recommendations for firms to manage the risks Liquidity Risk Management Banks should manage their liquidity risk by controlling the relationship between short term liabilities against short term assets. The banks should test the liquidity of their assets for the worse future situations. The risk must be managed with proper decision making framework by the banks. Loans and investment strategies must be clearly agreed at all board level. Unlike the Lehman Brothers, banks should not invest much in subprime loans as they are too risky. Proper liquidity planning should be there considering all kind of crisis situations. Leverage Risk Management Leverage of bank indicates that for an unit of money how much it can lend. But the banks should have a certain limit of leverage and they also manage their credit risk by assessing the credit rating of the borrower before lending money. Loans are the most primary source for credit risk and other sources can be banking book, trading book and their on and off balance sheet and also other financial instruments, bonds, equity, swaps, options, interbank lending and settlement of transactions (Guizot, 2006, p.127). As exposure to credit risk a major problem in banks globally that’s why management bodies should have keen awareness that they are having adequate liquidity against the risk that they can compensate it if situation occurs. They should also understand the presence of the credit risk. Managing of Risks related to sudden losses Banks should have some alternative strategies to compensate their losses which may occur suddenly. As discussed above in case of Lehman Brothers, management didn’t have any proper strategies to manage the losses in 2007 and 2008. This was because they didn’t have proper liquidity. Thus to manage this risk banks should have proper liquidity sources like they should be able to liquidate their assets as and when needed. Sufficiency of risk Management Techniques Used by Financial Institutions Management must establish certain rules to obtain proper risk management techniques within their bank. Main focus should be how to measure and manage the exposure to various risks which the institutions have identified as their center to control. Risk management techniques include setting up of standards and reports, position of limits or rules, investment guidelines and strategies and incentive contracts and compensation. These four techniques are sufficient in current market scenario for banks to control their risks (Oldfield, 1997, p.20). Management’s role in Financial investment Firm Management has a significant role on controlling the risk management techniques within financial investment firms. Risk management must be an important part of managerial operations. Management should define a proper risk management planning for each business activity. Apart from these specific risks that can be occurred in financial institutions must be identified and depending on that risk management tools should be implemented properly to avoid those risks. Managers should identify the credit rating of the borrowers before lending money. Fiduciary obligations of a financial firm towards its investors are related to its corporate social responsibilities (CSR) of the financial firm. Financial institutions should clearly mention the risk of investment to their investors. It should clearly mention the risk of investment in mortgage backed securities or subprime loans to the investors before investing their money to restrain their money from get wasted. Impact of Euro Crisis on foreign markets Euro zone crisis had a negative impact on the performance of foreign markets throughout the world. Investors had lost their money in euro crisis and now it has investors throughout the world have become cautious about their investments in any market. The main change that has happened in the behavior of investors is that now they mostly prefer less speculations and short term investment. Thus the market also is not investing in high risk assets for higher returns. Market is also expecting tax hike and raising inflation rates in the post crisis period. Financial firm’s strategy to minimize the risk of investment Global financial firms should implement proper strategies to minimize the risk of investment in foreign markets by taking advantage of International Investment Agreements and International arbitration. The first one is mainly signed between countries and also referred as bilateral investment treaties. It aims to reduce the discrimination between investors. International arbitration has a specific benefit that an investor can sue the host country if the host has not maintained its treaty obligations directed by international investment agreements (Siwiec, 2012). Role of Federal Reserve Federal Reserve Bank is the central banking system in USA. Major purpose of the bank is to support the favorable economic conditions which will help to stabilize the monetary policy of USA. This factor includes price stabilization, money supply, acquisition of credit and increase in overall growth and employment. As a central bank it also needs to monitor and supervise the operations of other commercial banks to make sure the safety and security and to protect the interest of the customers. It also maintains the strength of financial system to mitigate the risk of financial markets. The most important enforcement capability of Federal Reserve is that it controls inflation and generates employment opportunities in United States. It also helps the US govt. and other financial institutions in US in their operations. There are mainly three types of tools used by Federal Reserve Bank to implement the monetary policy- Open Market Operations, Discount Rate, Reserve Requirement. Monetary policy is set by basically raising or declining the discount rate that is charged to banks for interbank lending of surplus reserves. This rate is decided by the interbank market but FED also influences that by usage of three tools that are mentioned above. Consequences of Federal Reserve are that Federal funds rate actually affects the long term interest rates in the economy. Fed is able to keep monetary and financial conditions stable with its monetary policy. Fed can also make policies that will help to add more reserves to the banks which will encourage the lending in low interest rates thus influencing the growth of money and credit in the economy (Federal Reserve, 2013)). The regulatory environment may change in next five years depending on the US economy and its subsequent growth. References:- Federal Reserve. (2013). The Structure Of federal Reserve System. Retrieved from http://www.federalreserveeducation.org/about-the-fed/structure-and-functions/. Oldfield, G. (1997). The Place of Risk Management in Financial Institutions. Retrieved from http://fic.wharton.upenn.edu/fic/papers/95/9505.pdf. Siwiec, J. (2012). Investing Abroad: Minimize Your Risks by Taking Advantage of International Investment Agreements and International Arbitration. Retrieved from http://www.perlaw.ca/en/newsroom/publications/2012/2/9/investing-abroad-minimize-your-risks-by-taking-advantage McDonald, L. (2009). A Colossal Failure of Common Sense: The Incredible Inside Story of the Collapse of Lehman Brothers. USA: Random House.  Guizot, A. (2006). The Hedge Fund Compliance and Risk Management Guide. New Jersey: John Wiley & Sons. Read More