Risk management failures in the 2008 financial crisis

Bank Finance Management

The global economic crisis, that has its roots in the global financial crisis of 2007 and 2008 started off from the collapse of giant financial institutions such as Bears Stearns, Lehman Brothers and Citi Bank. In the pre 2007 era, the global economy and in particular the American economy saw a sharp boom in the credit and housing sector. In greed to attract clientele and business, financial institutions relied on weaker calculations of Value at Risk figures, which not only resulted in underestimation of risks but also resulted in poor monitoring of balance sheet growths.

There have been several direct and indirect problems pertaining to risk management practices that the financial institutions ignored and in turn saw found themselves near to insolvency. These included liquidity problems, problems pertaining to capital reserve requirements and further the pressure intensified by the Basel Accord provisions in a crisis situation.

Negative financial intermediation, lack of liquid assets, money multiplier effect, plunging prices of straight bonds and poor credit ratings have all contributed to what led to one of the greatest economic crisis in the history. In 2008, the President of USA devised a Working Group on Financial Regulation. The working group pointed out problems such as poor calculation methods of Valuation of Risk, liquidity pressures and exponential and unmonitored balance sheet growth as major contributing factors. The report also pointed out that lack of comprehensive and essential data required for adequate risk measurement was also an important issue that needs to be addressed.

Introduction

The government of United States of America has proposed a further cut in federal government spending. The government of United States of America states that the proposed cut is part of a short-term spending plan for the forthcoming fiscal term. Ever since the economic crunch has struck the country's economy, and business giants started to fall out of business, the government of United States of America increased its government spending to a substantial level. This was necessary given the rate with which unemployment levels were shooting up and GDP of the country was rapidly declining. While the increased government spending resulted in giving support to a lot of declining firms, it ended up increasing pressures on its current accounts. As a result, the existing Democratic government had to face severe criticism from the Republican opposition, who thought that the only solution to the declining economic growth is that the government should cut down on its spending. The science of economics suggests that scarce resources need to be efficiently utilized in order to achieve optimum outputs. Contrary to that, the opposition believes that the government spending are unproductive and continuing these spending would create an economic pressure on more productive economic activities. Government, amidst the ever increasing defence budgets, also had to allocate huge amount of money for bailout packages for huge giants, that until recently were major contributors of the U.S. economy. Some major collapsing corporate giants included Lehman Brothers, Citi Bank and AIG Insurance Inc.

The world has seen great economic evolutions over a period of time. Today, the contemporary world in general adheres to the mixed market economy system that works in amalgamation of private sector and the public sector. While micro economic decision making in all mixed economies lie with the private sector the degree to which public sector influences the economic decision making of the private sector may defer from country to economy. The macroeconomic goals that any government would want to achieve in order to stabilize its economy are common among all economies regardless of the kind of economic policies a country follows. These macroeconomic goals are discussed as follows.

Controlling inflation rates which involve prices stability.

Lowering the unemployment rate and achieving full employment.

Increasing national output and achieving economic growth.

Maintain a positive Balance of Payment

Redistribution of income and wealth which involve minimizing gaps between economical classes.

While all these aims are interrelated to each other in one way or the other the strongest basis of relationship is formed by Inflation and employment. While generally, they tend to have an inverse relationship. This means that when Inflation increase, employment decreases and vice versa. This makes it trickier for the governments to devising their economic policies as aiming at achieving price stability might end up resulting in increasing unemployment, which again goes against government objectives. The only situation where a direct relationship exists between the two economic goals, which is inflation and employment, is when the economy is going through 'stagflation'. Stagflation refers to a situation where inflation is extremely high and economic growth does not exist which results in an increasing unemployment rate at the same time. The recent economic crunch of 2007-2008 has pushed the United States of America and subsequently the global economy into a stagflationary situation. The responsibility of this massive economic crisis, one of the worst in the millennium, are allegedly the financial institution, and in particular the banking sector.

The economic trends between 2005 and 2010 have been a roller coaster ride for both the economists and the people in general. This made it necessary for economists and analysts to debate and argue about different types of financial concepts and their effects on the economy. The beginning of the U.S. recession in2007 has led to a phenomenal increase in the debating societies and associations of professionals which discuss topics such as financial intermediation, liquidity, interest rates, financial assets and money multiplier concepts. The importance of discussing these issues comes from the fact that they are directly or indirectly, in one way or the other, related to interest rates, which serves as a major role in an economy's growth or recession. The variation in interest rates paves way to changes in other economic indicators such as inflation, employment rates and balance of payments. Keeping in view the recent global economic recession, the role of financial intermediaries has also gained importance, as these are the agents which determine the interest rates, which consequently effects all other economic indicators. The subject of economics on micro and macro level highlights the importance of financial concepts. Discussion of these financial concepts is also important because understanding and application of such concepts differ from person to person as these concepts are complex in nature. The significance of these concepts is immense as these were the financial intermediaries which played the role in the bailouts of banks in major economies of the world and the downturn of stock markets around the world. The collapse of the real estate market was in one way or the other related to the same financial role models.

As stated earlier, the banking sector and other financial institutions had to carry the burden and were held responsible for the crisis. The primary reason of the crisis remained a sharp boom in the real estate and credit industry. Financial institutions underestimated risks and allowed extensive loans at huge mortgages. The end result was many financial institutions; especially those that underestimated risks and had little provisions for doubtful debts were frozen with almost negligible liquidity. This resulted in one of greatest economic downfall in the history.

Financial Intermediation and its contribution to Economic Growth

The term Financial Intermediation can be perfectly defined as "managing funds between surplus and deficit agents." However, the definition tends to be incomplete without understanding of the source through which such financial intermediation is performed. The financial intermediation is performed by a financial intermediary. The best example of such a financial intermediary is " Bank of America." The role of such financial intermediary is to maintain a balance between surplus and deficit. In other words it channels funds between agents of surplus and deficit. For example, if Bank of America obtains deposits from one of its customers and uses such deposits to advance loans to its other customers, then the bank is performing financial intermediation.

The concept of financial intermediation is of great significance as it plays a major role in the economic growth of any country. The financial intermediaries have a major role to play in economic growth as they determine the interest rates and other economic indicators which directly affects the rate of economic growth in an economy. Economists have differing opinions regarding the impacts and implications of financial intermediation on economic growth (Badun, n.d.). Economists have worked on many economic models, and each of these models discusses different channels through which finance influences growth. The theory of Montiel (2003) explains the link between financial intermediation and economic growth. The theory discusses three factors through which economic growth occurs through financial intermediation. The theory discusses how financial intermediaries can perform financial intermediation in order to trigger economic growth. The financial intermediation contributes to economic growth by creating opportunities for the accumulation of physical and human capital. The accumulation of physical capital is done by a financial intermediary. Such physical capital is diverted towards the most productive activities. The allocation of physical capital to such productive activities leads to the employment of human capital that is labor, which creates opportunities for economic growth.

Liquidity

Liquidity can be defined as the ability to convert an asset into cash quickly. In order to further explain, we can say that cash is the most liquid of all assets. With respect to financial assets liquidity is an important concept because the volatility of financial markets makes it an asset more valuable in the eyes of investor if its liquidity is high. If a particular asset is easily convertible into cash, we say that it has a high level of liquidity. A liquid asset has features such as rapid sale, with minimum loss of value, in the market. An illiquid asset is one that is cannot be sold readily at market value. Usually, examples of such assets can be found in the form of mortgage-related assets when there is severe economic recession and the housing market falls extensively. Discussing liquidity with respect to financial assets, it can be said that securities are liquid at any time if they can be sold in the market without loss of considerable value and in less time. Taking into account, the liquidity of financial assets, ranking them in descending order of liquidity can give a fair idea of the liquidity concept with respect to financial assets (Houston & Brigham 2009). These are ranked as follow: Corporate Bonds, Treasury Bills, Certificate of Deposits and ordinary shares of unquoted company. Summarizing this list of financial assets, it can be said that Corporate Bonds are least liquid of all financial assets listed above while ordinary shares are most liquid.

Money multiplier and Its Relationship with the Reserve Ratio

Money multiplier is a measure of the magnitude of changes in income. It shows the change that is brought about in national income due to a change in aggregate expenditure. The concept of multiplier explains that the initial change in aggregate expenditure in an economy will lead to an multiple changes in national income until the effect is nullified. The effect of such a multiplier in national income depends on the size of aggregate expenditure in an economy and the initial increase that is leading to the multiplier effect. For example, the government spends $10 million on government hospitals. The government expenditure of $10 million will inject money into the economy. This money will pass through the hands of labor that was involved in the construction of hospitals, the engineers involved in planning and the contractors. The expenditure of government is the income of these people. Such labor, engineers and contractors will save a part of their income and spend a part of it. The expenditure of such people than becomes the income of others and the cycle carries on until the expenditure is nullified. The multiplier effect finally comes to an end because every person's expenditure is the income of another but such person who receives it as an income, spends only a part of his income as expense. If a person spends $100 to buy a mobile phone, the expense of such a person is the income of the mobile shop owner. Now the mobile shop owner will spend a part of his income, so supposing that he spends $60, than such expense will become the income of another and so the cycle carries on. As the marginal propensity of not spending increases, the rate of multiplier decreases and so does its effect on national income.

The money multiplier is of great significance in the financial markets due to its deep relationship with the reserve ratio. If a customer deposits cash with a bank, that deposit is an asset to such a person but a liability to the bank. The bank holds the cash as an asset so its assets equal its liabilities. If the bank advances a loan to any other person on the basis of the money deposited, that will be an asset to the bank, but any deposit created will be a liability. But banks usually advance loans in amount which are a multiple of the amount deposited with them. This is due to the multiplier effect. To understand this concept, we need to understand the concept of the reserve ratio and its relationship with the multiplier effect. The reserve ratio is the percentage of amount that the banks intend to hold against the amount of deposits they have. For example, ten banks of equal size receive a deposit of $100 each. Each bank now enters in its books, assets and liabilities of $100. The banks are on a fractional reserve system and we assume that they wish to hold 10% reserves against all deposits. The new deposits put the banks into disequilibrium since they have 100% reserves against these new deposits. As the banks have maintained a reserve ratio of 10%, therefore their deposits increased to $1,000 and their loans increased to $900. The maintenance of reserve ratio by the banks created a multiplier effect with a numerical of 10 (Lipsey & Chrystal 1997).

Risk Management and the Basel Capital Accord

Risk management plan for this project must be such that is flexible and tailorable enough to adopt to unforeseen and volatile situations (Culp, 2001). Therefore best case scenarios and worst case scenarios are to be considered and compared to the existing scenarios. In order to implement a risk management plan successfully, it is essential that the plan should have a low probability and low impact index. The plan should be reviewed at time intervals to make way for any last minute changes and amendments.

In the financial sector especially when it comes to dealing with volatile economic situations, financial institutions must adhere to a very prudent approach towards risk management. This means that while the financial institutions must strive to boost their business, preparations must be made for the worst case scenarios. Under estimation of risks must be avoided at all costs while a bit of over estimation is still preferable. Ample provisions must be made for doubtful debts.

Economic researches carried out recently also claim that many financial giants saw a plunge and in many cases bankruptcy due to the extensive leveraging they allowed on short-term assets. Not only the leverages were too high but were done without adequate risk coverage. In many cases, such as the likes of Lehman Brothers, the capital reserves of the financial institution were too small relative to the risk the organization was being exposed too. This was again a clear example of an underestimation of risk (Jolly & Rampbell 2010).

Many Economic researches have claimed that the major factor that contributed to the crisis were the regulatory and governance problems pertaining to the banking sector. The Basel Capital Accord, a risk management tool devised by the Basel Committee suggests that in order to protect the solvency of financial institutions and there implicated effects on the global economy, the capital reserve that a bank holds should be directly proportional to the risk it is exposed to. As a result when a situation of crisis arose, the pressure of liquidation of assets mounted up with multiple times and the Value at Risk numbers of giants such as Lehman Brothers and Bear Stearns drastically went upwards within months. According to the President's Working Group of 2008, weak control and monitoring of balance sheet growths were another reason that added to the financial plunge.

Conclusion

Effective risk management is essential for financial institutions. Poor regulatory measures cannot only push the bank itself into an insolvency situation, but can be implicated on the overall economy. In order to avoid this, it is necessary that banks maintain a consistent liquidation policy relative to the risk they are exposed to. The capital reserve requirement must also be in line with the risk. It is highly important that risks are not underestimated. Moreover, exponential balance sheet growth must also be curtailed and balance sheet growth must be closely monitored.