Banks & Financial Institutions - Term Paper Example

Contribution of Credit Risk and Liquidity Risk to the current banking crisis - Is the crisis due to failure of risk management ID 19714 Order No. 279865 [Name] [University Name] [Course Name] [Supervisor] [Any other details] 14 March 2009 Table of Contents: Table of Figures Figure No. Description and Word Hyperlink Figure 1 Loan Application Scrutiny Workflow (Source: FMA, 2004. pp16) Figure 2 Interest rates climbed gradually after 2005 (Office of Federal Housing Enterprise; Source: Murali and Muralikrishnan. 2008) Figure 3 Interest rates climbed gradually after 2005 (Source: Murali and Muralikrishnan. 2008) Figure 4 Global CDO Issuance as presented by Federal Reserve (Source: www.dailykos.com/story/2009/2/11/2249/99227) Figure 5 Introduction and Growth of Risky Products during 2003 - 2006 (Office of Federal Housing Enterprise; Source: Murali and Muralikrishnan. 2008) Introduction: In the recent times, banks appeared to have increased their risk appetite considerably and hence enhancement of exposure to risks became the way of business. Banks & Financial Institutions gradually increased the exposure of their investment capital to credit & liquidity risks (due to exposure to market risks which was never linked with banks as such) in order to earn higher returns whereby they practised mechanisms of transfer of risks to unregulated investors operating outside the banking system (Special Investment Vehicles and Special Purpose Vehicles). The current sub-prime crisis in the USA is a painful learning for all Banking Risk Management professionals on how stretching the strings in uncontrolled manner can result in absolute rupture. The crisis is perceived to have occurred due to inadequate Credit Risk Management when lending to Sub-Prime customers that are individuals/companies who do not have clean credit history or regular source of income. The Banks & Financial Institutions avail the benefits of higher interest rates by lending to Sub-Prime customers but expose the capital to higher risks. The Banks used a mechanism of distributing the risk of the lending to the investors outside the Banking system through a process called "Securitization" (A phenomenon that occurred in the booming Credit Derivative Market). This phenomenon occurred extensively in the US Sub-Prime Mortgage Market that helped the banks to increase the number of risky products but still reduce the liabilities on their balance sheets (apparently!!) because the money is flowing through so called "conduits" from investors to the borrowers. As per experts the primary drawbacks have been imperfections in the Credit Markets given poor valuation of assets acquired against the credit instruments thus resulting in uncertain asset valuation & high credit risk exposure. Even the rating agencies couldn't predict the Sub-Prime crisis through their valuations because the securitization process was too complex and the Bank's risk assessment was inadequate in screening the borrowers and informing the investors about the risks in the securitized products. The system became so huge that the root of the risks was completely covered by hyped data and analytics about the new credit instruments. [Schmitz, Michael. C and Forray, Susan J. pp28-30; Clerc, Laurent. 2008. pp1-4] In this paper, the process of Credit & Liquidity risk measurement by the Banks is presented with a discussion on how they have contributed to the overall Financial Crisis faced by the world. A brief on Credit and Liquidity Risk Management practiced by Banks Every bank has a native underwriting process to support the "Credit Approval System" for evaluation of credit risk resulting from a possible exposure when scrutinizing a loan application. As per Basel Capital Accord (Basel-II), the primary parameters that are assessed during scrutiny of a loan application are: Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD) and Maturity (M). The Probability of Default is assessed form the records of credit history of the borrower, current & future ability to repay the interest & principal components of the loan, and sustainability of borrower's occupation (and other sources of income) given the general economics of the region and the Nation as a whole. The Loss Given Default is calculated in terms of value & type of the "Collateral" taken into account when approving the loan. The Exposure at Default is the amount owed by the borrower to the bank at the time of default. [Milne, Alistair Dr. 2009. pp55-64; FMA. 2004. pp10-12] The process of loan application screening is carried out by capturing relevant information/data through loan application forms like age, income, past employment history, banking transactions of past three years, credit history, length of time at an address of residence, etc. which are then assigned a weighting by virtue of an "internal rating system" of the bank through a computerized risk assessment system. If the system approves the loan automatically, then the processing & approval becomes faster. However, if the system disapproves the loan then the application is scrutinized more closely and more information/data is requested from the applicant. The backend risk assessment systems of the banks are powered by loads of historical data & analytics thus supporting the decision making process through empirical data & information collected over a number of years (like, Empirical Default Frequencies). [Milne, Alistair Dr. 2009. pp61, 86-89] Figure 1: Loan Application Scrutiny Workflow (Source: FMA, 2004. pp16) Figure 1 presents the workflow of loan scrutiny process. The key steps here are Credit Review and Collateral & Risk Assessment. In Mortgage markets, physical assets (like houses & buildings, plants, machineries, etc.) are mortgaged with the Bank against the Loan disbursal such that they can be auctioned to recover the amount owed to the bank by the borrower at the time of default. The other essential aspect of risk management in banks is the Liquidity Risk Assessment. Liquidity is the ability of the bank to meet the obligations, fund increase of assets, absorb losses incurred due to non-performing assets and prevent incurring of unplanned/unacceptable losses. Liquidity Risk Management is defined in detail by the Basel Committee on Banking Supervision in their detailed paper "Liquidity Risk Management and Supervisory Challenges" (BCBS. 2008. pp3-5). The committee published 17 principles of Liquidity Risk management pertaining to: 1. Bank's accountability, 2. Clear articulation of liquidity risk tolerance, 3. Strategies, policies & practices to manage liquidity risk, 4. Incorporation of liquidity costs, benefits & risks in product pricings, 5. Identifying, measuring, monitoring & controlling liquidity risk, 6. Management of liquidity risk exposures, 7. Pre-established funding strategies, 8. Management of intraday liquidity positioning & risks, 9. Management of collateral positions, 10. Conducting regular stress tests, 11. Formal contingency funding plan, 12. Insurance against liquidity stress scenarios, 13. Regular public disclosure about soundness of liquidity position 14. Regular assessment of the overall liquidity risk management framework, 15. Monitoring of internal reports, prudential reports & market information, 16. Timely intervention & timely remedial action and 17. Regular internal communication as well as with public authorities A Brief on the current Sub-Prime Crisis The Sub-Prime crisis actually has occurred due to over reliance on the Risk Management processes to develop risky products with higher returns. The interest rates & fees for Mortgage Loans for Sub-Prime customers have been higher than those for the customers with reliable track records. The interest rates increased gradually after 2005 (Figure 2) thus making such deals appear more lucrative for the banks. But on the other hand the existing borrowers having their real estate properties mortgaged & having adjustable interest rates faced overstretched and their sustenance was just possible till the time they could bear the instalments. Figure 2: Interest rates climbed gradually after 2005 (Office of Federal Housing Enterprise; Source: Murali and Muralikrishnan. 2008) A number of high risk products were launched during this period and the credit approval system changed completely much outside the control of the Federal Government. In fact the system had become so complex that no one had any clue what was happening. The Figure 3 presents the modified loan approval process employing the "conduit" process: Figure 3: Interest rates climbed gradually after 2005 (Source: Murali and Muralikrishnan. 2008) The original loan life cycle process required the asset details to be shown on the balance sheets of the bank thus allowing close monitoring & risk assessment - both credit as well as liquidity. The elements of risk assessment were clear & tangible thus allowing the assessors to keep close eye on the bigger picture. The modified loan life cycle process comprises of pooling of all loans into SPVs and then sell them to investors acquiring what was termed as "Collateralized Debt Obligations (CDOs)". This gives a notion that the risk is transferred to investors and hence the CDOs have gone out of the balance sheets given that money is flowing to the borrowers from the investors "directly through the conduits". These assets were probably not looked at closely by risk assessors when analyzing credit & liquidity risks. The CDO market grew substantially in a short span of time as presented in Figure 4 below: Figure 4: Global CDO Issuance as presented by Federal Reserve (Source: www.dailykos.com/story/2009/2/11/2249/99227) The rating agencies continued to do their job on credit risks but didn't look at the liquidity risks per se. The incentives per investor was not justified for them to look into the nature & sensitivity of ratings provided by the rating agencies. One the other hand, the uncontrolled diversity & complexity of valuation techniques resulted in considerable variation in fair value estimates. Wide distribution of risks by virtue of such complex products shielded the actual risk where the exposure was wide open but hidden behind loads of "unconventional" risk assessment databases. The following chart shows a surge in increase of one of the risky products called Piggyback Loan in the year 2003 to 2006: Figure 5: Introduction and Growth of Risky Products during 2003 - 2006 (Office of Federal Housing Enterprise; Source: Murali and Muralikrishnan. 2008) This Risky Product was within the threshold of 50% in the first three quarters of 2006 and suddenly surged to 70% in the fourth quarter of 2006. It is a matter of common sense that the maturity of internal risk assessment processes of the banks cannot improve to such extent in just one quarter that the risky product offerings can be allowed to surge from little above 50% to 70% in just one quarter (Murali and Muralikrishnan. 2008). This sample is just one small representation of the bigger phenomena that occurred in the Sub-Prime Mortgage industry. The Banks were never safe by selling the SPVs to investors via the process of Securitization. These investors were protected with backup lines of credits and such other forms of guarantees by the sponsoring banks. Hence, large amount of loan backed instruments acquired through the Conduits/SPVs were backed by the Contingency Funds setup by bank to face liquidity risks. The actual assets that was backing this entire "virtual system" were the mortgaged properties. In 2006 when the home prices reached extremes, the borrowers signed loan agreements at much higher monthly mortgage payments. The speculators that had hyped home prices couldn't hold it for long and they started reducing rapidly while in the mean time interest rates continued to grow. The borrowers couldn't withstand the pressure of increased monthly mortgage payments and hence filed for mortgage insurance claims. A number of foreclosures occurred and borrowers lost their homes but banks were left with non-performing mortgages given that the home prices had already reached the bottoms. For example, a $500000 mortgaged property in 2005 was reduced to $300000 in 2008 at the time of foreclosure. This was the only fundamental supporting the entire "virtual system" that collapsed thus resulting in serious credit & liquidity exposures. Millions of homes are lying with banks to be auctioned with no buyers around. This turmoil has lead to the current Sub-Prime crisis that propagated through a number of phenomena resulting in an overall economic downturn. One such phenomenon was the complete ignorance by the Federal Government about this new system of credit risk management and later desperate bail-out attempts by pumping good money into bad debts of the Banks. The other phenomenon was mitigation of risk of reputational loss by banks that compelled them to hide the information of the crisis till 2008 when it exploded automatically although the crisis was visible in 2006 itself. [Murali, Thadi and Muralikrishnan, Srividhya et al. 2008. pp12-13; Kneuer, Paul. 2008. pp11-12; Yuliya, Demyanyk. 2008. pp1; Clerc, Laurent. 2008. pp1-4] Conclusion: Is the current Banking Crisis due to Failure of Risk Management The author concludes that the current economic crisis is clearly due to failure of both credit & liquidity risk management. These risk management techniques were never linked to market risks in the traditional mechanism of loan life cycles when the risk assessment were carried out based on hard core native historical data available with the banks having direct link with the real economics, condition of buyers, cash flows, reserves, etc. all in control of the banks. Risk management gets more and more effective with the age of the underlying data. The new credit system never gave adequate time to the risk managers to redesign their assessment strategies that lacked grossly in the quantitative aspects. A lot of qualitative data was available in the new credit system about the structured instruments. However, due to lack of historical data (the market grew extremely fast amidst hypes & hypothecations giving no room for consolidation of information) the risk managers couldn't discover how these new financial instruments will behave under stress situations. The fundamentals of the SPVs/Conduits were lying outside the banking system forcing the risks assessors to operate upon unreliable data/information. Moreover, the CDOs were kept outside the balance sheets thus resulting in false liquidity assessments with a notion that the risk is already transferred to the investors. The exposure to market risks occurred automatically in this phenomenon which otherwise would never happen to the traditional credit procedures. Hence, overall it was a complete failure of the Risk Management that led to the financial crisis. Reference List: Credit Approval Process and Credit Risk Management. Financial Market Authority (FMA). 2004. pp10-12, 16. Clerc, Laurent. A Primer on the Sub-Prime crisis. Financial Stability Directorate. Occasional Papers - Banque De France. 2008. pp1-4. Horowitz, Bertram. Our Titanic Crisis - An Economic Rescue Plan. Risk Management - The Current Financial Crisis, Lessons Learnt and Future Implications. Presented by Society of Actuaries, The Casualty Actuarial Society and The Canadian Institute of Actuaries. 2008. pp15. Kneuer, Paul. Bubbles, Cycles and Insurer's ERM - What Just Happened. Risk Management - The Current Financial Crisis, Lessons Learnt and Future Implications. Presented by Society of Actuaries, The Casualty Actuarial Society and The Canadian Institute of Actuaries. 2008. pp11-12. Milne, Alistair Dr. 2009. Banking: the Management of Risks and Return. Copyrighted by Author. 2009. pp55-64, 86-89. Murali, Thadi and Muralikrishnan, Srividhya et al. Sub Prime Crisis and Credit Risk Measurement: Lessons Learnt. Infosys Technologies Limited. 2008. pp12-13. Principles for Sound Liquidity Risk Management and Supervision. Basel Committee on Banking Supervision. Bank for International Settlements. 2008. pp3-5. Schmitz, Michael. C and Forray, Susan J. The Democratization of Risk Management. Risk Management - The Current Financial Crisis, Lessons Learnt and Future Implications. Presented by Society of Actuaries, The Casualty Actuarial Society and The Canadian Institute of Actuaries. 2008. pp28-30. Yuliya, Demyanyk. Did Credit Scores Predict the Sub-Prime Crisis. Federal Reserve Bank of St. Louis. Proquest Information and Learning. Published at The Regional Economist. 2008. pp1. End of Document Read More