Market Risk Examination as one of the Various Preliminaries of Investment in Securities - Research Paper Example

Introduction: Banks are now more exposed to operational and financial risks than ever before. This has been pointed out by several economists through the examples of the banking systems throughout the world. In general, it can be concluded that bank failure is difficult to attribute to poor market discipline or increased instability of an economy. Higher failure rate is only due to poorly-designed safety net policies of the regulators, which lead to moral hazards and agency problems. “During the 1980s the US banking industry has experienced a rapidly growing number of failures. Many factors have contributes to this trend including deregulation, technology, individual bank management, and economic conditions.” (Smale 1987). The seminar on Bank Failure – evidence of what happens when credit risk management procedures fail was an informative and thought provoking one for all participants. The seminar has enabled me to enhance my knowledge of the realities of banking risks and its challenges. At each session of the seminar, I was enriched by new information and ideas which inspired me to think and generate more ideas on the topic. Besides, I learned from the seminar that what credit risks are and how effectively they can be managed. Finally, I obtained priceless knowledge which will be of great use for my future studies and career. Bank Failure: Banks fail only when the market value of liabilities grows more than the market value of assets. In such a situation, a bank shows its inability to pay its depositors (saving deposits or short-term deposits or time deposits). But, sometimes the government provides funds to save a bank. Allowing such an insolvent bank to operate in the economy benefits only the informed depositors. They will withdraw their deposits at par, and loss will then be borne by small depositors and depositors who have long-term deposits. The major stakeholders who suffer heavy losses from any bank failure are the shareholders, depositors, unsecured creditors and deposit insurers. To prevent widespread failure of banks and reduce the systemic risk in the banking system, governments should formulate policies which eliminate or reduce the force of factors that create instability and build price bubbles in the economy. While it is very difficult to prepare and articulate such policy, many economists argue that it is not impossible to achieve this. Policies which increase the financial stability and which are free from the side effects of moral hazard and agency problems can be made. “With an estimated $32 billion in assets, Indy Mac Bank of Pasadena, Calif., which federal regulators seized Friday, is poised to become the third-largest bank failure in American history. Here is a list of the top 10 failures, based on total assets, according to Federal Deposit Insurance Corp. data covering 1934 through 2007.” (Konieczko 2008). Reasons for Bank Failure: Low Capital Adequacy Ratio (CAR): When banks keep low CAR, it is not easy for them to absorb losses during the recession period of the economy. Low Cash to Assets Ratio: The rush time to withdraw deposits creates unsolvable tussle for banks if they have low cash to assets ratio, that sometimes leads to fire sale of assets, and ultimately the result might be a bank failure. It is not that banks should maintain a high level of cash to meet any unexpected demand of depositors, but they should keep a sufficient level of liquid assets which can be used to avoid any run on the bank by the depositors. Higher Ratio of Demand Deposits to Total Deposits: Banks' mad rush to accept deposits without caring about the duration of deposits might create a situation where the duration of the liabilities is less than the duration of the assets. This leads to the sale of non-liquid assets at huge discount to pay off the running depositors. Apart from the above, the other reason that can lead to a run on banks is a bank's investment in opaque, illiquid assets whose marketability is low and whose value could change abruptly. In such an environment, if there is a spurt in the demand for withdrawal, depositors could irrationally run on banks. Bank Failures and Systemic Risk: Banks, in any economy, are interlinked with each other and other intermediaries in the financial system very deeply. They lend to and borrow from each other and hold deposits with each other. One more important area where banks intertwine with each other is the payment clearing system. So, clearly, the problem faced by any one bank could spillover to other banks also. It can be said that the banking system possesses more systemic risk than any other industry in an economy, because a default by any one bank could affect the ability of the other banks to meet the depositors' demand, and in turn, affect other parts of the economy too. PART B In the light of the current financial climate I have been asked to review developments in market risk assessment. My brief requires you to summarize the alternative methods and their pros and cons (quoting references to authorities used) whilst reviewing their adequacy in today's economic climate. Introduction: The current financial markets across the world are exposed to many financial and non-financial risks, which have a bearing on the global economic condition. A large number of reasons can be attributed to this phenomenon. This necessitates a careful risk analysis and measurement from the part of the authorities and proper management. Since there is no uniform structure among the capital markets in the world, no single methodology could be applied to find a lasting solution to the problem. For a couple of weeks in the recent past new heights of the turmoil have been experienced, which led the financial markets to what is described as market meltdown. The regulators and leaders are thinking seriously about the incidents and are trying to curb the unpleasant situation in the capital market. Credit Risk-US Sub-prime Crisis: The first and foremost reason that can be traced here which led to the present condition of the financial market is the sub-prime mortgage crisis in the United States. The recent financial turmoil on account of mortgage crisis/sub prime lending crisis has appealed the attention of economists as well as non-economists (general public) across the globe. The US originated crisis started late in the 20th century became acute in 2007 and trembled the entire global financial system. The US sub prime lending market crisis continues to rattle the global financial markets like a distant tornado. The epicentre of this tremor was the US, but its ripples were felt all over the world. More than two million homes financed by sub prime lenders were expected to face foreclosure in the period of crisis and nearly 17% of sub prime mortgages issued so far were projected to fail. (Research and Publications. 2008). The roots of the current US sub prime lending crisis can be traced back to the spiralling housing prices in the first half of this decade. Extremely low lending and borrowing rates increased the demand and supply of existing and new houses. Several institutions started offering sub prime mortgages to borrowers who had unfavourable credit history, at lower than normal repayment level with little or no down-payments. “As the crisis unfolds in August 2007, he related how the domino and multiplier effect, can have an impact on the financial system, the investors who habitually bought commercial papers issued by the SIVs stopped buying them because they no longer had confidence in the health and credibility of the SIVs. Consequently the SIVs lacked liquidity for buying mortgage bonds and the crisis worsened. The big banks that had created these SIVs had to honour SIV commitments to avoid them going bankrupt.” (Powazek 2008). One of the stock exchange journals reported that “Referring to the US sub prime crisis caused by excessive surge in property value which zoomed to $12 trillion the report said banks and investors were being punished for ignoring risk and lending recklessly. With regard to the impact on sub prime crisis, it added, as borrowers default on their mortgages, the panic has spread, paralyzing parts of the financial system and threatening to undermine the global economy.” (US Subprime Crisis may Depress Stock Markets: Economist. 2007). Liquidity Risk: Market liquidity has always been crucial to the capital market stability, primarily because of its influence on the market efficiency and secondly, because of its sudden disappearance from the market which may lead to a systematic crisis. Various researches and studies on financial crisis point to the fact that the scarcity of liquidity is always present at times of major crises. But surprisingly, this element of market risk that is difficult to capture is still not properly accounted for in managing and measuring the risk. This can be detrimental since it can eventually lead to serious failures at a later point of time. In the last couple of years, the modernization of financial systems has witnessed an increased marketability of financial instruments and also greater transferability of risk. Market Liquidity and the Importance of Transaction Cost: In simple terms, liquidity may be defined as a range of features rather than as a one-dimensional attribute of assets and the market in which they are traded. Liquidity can also be looked from the conceptual point of view, as the more liquid the asset, the more easily it is traded and at a shorter notice without any notable change in the price. Thus, in a perfect liquid market, there would be a guaranteed bid-ask price at all times irrespective of the quantities being traded. But the financial markets, even the ones that are considered to be the most liquid, are actually far-off from the ideal perfect liquid markets. Liquidity risk is thus the risk associated with the inability to immediately liquidate or hedge a position at the current market prices. At this point, it is important to note that this market liquidity risk is different from the balance sheet liquidity risk that refers to the inability to raise the liquid funds through offloading the assets or borrowing. This stems out from the fact that markets are not perfect at all times and in all segments. The degree of liquidity of a market is traditionally studied on the basis of three fundamental criteria, which are mentioned below: (Liquidity. 2009). a) The tightness of the bid-ask spread. b) Market depth, i.e., the volume of transactions that may be immediately executed. c) Market resilience, i.e., the speed with which prices revert to their equilibrium level following a random shock in the transaction flow. The tightness of the bid-ask spread provides a direct measure of the transaction cost that excludes other operational costs, namely the brokerage commission and clearing and settlement fees. The aspects of market depth and the market resilience indicate the market's ability to absorb the significant volume without adversely affecting the price of the securities. The bid price is defined as the highest price that a market maker is willing to pay at a given time to acquire a specific amount of assets. Similarly, the ask price is the lowest price at which the market maker is ready to sell a given amount of assets. The difference between the bid-ask prices facilitates the market maker to quicken the execution that is offered to its counter parties. The spread measures the cost involved in sell/buy or a buy/sell transaction only over a short period. Therefore, going by this logic, only half-spread should be attributed to a single transaction, considering the fact that the average price should be paid in a perfectly liquid market. The cost of processing the orders from the market makers, the size and the volatility of the accumulated order flows and the degree of information asymmetry between the market makers and the initiators of transactions, influence the tightness of the spread. “Numerous theoretical arguments and mounting empirical evidence suggest that securities market liquidity is related to informational efficiency. One view is that illiquidity represents a transaction cost for informed arbitrageurs whose trades make prices more efficient. For example, when liquidity increases in Kyle’s (1985) model, informed traders bet more aggressively based on their existing information because their trades have a smaller impact on prices. In addition, informed traders have greater incentives to acquire more precise information in liquid markets. If informed arbitrageurs are less active in illiquid markets where trading is expensive, securities’ prices in these markets may deviate by large amounts from their fundamental values.” (Tetlock 2007). Liquidity in a market essentially depends on the presence of a sufficient number of counter parties and their willingness to trade. The factor of willingness to trade depends on the investors' expectation pertaining to the price developments and also their aversion towards risk at any given time and also the information available to them. Certain class of analysts believes that, highly leveraged institutions operating under few regulations contribute largely towards market making and liquidity. At the same time, it is also true that liquidity is cumulative in nature and the opening up of markets to new participants would always facilitate in strengthening the positive externalities produced by a broader investor base. (Geithner 2007). The perception of a guaranteed liquidity has prompted a number of financial players to take excessive risky positions, that, in most occasions, have resulted in financial crisis and these crisis were typically preceded by phases of excessive confidence that is characterized by heightened exposure and fuelled by leverage. Thus, it only takes a hint of doubt in the investor's mind to radically change the market configuration and trigger a liquidity crisis. Liquidity crisis is basically illiquidity risk that has reached its outburst. This may be defined as the market's inability to absorb the order flows without triggering a violent price adjustment that is unrelated to fundamental value. This is characterized by the sudden widening of the bid-ask spread or even the total disappearance of the flows and the inability to trade. It often leads to an increase in the near-term volatility as the slump of the primary markets. Thus, it carries on the seeds of a serious systematic problem. This type of event has the primary risk of booking major losses as it becomes necessary to unwind the positions, so as to settle the liabilities and also to meet the hedging requirements. It is very difficult to capture this risk, as it refers back to the paradoxical nature of liquidity as pointed out by Keynes way back in 1936 when he mentioned that the liquidity of financial asset does not simply exist for the financial community as a whole. In other words, an asset will remain liquid until its liquidity is put to test. Market risk: Capital market risk is commonly understood as the risk involved in the investments of securities that are traded in the stock market. The possibility of incurring losses because of sudden increase or decrease in the value of securities is the immediate cause for market risks. The most salient feature of market risk is that it cannot be diversified. Because of this nature of risk, it can also be referred to as the capital market systematic risk. “While an individual is investing on a security, the risk and return cannot be separated. The risk is the integrated part of the investment. The higher the potential of return, the higher is the risk associated with it.” (Capital Market Risk. 2008). Market risk examination is one of the various preliminaries of investment in securities. As already mentioned, systematic risk affects all the industries and assets (physical or financial) alike. Any investment in stocks or bonds comes with the following types of risks. Market Risk Industry Risk Regulatory Risk Business Risk Bibliography Capital Market Risk. (2008). [online]. FinanceMapsofworld.com. Last accessed 12 January 2009 at: http://finance.mapsofworld.com/capital-market/risk.html GEI THNER, Timothy. (2007). Restoring Market Liquidity in Financial Crisis. [online]. Federal Reserve Bank of New York. Last accessed 12 January 2009 at: http://www.newyorkfed.org/newsevents/speeches/2007/gei071213.html KONIECZKO, Jill. (2008). Business & Economy: The 10 Biggest U.S Bank Failures. [online]. US News. Last accessed 12 January 2009 at: http://www.usnews.com/articles/business/economy/2008/07/15/the-10-biggest-us-bank-failures.html Liquidity. (2009). [online]. Investopedia. Last accessed 12 January 2009 at: http://www.investopedia.com/terms/l/liquidity.asp POWAZEK, Derek. (2008). Readings From a Political Duo-ble. [online]. Wordpress.com. Last accessed 12 January 2009 at: http://aussgworldpolitics.wordpress.com/2008/02/16/understanding-the-global-impact-of-the-subprime-crisis-implications-of-gic-and-temasek-holdings-bailout/ Research and Publications. (2008). [online]. Centre for Responsible Lending. Last accessed 12 January 2009 at: http://www.responsiblelending.org/research/index.jsp?issue=Issue_mortgage&pubtype=&page=2 SMALE, Pauline. (1987). Bank Failures: Recent Trends and Policy Options. [online]. Northern Kentucky University Library. Last accessed 12 January 2009 at: http://digital.library.unt.edu/govdocs/crs/permalink/meta-crs-9064:1 TETLOCK, Paul C. (2007). Does Liquidity Affect Securities Market Efficiency? [online]. Last accessed 12 January 2009 at: http://www.mccombs.utexas.edu/faculty/paul.tetlock/papers/Tetlock_Liquidity_and_Efficiency_03_07.pdf US Subprime Crisis may Depress Stock Markets: Economist. (2007). [online]. Livemint.com. Last accessed 12 January 2009 at: http://www.livemint.com/2007/09/18113520/US-subprime-crisis-may-depress.html?d=1 Read More