Risk Management in GFC - Case Study Example

Risk Management in GFC Name: Institution: Date: Abstract This essay development is based on the need to evaluate the critical and underlying causes of the 2008 global financial crisis. In this case, the overall argument in the market has been that the key cause of the industry failure was the real estate industry failure. However, the background analysis of the essay underscores the role played by other economic and financial factors in the market. The evaluation process includes a critical focus of key examples in the market who were major financial industry players in the USA financial industry at the time of the crisis. The failure of the key organisations forms the basis through which the study review is developed. In the analysis of the key causes, the essay establishes that among the key cause of the crisis included the use of credit derivatives and collateral loans. Although the initial formulation and use of the tools were applied as a form of creating financial insurance and safety, they evolved into main contributors to the crisis emergence. In this case, the banks resulted to over use of the credit derivatives a move that crested minimal care in advancing loans. Additional cause included the lack of proper strict financial policies and lack of ethical corporate governance, as well as the interconnectivity nature of financial industry risks. This led the managers top making and presenting inaccurate financial statements to increase lending and borrowing with rates that they could not meet their liquidity expectations in the short term period. Finally, the review concluded that with the development of the IS0 31000:2009 regulations, the industry will develop strategies and systems to regulate against the crisis recurrence. Introduction The world global financial history has been characterised by a series of financial failures and challenges over the decades. However, the most pronounced and most recent financial crisis was the 2008 global financial crisis. Although the crisis was officially recognised in 2008 as its implications to the global market players became apparent, its evolution cycle is linked years back to as early as 2002 in the western financial economies. In History and financial data, it is reported that the rise of the GFC was through the emergence of credit derivatives. In basic definitions, a credit derivative is a tool that allows a financial institution to transfer a debt risk of loan non-repayment from one entry to the other (Schoonbucher, 2003). At this period the peak of the GFC was characterised by the emergence of a rising tide of credit derivatives as banks transferred their loans risk to others in the global market. In this regard, the recipient of the risks was associated and followed by earnings and benefits. This essay develops a critical focus of the process through which the GFC emerged. In this regard, the essay offers a critical exploration of a case study of failed financial institutions, discussing how the use of the credit and risk derivatives led to the crisis, and how the interconnectivity of risks, as well as failures in governance led to the GFC emergence. Finally the essay develops a critical focus on the role that ISO31000:2009 plays in ensuring that the global market remains resilient and avoids the recurrence of the GFC in the future. Derivatives and Collateral Loans Contribution The first key attributed cause of the GFC in 2008 was the aspect of credit derivatives in the global market. However, this argument has been perceived as a contrast to the principles and the real value of credit derivatives in the market. As already discussed, a credit derivative is a financial tool that allows a lender to transfer the risk of a loan non-repayment to a third party in the market. In this case, the financial principles behind the development and establishment of the derivatives were to ensure that the financial market risks were shared. This is a form of risk management system where the risk of a non-performing loan is shared amongst bank. In the development of this credit factor, the existing challenging was a rising risk of failure among the retail and smaller banks in the global market. In this case, the smaller banks in the market lend out a large proportion and percentage of their overall worth (Helleiner, 2011). Thus, if a number of the loans advanced are not repaid, the risk of failure for such a banking industry expands and increases exponentially. Therefore, as an alternative approach to this, an insurance system was developed. Under this insurance policy, the financial sector ensured that it shared in both the profits and losses made in advanced loans. On one hand, the lending bank could identify a large stable bank in the same market with shared policies. As such, it would establish a credit derivative in that in the event that the loanee failed to pay up the loans, the insuring bank would pay up and compensate the lending bank to a value of up to the agreed amount of the loan as per the insurance policy developed. Thus, in the period prior to the 2008 Global financial crisis, banks would insure with one another to reduce the risk of failure and losses caused by the lack of loan repayment respectively. However, although initially developed an insurance policy for the banking and financial industry, the use of derivatives evolved as a major financial risk source. In this case, the ability to transfer the risks of a loan non-repayment from the lending bank to the third party created a laxity in the lending banks institutions. As such, due to the reduced risks of loan non-repayment, the lending banks were more willing and accommodative of risky loans. Thus, in the long run period, the use of the credit derivatives led to the emergence of higher non-performing loans in the market. Consequently, this implies that through the increasing non-repayment loan system, the larger banks were equally affected. This led to a chain of events and interconnection between the banking industries (Crotty, 2009). For instance, in 2008, the Black Stone group announced a 90%decline in its profitability over the last quarter. This was the moment one of the largest buyout funds in the global market. As such, once the group announced o the impending challenges, a panic engulfed a majority of the retail banks in the market were facing turmoil. This is because, with the declarations, and with the subsequent decline of the large banks in the market, there was a decline in the ability of the banks to repay and cover for the derivatives amount insured (De Cock, 2009). Thus, this analysis indicates that through the use of derivatives, there was a reckless trend towards lending which in turn led to an increased rate and risk of non-repaid loans in the global market. An additional derivative tool that propelled the emergence and the escalation of the GFC in 2008 was the use of collateralised loans. In this period, the banking industry reverted to the use of collateralised loans as a means of creating the advanced loans securities in the market. In this period, one of the most rising assets in value was the real estate. This was a period at which land prices were on the rise and as such, the use of real estate as collateral for a majority of the offered loans was a common phenomenon. In fact, a majority of the banks in the western financial economy encouraged the use of real assets as financial loan collateral due to the ability by such assets to increase in value. This ensured that in the event that the loans failed to over and compensate for the offered loans, the banks would auction and recover their advanced loans values at a higher price that created profits in the long run period. However, although this was a positive trend in the management of loan-non-repayment risks, the increased use of this trend was a major contributor of the GFC in 2008. This is closely related by the burst of the real estate and the housing industry bubble in the late quarter in 2007. In this case, once the real estate bubble burst, there as a global and especially a major decline in the USA real Estate prices. This means that the overall value of the real estate industry led to a major fall in the value of the used certificates and registration documents in the market. As such, this means that the value of the loans insured by the collateral declined. Thus, in the event that the loanees failed to pay up the advanced loans in the market, the banks auctioning off the real estate collateral would not cover the incurred losses. In essence, statistics indicate that besides the use of real estate as collateral, a large number of the loans were advanced to purchase real estates and houses that were offering a high return and profitability (Shiller, R2012). Thus, the bursting of the real estate bubble meant that the banks not only lost the value of insured collateral for loans, but also had a large share of non-performing loans in the market. This led to a major banking industry failure as a majority of the large banks in the market lost a large share of their assets in the market. Risks Interconnectivity The second identified cause of market failure and the emergence of the GFC 2008 was the interconnectivity of the banking industry risks, such as operational risks, credit risks and liquidity risks respectively. In this case, the interconnectivity and correlation the above risk factors have been a major contributor of the GFC. In this case, prior to developing the above analysis, it is vital to understand the fundamental principles and definitions underlying these risks. On one hand, a credit risk is a risk emerging in the process of a banking institution offering loans to the market. The main credit risk is on the failure by its debtors to repay back the advanced loans in the market. On the other hand, a liquidity risk emerges in the event that a banking institution lacks enough cash and funds to cover for its short term expense (Shin, 2009). In this case, although an institution would have enough assets to cover for its long-term needs, the lack of a short-term capability to cover liabilities emerges when the cash inflows are less than the cash outflows in the market. There exists a direct correlation and interconnectivity between these two main risks in the market. On one hand, the credit risks risk poses a major challenge to the banking institutions to meet their short-term goals and needs respectively. For instance, a majority of the banks commit a significant amount and proportion of their cash to long-term projects that offer low risks and a higher rate of benefits with increased reliability (Rey, 2015). The remaining funds are advanced as short term and recurrent loans in the market. In this case, the financial planning is hedged towards the maximisation of the available operating capital. Thus, the banking institutions plan and develop an operational framework through which funds and cash obtained as loan repayments are channelled as expenses in the short term liabilities. Hence, this means that the ability by a financial institution to meet its shit term liability needs is reliant on its loans performance rates. Thus, if a high credit risk occurs, there is a high likelihood that a liquidity risk will emerge as there will be minimal cash inflows as compared to the required cash outflows. This was the case at the Bear Stearns Company failure in the USA in the GFC period. At this period, it is argued that the company failed as a result of a liquidity crisis, where it was unable to meet its short-term goals and liabilities. This was a scenario was replicated by the Lehman Brothers Bank whose bankruptcy was linked to a liquidity challenge in the market. In this case, it was argued that the bank had invested a substantial part of its assets in long-term projects (Grove & Patelli, 2013). Thus, even if a cash need arose, it was impossible to liquidate such assets into cash to meet short term needs. Instead, its main easily liquidatable assets to cover for short term goals were the available collateral assets on loans as well as the loan repayments done mainly on a monthly basis. In the wake of the real estate bubble burst, and the rising trends of a low loans repayment rate, the bank was unable to meet its short-term liabilities. This was similarly the case with the AIG Company. On its part, the company had issued out a number and a large sum of the credit derivatives to the other financial industry players. Thus, this meant that the AIG served as a major insurance company in the financial market. Thus, in the event that the existing loans were not honoured. The AIG Company would be expected to compensate the financial banks in the market. However, the risk of credit rating in the market emerged. In this case, there were more and more non-repaid loans that required the AIG Company to compensate key players. Unfortunately, much of the company investments were in long term projects. Resulting to a liquidity crisis that threatened the company fall. The ripple effect caused by the fear if the industry and banks failure were a major stimulant for its liquidity failure. In this regard, as the news of the failing loans repayment rates spread, many of the depositors feared that the bank would eventually fall or be placed under receivership. Thus, there was a withdrawal cash rush in its different branches. Thus, the amount of withdrawal cash demanded by the customers was way higher than the banks planned rates in the market, which led to a high liquidity crisis in the market. Lack of Strict Policies and Corporate Governance A third documented cause of the GFC 2008 occurrence in the market was the lack of proper ethical and corporate governance systems in the banking industry. For instance, an evaluation of the Bear Stearns bank illustrates an unethical leadership practice in its acceptance of credit derivati9ves in the smaller banks in the market. In this case, an evaluation of the bank operations systems illustrates that the management was aware of the lack of enough and sufficient liquidity to honour such credit derivatives offered by the smaller banks. However, the management, in a bid to acquire the associated payment of the derivatives fabricated and presented non true financial statements. As a result, his led to a higher liquidity challenge as the rate of loans non-repayments. Consequently, the bank was unable to meet a majority of the short term liabilities in the market. In this context, the case study above represents a case of poor governance and lack of proper ethical management systems. The fact that the venture directors were compromised to represent edited financial records was perceived as a common phenomenon even in other banks such as the Meryl Lynch among others in the US financial industry. The role of Regulation into the Future The development of the IS0 31000:2009, regulations that touch on operations risks management is expected to be a major platform and pillar through which the recurrence of the 2008 GFC will be avoided and eliminated into the future. The setting up of the regulations were based on the realisation that although there exists a major shift in the perception of risk management as a core in business development processes, there lacks a standardisation process. One of the key areas through which the rolling out of the regulations will enhance proper risk management into the future will be through the creation of shared vocabulary and description of terms. In the wake of the 2008 GFC, the financial industry had a different perception of the hedge and derivatives credit systems. In this case, to the different financial institutions, they were perceived as different tools and had different perceptions and descriptions. Consequently, this led to the eventual lack of understanding and shared correlation in the perception of the derivatives. The lack of a standardised understanding and the perception of the existing operational risks in the banking and the financial industry has been a major limitation. In this case, different financial markets and economies have different risk management systems, which lead to financial risks occurrences and global industry confusion. The second category the set regulations will play and serve in controlling the recurrence of the GFC will be through its setting up of performance criteria. One of the objectives for the regulations development was to set up performance criteria. In this case, the criteria set and level of performance attainment will be applied in two ways (Bezzina, Grima & Mamo, 2014). On one hand, the attainment of the set performance criteria will be a key tool in evaluating and identifying healthy financial institutions. Thus, this will ensure that global market investors will have proper and standardised criteria through which to evaluate the performance rating of financial institutions in dealing with risks, prior to partnering and investing in such organisations. The second application area for the performance evaluation tool will ensure that the healthy risk management systems. As such, through the evaluation of such measures it would be possible to single out failing organisations in the market. This will ensure that the developed early warning systems are developed and actualized. Thus, potential risks such as credit, operational, and liquidity risks will be identified well in advance. This will ensure that the different financial industry stakeholders identify key problems and challenges proactively hence allowing for the development of proper mitigation measures in the market. Through the management of such a performance measure, the industry will be able to identify and deal with emerging risks before they blossom and evolve into major challenges. The GFC escalation is mainly attributed to the lack of proper performances and regulatory framework that could create a proper sequence of actions through a structured approach. The presence of such a proper regulatory and management performance framework, the policies under the ISO framework would ensure that problems and risks are dealt with in a uniform approach at their formative stages. Conclusion In summary the essay has developed a critical focus on the emergence of the GFC and its key causative forces both before and during the crisis periods. In this context, the essay evaluated three main causes of the crisis. It evaluated the role of credit derivatives and collateral loans in the market. First, it established that the ability to transfer the risks to a third party reduced the keenness in evaluating the customer’s credit viability in the market, increasing instances of loan non-repayment respectively. This increased the credit risks in the market. Similarly, the burst of the real estate bubble led to a decline in collateral assets value in the market. The second key cause of the crisis was the interconnectivity of financial risks such as credit and liquidity risks. This occurred where organisations were unable to meet their cash liquidity needs as a result of high credit risks in the market and subsequent non-repaid loans. Finally, the lack of proper registrations and poor corporate governance led to the escalation of the crisis. The key solution in the industry would be the development of relevant internal corporate governance systems in organisations. This would ensure that the organisations participate in ethical financial practices that do not endanger the entire industry financial health. References Bezzina, F., Grima, S., & Mamo, J. (2014). Risk management practices adopted by financial firms in Malta. Managerial Finance, 40(6), 587-612. Crotty, J. (2009). Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture’. Cambridge Journal of Economics, 33(4), 563-580. De Cock, C. (2009). What I read about the global financial crisis in 2007 and 2008. Ephemera: Theory and Politics in Organization, 9(1), 34-48 Grove, H., & Patelli, L. (2013). Lehman Brothers and Bear Stearns: Risk Assessment and Corporate Governance Differences?. Corporate Ownership and Control, 611-625. Helleiner, E. (2011). Understanding the 2007-2008 global financial crisis: Lessons for scholars of international political economy. Annual Review of Political Science, 14, 67-87. Hensarling, J., (2013). Regulation – Not Lack Thereof – Led U.S. into Financial Crisis. American Banker. Retrieved From < http://www.americanbanker.com/bankthink/regulation-not-lack-thereof-led-us-into-financial-crisis-1062366-1.html> Rey, H. (2015). Dilemma not trilemma: the global financial cycle and monetary policy independence (No. w21162). National Bureau of Economic Research. Schönbucher, P. J. (2003). Credit derivatives pricing models: Models, pricing and implementation. Chichester: Wiley. Shiller, R. J. (2012). The subprime solution: How today's global financial crisis happened, and what to do about it. New York: Princeton University Press. Shin, H. S. (2009). Reflections on Northern Rock: The bank run that heralded the global financial crisis. The Journal of Economic Perspectives, 23(1), 101-120. Read More