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Abstract
Banks and other financial institutions forming part of the financial system contribute greatly to the development of any economy. Business and industrial enterprises look for increased financial support from these institutions, since they can develop and introduce innovative financial products and services. Because of the nature of products and services handled by the financial institutions, they are exposed to different types of financial risks. There has been increased exposure of financial institutions to various risks before and during the recent financial crisis.
In this context, this research extends to the examination of risk management under conditions of the financial crisis. The study covers the classification of risks and the salient aspects of risk management. Different risk assessment models and their deficiencies are also focused. The research engages qualitative case studies of the risk management failures in Lehman Brothers and 2007/2008 subprime financing to report on the implications of risk management on the financial institutions. Suggestions on concrete measures for improving risk management in financial institutions are not included in the scope of this study.
Introduction
The word risk originates from the Italian word risicare meaning to dare. Websters Dictionary (1989) defines the word risk to mean
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expose to the chance of injury or loss
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a hazard or dangerous chance
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the hazard or chance of loss
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the degree of probability of such loss
The understanding of risk, measuring it and analyzing its consequences has made risk-taking as one of the drivers of the modern Western industrial development. Economic growth, improved quality of life and technological advancements all have been the positive outcomes of risk-taking. In the traditional setting, codes, predetermined standards, and fixed hardware requirements guided the carrying out of hazardous activities. In the modern world, there is a complete change in the focus were with the functional orientation what is interesting is the result to achieve, rather than the solutions or guidelines to achieve the desired end. In such a functional system, the ability to address risk becomes the key element. Therefore identifying and categorizing risks is of critical importance for providing decision support for making suitable choices of arrangements and measures to achieve what is planned.
Risk Management An Overview
While risk is the potential loss that occurs because of natural or human activities, the potential losses are the adverse consequences of such activities in the form of loss of human life, adverse health effects, loss of property, and damage to the natural environment (Modarres, 2006). Risk analysis, therefore, is a process, which characterizes, manages and informs others about the existence, nature, magnitude, and prevalence of potential losses in any situation. The process also describes and cautions on the contributing factors and uncertainties connected with such potential losses.
In engineering systems comprising of hardware, software, and human organizations potential losses due to the associated risks may arise externally to the system or losses caused by the system to the humans, organization, assets and/or environment. The loss may also occur internally resulting in damages to the system only. From an engineering perspective, the risk or potential loss results in exposure of recipients to hazards and such hazards normally extend to injury or loss of life, reconstruction cost, loss of economic activity and environmental losses . In engineering systems, risk analysis is undertaken to measure the extent of the potential loss as well as to identify the elements of the system, which are most responsible for causing such losses.
The risk management system thus signifies the ability to define the probable future course of events, making closer to a realistic assessment of the associated risks and uncertainties and to enable decision-making among the available alternatives. Risk management extends the decision-making ability to several varied social, economic, business and political issues. Based on an evaluation of several quantitative and qualitative factors interconnected with the issues under consideration, the best alternative giving the highest probability needs to be selected in any decision-making process. In business situations, choosing a specific alternative depends on the consideration of associated costs and other key performance measures as well as a careful assessment of risk and uncertainties to ensure positive outcomes. However, it cannot be ruled out that there might also result in some negative outcomes; but positive outcomes should be visualized as the overall outcomes. This is the essence of risk assessment and the process of risk management.
Risk analysis has its intellectual roots traced back to a hundred years, yet this discipline is developed into an organized body of knowledge only within the past two decades. Risk analysis is undertaken to serve several purposes such as determination of environmental and health hazards associated with several activities or substances or for comparing new and existing technologies or for determining the effectiveness of different control and mitigation techniques designed to reduce risks (Cohrssen & Covello, 1999). Risk analysis is also undertaken to set the priorities of the management in choosing one among several activities for regulatory or corrective action.
Risk assessment, on the other hand, is the technical assessment of the nature and magnitude of risk. Both the terms risk analysis and risk assessment are mostly used synonymously. Risk management uses information and data gathered from risk assessment and analysis and assimilate such information with information on technical resources, social, economic and political values for choosing the control or response options. Risk management is resorted to determine means of reducing the risk or getting rid of the risk. The difference between risk management and risk assessment is subject to wider debates and is not within the purview of this report. However, risk perceptions have a large influence on both risk management and risk assessment.
People have different perceptions about risks and such perceptions are affected by different elements such as the persons or things likely to be affected, nature, familiarity and magnitude of perceived effects. The perceptions often also based on the likely benefits to accrue from acceptance of the risks. Because risk is ubiquitous, risk analysis techniques are used to analyze several phenomena having different magnitudes. Risk analysis makes use of a wide variety of techniques, which are used in situations where the solutions are not explicitly available and where the information on the potential losses is ambiguous and uncertain. Risk analysis uses various disciplines like science, engineering, and statistics for analyzing the risk-related information and for making estimation and evaluation of the probability and magnitude of the associated risks.
Problem Definition
In any economy, business houses and industrial enterprises depend on the financial institutions for their financial support, as these institutions develop and provide innovative financial products and services. Given the nature of products being dealt with by the banks and financial institutions as also the nature of transactions the institutions are exposed to different kinds of risks. Some activities carry risks of complex nature like the case of illiquid and proprietary assets being held by the banks (Santomero & Trester, 1997).
Financial institutions need to adopt systems for identification; assessment and management of risks to their operations and these risks may arise because of the influence of external and internal factors. These risk mitigation initiatives are considered important to enhance the ability of the financial institutions to respond to movements in the financial markets, which are quick and unexpected. The efficiency of risk management of a financial institution depends partly on the effectiveness of corporate governance practices of the institution, which focus on risk mitigation across the institution. There are different types of risks faced by financial institutions, which influence their risk management practices.
The risk management in the financial institutions centers around two basic issues as to the impact of risk on the functioning of the financial institutions and how the institutions can work to mitigate the potential risks involved which form an integral part of the products of the financial institutions (Stulz, 1984). The available literature points out four distinct reasons for practicing risk management in any financial institution. They are (a) self-interest of the managerial people involved in the business processes of the financial institutions, (b) impact of taxation, (c) the cost of financial distress and the resultant economic losses and (d) capital market imperfections (Santomero, 1995). In each of the above instances, the profits are volatile, which may result in a reduction of the firms value to some of the stakeholders. Anyone of the above reasons would have the effect of motivating the management to make a careful assessment of the risks associated with the different products and techniques for risk mitigation.
Risk management in the financial service industry has assumed greater importance in the wake of a balanced economic development of the nation. An intrusive risk management system is considered very much essential given the concern about the safety and soundness of the financial service industry. However, the advancement in the information and communication technology, the enlargement in the financial services industry, the ambiguity in the distinction of banking and non-banking financial institutions and the creation and offering of numerous financial service products have put the banking system in a state of perpetual change and instability. Thus, the transformation of the industry into a highly competitive and dynamic environment has made the system incompatible with traditional risk management systems. The key question remains that whether at all it is possible to adopt appropriate risk management systems meeting the needs of the increasingly competitive environment of the banking systems.
In the years leading up to the recent financial crisis, some of the authorities have recognized that and intimated several investment banks, that they have not implemented efficient risk mitigation initiatives. Despite the advice from the regulators, these institutions have not taken any steps to remove these weaknesses in their risk management systems such as making changes in the system of risk assessments, until the crisis occurred. This is because these institutions reported a strong financial position. Based on such reporting, the senior management had presented the plans for change in their risk management plans. In some instances, the authorities themselves were not convinced about the existence of deficiencies in the risk management until such time the institutions were affected financially by a lack of proper risk mitigating plans because of the recent financial crisis. Authorities have accepted their heavy reliance on the risk reports of the top management of investment banks. This makes the necessity of the senior management of the financial institutions especially the commercial banks understanding the risk assessment and management under the financial crisis an important and significant task. This thesis studies the issue of risk management under conditions of financial crisis and challenges faced by the financial institutions to mitigate risks, which will add to the existing knowledge on risk management of financial institutions.
Research Objective
Examining risk management under conditions of the financial crisis and the challenges faced by financial institutions is the central aim of this study. In achieving this central aim, the stud attempts to achieve the following other objectives.
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To study and make an in-depth report on the concept of risk, the rationale for risk management risks faced by the financial institutions and methods of measuring risk
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To make an in-depth study of the deficiencies in risk management by financial institutions during the recent financial crisis
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To report on the effects of the deficiencies in managing risk effectively
The study will achieve other objectives incidental to the above objectives.
Research Questions
Based on the theoretical observations from case studies, the research will find answers to the following research questions.
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What are the salient aspects of risk management by financial institutions under conditions of the financial crisis?
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What are the deficiencies in the risk assessment and risk management techniques followed by the financial institutions during the recent financial crisis?
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What are the effects of the deficiencies in managing risks effectively by the financial institutions?
Research Methodology
This research has been undertaken to examine the salient aspects of risk management under conditions of the financial crisis and the challenge of financial institutions functioning in the United States in this respect.
Denzin and Lincoln (1998) state the researcher is independent to engage any research approach, so long as the method engaged enables him to complete the research and achieve its objectives. To achieve its objectives, this research proposes to use the deductive or qualitative approach. The qualitative research method is also referred to as naturalistic research (Bogdan and Biklen (1982); Lincoln and Guba (1985); Patton (1990); Eisner (1991). According to Marshall and Rossman (1995), qualitative research is based on the collection of data from different sources and the data already collected forms the basis for reporting the findings of the study and making recommendations. Yin (1984) identified different sources like archival records, direct observations, interviews, and observation of the participants, for data collection to conduct qualitative research.
The research design of the case study was adopted for the study. Case study design can be considered as the appropriate one, as this method allows an examination in depth (Burns, 2000 p. 461). According to Burns (2000), using a case study method, the researcher will be able to undertake an intensive analysis of the research topic to get deep insights on the subject studied (p. 461). Punch (1998) observes that the case study allows for a variety of research questions and purposes, which enables the researcher to gather a full understanding of the case to the extent possible, (p.150). However, the case study may be considered as more subjective. Burns (2000) points out that the case study may turn the researcher to be selective in interpreting the results. This makes the observations and interpretations devoid of easy checking or verification. The case study allows an opportunity for the researcher to advance personal causes (Burns, 2000, p 474). The research will use secondary data for researching literature review and case studies.
Collection of Secondary Data
According to Al-Mashari, Zahir & Zairi (2001), because of a lack of methodological research constructs it becomes important that an in-depth review of the relevant literature is undertaken. Therefore, an extensive literature review will be attempted using professional journals and other research publications containing articles on risk management by financial institutions and factors affecting risk mitigation. The research will review the theoretical contributions of several research scholars and practitioners to form the theoretical base for the research.
Data Analysis Method
Since the information gathered is qualitative, there will be no statistical methods used to analyze the data collected. An in-depth analysis of the factors and their comparison with the oretical findings will be undertaken to achieve the research objectives.
One of the serious limitations of this research is the smaller number of samples that will be selected for the case study. Generalization of the deficiencies in managing risk effectively during the financial crisis, based on the findings of this research, using the case study of Lehman Brothers and 2007/2008 subprime mortgage, may not be possible and to this extent, this study suffers a serious limitation. Another limitation of the study was the availability of an abundance of literature on the topic of risk management by financial institutions. Considerable time has to be spent on reviewing the available literature and extracting the relevant ideas for inclusion in the thesis. This has impeded the progress of the research to some extent.
The case study will cover the failure of effective risk management in Lehman Brothers and 2007/2008 subprime mortgage, to assess and report on risk management during times of financial crisis. Secondary research was used to collect information on risk management under the circumstances of the financial crisis. The scope of the current research is limited to assess the deficiencies in risk management by financial institutions in the context of the United States and has not been extended to suggesting ways of improving risk management by financial institutions during the financial crisis.
Thesis Structure
To make a comprehensive presentation, this thesis is structured to have five chapters. This Chapter, while presenting a background of the research issue, also laid the objectives of the study as well as the research method, aims, and structure of the thesis. Chapter Two presents a review of the recent literature on risk management to add to the existing knowledge on the effect of deficiencies of managing risk effectively by the financial institutions during the financial crisis. Chapter Three provides a brief description of the research method followed for the research. Chapter Four contains case studies on risk management practices of Lehman Brothers and 2007/2008 Subprime mortgage and a discussion on the findings of the case studies. Chapter Five is the concluding chapter, which contains a summary of the most important findings of the research and answers to the research questions. This chapter also contains a few recommendations for further research in the field.
Literature Review
The objective of this chapter is to present an analytical discussion of the relevant prior research work in the area of risk management by financial institutions to add to the current knowledge on the research topic. The added knowledge will enable an in-depth understanding of the implications of the findings of the current research.
Financial Service Industry
Risk management in the financial service industry has assumed greater importance in the wake of a balanced economic development of the nation. Efficient risk management is considered very much essential because of the concern about the safety and soundness of the financial service industry. However, the advancement in the information and communication technology, the enlargement in the financial services industry, the ambiguity in the distinction of banking and non-banking financial institutions and the creation and offering of numerous financial service products have put the financial system in a state of perpetual change and instability.
Thus, the transformation of the industry into a highly competitive and dynamic environment has made the system incompatible with the traditional risk management models and their application to the industry. The key question remains that whether at all it is possible to adopt a risk management model mitigating all types of risks associated with the operations of financial institutions in the increasingly competitive environment of the financial system. This review examines different aspects of risks faced by banking and other financial institutions.
In the present day business environment to enhance the competitive strength, the firms constantly look for information and knowledge relating to the shift in the market conditions and also enabled services for putting forth the financial and other transactions. In this sphere, the services by the financial services organizations are extremely important and necessary for the business houses to accomplish their financial objectives. However, the products and services being dealt with by the financial service organizations are so vulnerable that these firms are exposed to different kinds of risks while operating in the market. Hence, the firms in the financial services industry attach more importance to risk management in their organizations. Risk management in the financial services organizations is necessitated due to various reasons.
The most important reason is the potential economic losses to which the firms will be exposed in case they had to meet with some unforeseen risk and it may erode the entire capital of the firm. There are other reasons for undertaking risk management in these firms like the tax implications of the transactions, movement in the capital and stock markets and the persistent fear of the people managing the financial services businesses that their decisions may be proved wrong by the course of business events. In any risk, being faced by the financial service firm there is the potential danger of the firm losing profits, which in turn would result in the decline of the firm value for some of the stakeholders. Similarly, all or any of these reasons for managing the risk may force the management of the firm to make an assessment of the risks involved and take necessary corrective or preventive action to protect the firm against the risks identified. In this article, the different kinds of risks to which the financial institutions are exposed and how the firms can protect them against these risks are discussed.
Methods to Protect Against Risks
The financial institutions adopt several ways of protecting them against the risks associated with their businesses. In general, the organizations can find out the best business practices in the industry concerning risk management and adopt them in their organizations. Alternatively, the organizations can find convenient ways of transferring the risks to other players in the market or the organizations can employ specialized risk management programs at their organizational level to protect them against any financial loss resulting from the risks.
The best practices in the industry are the normally adopted risk management procedure by most of the organizations in which the organizations take actions like underwriting and reinsurance of risk so that the risks will be spread among the operators which have the effect of reducing the risks of apparent risks associated with the business. Also, the financial institutions may undertake hedging of their balance sheet items to protect any possible financial risks due to change in interest rates or exchange rates if the assets and liabilities are held in foreign companies. The basic objective behind these measures can be seen from the fact that the organizations do not want to carry the risks, which are part of the businesses undertaken by them and to maintain the level of total risks under controllable levels.
There are systemic risks that can be eliminated by a proper assessment of the risks and taking risk protection programs to safeguard the financial interests of the organizations. Similarly, in the case of risks that the organizations may face due to the frauds committed by the staff and employees, losses arising out of oversights and mistakes of the employees due to limited control by senior-level management known as operational risks the organizations can find suitable ways to minimize these risks. In any case, it must be noted that the organizations would suffer from possible erosion of profits due to excessive protective measures being taken by them to control the risks. However, it may be possible for the organizations to make a cost justification for the extended risk management measures and communicate them to the stakeholders to make them agree for the reduced earnings.
A significant part of the risks of the financial institutions is getting transferred to other willing counterparts by a method called Risk transfer where the assets created by the financial institutions are transferred to other business counterparts on a fair market value mutually agreed by both the parties.
Such transfers are commonly accepted by the organizations if they find that keeping the assets may not bring any additional financial advantage to them rather than increasing the associated risks. There are specialized markets and players to deal with such claims issued or other financial assets created by the organizations. Individuals and organizations acquire such kind of assets as a part of diversification programs of their portfolios.
Yet another bundle of risks connected with the business of the financial institutions, which have the characteristic feature of being inherently associated with the transactions and which need constant monitoring and control by the institutions. There is no other alternative available to the organizations to shirk away from the responsibility for these risks except to take and provide for the losses arising out of these risks. However, the organizations can employ aggressive techniques of risk management, which may entail additional resources for engaging such risk management techniques. These risks in a way are out of the ordinary and carry certain special features, which make them distinct requiring special attention from the organizations to control the damage on their account.
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As found in the case of some defined pension and other retirement benefits schemes, there are some equity claims in respect of which the financial institutions are accountable for a fiduciary liability where it is not possible to trade in or hedge against the specific claims even if the investors would like to do so. In these cases, the organization should take adequate precautions and protective measures to minimize their risk exposure on these accounts.
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The other areas where such kinds of risks operate are the illiquid and proprietary assets being owned by financial institutions like banks. Such risks are very complex demanding aggressive risk management techniques to be employed by the organizations.
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There are transactions where there are elements of moral hazard forcing the financial institutions to undertake strong measures of risk management to protect the interests of the stakeholders. The application of such risk management techniques forms part of the operating procedures of the organizations and all the risk management programs are considered an integral part of the business of the financial institutions.
What Are Financial Services?
The basic functions of banks, stockbrokers, insurance companies and other financial service providers comprise of services relating to:
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Collecting the savings of the people to provide them compensation in the form of interest for foregoing the current utility of those savings and
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Providing fiancé to those people, firms and even governments who have the intention of investing the finance so provided which will enable them to pay back the institutions the financing and other service charges in the future.
Another service provided by the financial institutions is the use of money or other financial instruments to realize the payments due on purchases of goods and services on behalf of the customers. To perform this function efficiently the banks and the financial institutions have developed instruments like checks, wire transfers, credit and debit cards including smart cards and a host of other instruments which are known as the payment mechanism of the economy.
Yet another addition to the financial services includes the provision of guidance to the potential savers on how effectively use their savings to reap a good return on their investment which service is recognized as asset management and treasury management. (The Environment)
The financial services have taken the provision of a fifth service, which is the risk management to both the investors and savers. Risk management in its traditional form covered only the insurance of buildings, workers lives, and property. However, the present-day concept of insurance has extended its horizon to cover a wide range of activities including financial derivatives to manage price, interest rate, exchange rate, and even credit risks apart from covering the property, accidents, and self. Thus, financial services encompass the following mechanisms:
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Mechanisms or instruments that enable the potential savers to park their savings safely and profitably
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Mechanisms which provide the needy investors or borrowers the required funds to fund their projects
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Mechanisms that govern the payments on behalf of the customers and
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Provision of advice to the savers as to the manner of dealing with their financial needs, as well as managing the assets of the investors and savers and
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Mechanisms to protect and manage the life, property, and finances of the constituents
The Environment
The US financial system consists of an array of financial institutions that provide any of the abovementioned financial services. Despite being the most developed and extensive in the world, financial service institutions face several risks in providing the above services. This review will cover risk management from the perspective of financial institutions providing all the above services and products.
Concept of Risk
This section elaborates on the concept of risk as it is applied in the context of financial institutions. The word concept is considered appropriate because the risk is not a directly observable and objective phenomenon of the natural world. The greatest challenge of risk management is that risk is to be construed by the people directly affected by the phenomenon.
Although the studies relating to risk are, varied and wide still there has not been evolved a comprehensive definition that covers all the aspects of risk. Quite often risk is perceived as incidents or happenings which have unwanted or unfavorable consequences. But such a definition results in accepting misleading concepts of risk being viewed as having negative and positive consequences alike and secondly risk not only covers single events but also relates itself to the future project directions. There are chances that the project conditions may change in a favorable or unfavorable direction. The point here is that it is difficult to predict the course of the future project direction at the beginning of the project life cycle. Moreover, there are plenty of chances that the prevailing conditions change during the period at which the project progresses. The risk here is that the conditions are diverse and might be potentially severe far more than the estimations.
It so happens in the investment management process the risks that are already identified as certain and definite are only analyzed to preven
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