Risk Aversion Over the Last essay

  • Length: 14 pages
  • Sources: 10
  • Subject: Economics
  • Type: essay
  • Paper: #64968357

Excerpt from essay :

This was because they were seeing one of their primary competitors (Travelers) merging with Citicorp (which created a juggernaut of: insurance, banking and brokerage activities). At which point, executives at AIG felt that in order to: maintain their dominance in the industry and offer new products they should become involved in similar activities. The difference was that they would grow the company by expanding into areas that were considered to be speculative to include: commodities, stocks, options and credit default swaps. The way that this was accomplished is by purchasing a host of businesses that were involved in these activities. This is significant, because it meant that a shift would take place in: how managers were accounting for risks and the kinds of activities that they were becoming involved in. With the newly acquired companies; bringing over executives that did not practice the same kind of strategies for dealing with various risks. Over the medium term, this meant that the company would see a dramatic increase in their operating income. as, it multiplied from: $900 million in 1998 to $4.4 billion in 2005. (Sullivan, 2007)

However, in the long-term these different activities meant that executives were increasing the overall risks facing the company. Evidence of this can be seen by looking at the total amount of leverage that AIG has in comparison with their competitors. The below table illustrates the amount of leveraged equity at the company in contrast with others in the industry during 2007. (Sullivan, 2007)

Total Amount of Leverage at AIG in Comparison to their Competitors




11 to 1


4 to 1

Berkshire Hathaway

2 to 1

Montpelier RE

2 to 1

White Mountain Insurance

4 to 1


4 to 1

(Sullivan, 2007)

These different figures are important, because they are showing how AIG had a significantly larger portion of leveraged equity in comparison with the rest of the sector. This is problematic, because it meant that the actions that executives were taking were increasing the overall bottom line dramatically. While at the same time, it was exposing the company to: shifts in the economic cycle and a possible implosion in a host of different asset classes. Once this occurred, it meant that it would be only a matter of time until the entire company would be exposed to the risks that were taken by managers. (Sullivan, 2007)

In many ways, one could argue that the repeal of Glass Steagall Act has increased the overall threats, facing large firms in comparison with smaller entities. as, the lack of regulation is allowing these organizations to: become major threats to the economy. This is because they have become such a vital part of economic activity moving forward; that any kind of volatility will: have an impact upon their lending activities to consumers and businesses. As a result, small firms are more able to deal with these challenges in comparison with their larger counterparts.

Differences in the Risks Associated with Small Firms in Comparison with Large Ones

The biggest risks facing large financial organizations, is that they their interconnected business model will mean that they are overexposed to more risky asset classes. This is problematic, because during times of volatility these kinds of securities will often underperform the markets (due to the high degree of speculation that it involves). As a result, a variety of brokerage houses have increased the possibility that they will face a number of liquidity challenges when these situations arise. At the same time, the lack of regulating these entities (due to a number of companies conducting business in various countries around the world) has made the situation grim. As a variety of financial organizations are effectively able to circumvent the securities laws of different counties. Once this occurs, it means that there is no effective way to know what investments they are holding and the effect that changes in the value could have on the business. At which point, the risks increase that the collapse of one financial firm can cause secondary ripple effects on those organizations they are working with. This is significant, because it showing how the overall threats facing large firms has increased exponentially from these different factors.

In the case of small firms, they are dealing with similar kinds of regulations as the bigger organizations. The big difference is that the overall scope of their business model is focused on: providing various financial services to customers in specific regions and geared towards certain demographics of the population. This means that they are more highly regulated, because they have to follow stricter regulations for their business activities (in comparison with large firms). The reason why, is many of the smaller entities do not cross national borders, which makes it easier to regulate and monitor their activities. This is important, because the underlying amounts of regulation mean that there is: greater scrutiny and transparency for these organizations. (Baum, 2009)

A good example of this can be seen in a study that was conducted by Boston College. They found that those firms that are more regulated have less financial problems down the road. The reason why, is because these regulations limited the overall amounts of speculation and exposure an entity can have to various areas. Over the course of time, this means that these kinds of firms will engage in actions that are in line with regulations (which reduces: the underlying risks facing their organization). This is significant, because it showing a major advantage that these firms have over other larger entities. During times of volatility, this means that that these kinds of organizations are able to withstand more extreme economic conditions. (Baum, 2009)

A second advantage that small firms have over large organizations is: that they do not have the same kinds of access to the public markets. This is because many big brokerage houses / banks will often turn to the equity and bond markets, to help finance the continued expansion of their operations. During times of economic expansion and low interest rates this supports the long-term growth of the firm, by providing them with the capital they need. However, once a major contraction occurs, is when these kinds of organizations will face a tremendous amount of challenges. The reason why, is because the large amounts financing that they conducted in the public markets, which means that they have high levels of debt. This will have a direct impact upon the ability of the firm to: pay their short and medium term expenses. As they have to dedicate a larger amount of their declining profit margins, to cover the interest charges on the outstanding debt. Once this begins to take place, it means that many companies will have trouble maintaining these levels (which brings them one step closer to liquidation). This is important, because it shows how this contributes to the overall threats being faced by larger firms. (Weinberg, 1994, pp. 19 -- 41)

In the case of smaller organizations, they do not have as much access to the public markets. This means that they will keep their levels of debt lower in comparison with other companies. As they will often use more traditional ways to: fund their operations and will maintain larger amounts of cash reserves (on their balance sheet). The reason why, is because executives have to carefully plan how capital will be allocated (due to the fact that there are limited resources available to them). Over the course of time, this means that these kinds of firms will have more of a financial foundation to: deal with various adversities that they are facing. This is important, because it showing how these kinds of companies are protected against tremendous amounts of volatility. (Weinberg, 1994, pp. 19 -- 41)

At the same time, many smaller firms will also engage in strategies that take into account diversification. This is when you are spreading out the assets of the firm among a variety of areas. The basic idea it that by having the firm invested in different asset classes will: protect them and their clients against sudden shift in capital outflows. During times of economic calamities, many investors begin withdrawing funds from a variety of the more speculative assets. This is because, they are concerned about the underlying amounts of risk and the effect that it will could have their portfolios (which causes prices to begin collapsing). When a firm is diversified in a number of asset classes, this will protect them against sudden shocks. Once this occurs, it means that their earnings will be more stable and they can adjust to drastic changes that have taken place in the economy. This is significant, because it is showing how diversification is giving smaller firms greater amounts of stability (in comparison with larger organizations). (Weinberg, 1994, pp. 19 -- 41)

The Risk -- Reward Metrics of the Two Firms

When you look at the risk -- reward metrics between the two different kinds…

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