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Bank Funding Structures And Evidence Risk

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Question:

Discuss about the Bank Funding Structures and Evidence Risk.
 
 

Answer:

Introduction:

The financial crisis of 2007-2008 in the United States is often described as an example of faulty investment decisions by corporate world and household sector. The faulty investment decision resulted in inflation, huge financial losses and insolvency of several organisations. The downturn was so powerful that it impacted the whole economy of the United States and the world causing a serious lack of liquid capital. The liquidity of capital gripped the business organisations, even the big ones which created a shortage of liquid money thus reducing cpaitral flow between the household and the industrial sectors. The economic crisis was so dangerous that it forced big American banks Meryl Lynch, Lehman Brothers and AIG to file for bankruptcy. The crisis was related to lack of regulation of derivative markets and housing industry. According to experts the financial crisis of 2007-2008 was caused by lack of government and institutional control on the housing loan sector. The government of the United States made law to help the middle class Americans get mortgage loans to build houses at high default rate. A large number of home buyers were willing to borrow money from the banks like Merill Lynch which led to the prices of the houses plummet. The people started taking debts to make houses but were unable to pay back. This led to a fall in the value of the financial securities and derivative market. It created a liquidity crisis for the big banks which were forced to close their operations. The federal government of the United States took over AIG to save it from bankruptcy. The financial crisis took the stock market into its clutches and the entire global securities and derivative market crashed. The led to liquidity shortage in the world which had far reaching consequences (Reinhart, 2013).

The global financial crisis showed the world that operational, credit and systemic risks are interconnected and can lead to devastation of the world economy. The United States government created a high risk or subprime mortgage loan to enable the low and the middle class Americans to buy houses. The financial institutions bundled these asset products and sold them to the borrowers. These loans were often bundled with other financial and derivative instruments to attract maximum number of borrowers. Presence of high demand led to a high rise in the prices of houses which once again encouraged people to take more loans. The regulatory bodies in order to ensure the success of the loans easily approved loans through slack underwriting criteria. This led to improper examination of the borrowers’ credibility to pay back the loan which led to erosion of the value of the securities instruments. Money lent on loans and mortgages act as asset for the banks which generate huge interest income for them. The bankruptcy of the vast middle class population created took its toll on the earnings of the banks like Lehman Brothers with advanced risk management systems which appealed the Bank of America and Barclays to take it over (Mensah, 2015). The law of mortgage created by the federal government lacked foresight and left the institutes free to misuse the products to earn high rate of interest. The household sector borrowed without considering its limited financial resources to pay back loans and debts. The regulatory authorities and the approving departments of the banks approved the loans easily without assessing the financial background of the borrowers(Carroll & Buchholtz, 2014). They did not examine whether the borrowers were capable of paying the debt back to the banks so that the banks could use it for further lending and earning of revenue in form of interest. It can be stated that the financial crunch of 2007-2008 was consequences of lack of efficiency on the side of the governments, banks, estate companies and household sector to operate a new profitable law. This operational risk turned a law passed to boost money into the house sector into a reason behind a global financial crisis and credit risk (Helleiner, 2014).

 

The global financial crises affected the banks more than any other body and submerged them into acute credit shortage and risks. The historical incidence showed that the regulatory framework and legal systems in the country have important roles to play in the capacity of banks to take credit risks and lend towards the development of the economic sector. The crisis led to more government regulation and formation of laws to help backs create capital buffers to handle financial and credit risks. The incidence showed that the banks need to work under the Basel III standard to be able to avoid any such crash in the future (Vazquez & Federico, 2015).

As pointed out that failure of the household sector to repay loans eroded the value of the derivative instruments. The banks which lent money to the middle class to buy houses lost huge revenue because their capital was locked in the mortgage. This gave rise to liquidity risks and affected the credit giving capacity of the banks or credit risk(Correa, Goldberg & Rice, 2014). The banks of America also relaxed their credit assessment in order to compete with the European banks like Barclays and Royal bank of Scotland. These American banks lowered the risk assessment parameters of their securities and derivative instruments which ultimately led to the unsecured borrowing done only to earn short term revenue. The banks like Lehman Brothers and Merrill Lynch were sold to at very low prices. AIG was taken over by the government at $85 billion in order to save it from bankruptcy (Diebold & Y?lmaz, 2014).

Banks are borrowers of money in terms of current accounts and lend money in forms of loans against securities and derivative instruments. The banks make money flow in the global economy and ensure liquidity of funds for production processes in the whole world. The multinational banks are supposed to have more credit giving power than smaller banks. The multinational banks are believed to be at better positions to handle financial crises and follow Basel standards (Kapan & Minoiu, 2016).  The financial crises led to the fall of big banks which created credit risk and liquidity crunch in the global economy. The derivative market crashed all round the world and the deficiency of available credit enveloped the whole world. The credit risk affected the global economy and created systemic risk which engulfed all the industries creating acute market downfall (Bekaert et al., 2014).

Financial derivates products are contracts whose value are dependent on underlying assets like bonds, shares and so on. The mortgages were initially backed by securities which apparently shielded the banks against the risk of losing their credit. The regulatory and approval authorities slackened risk assessment before lending the money which made the loans easily available to the borrowers (Claessens & Ratnovski, 2015). The borrowers borrowed huge sum of money against unjustifiable derivate instruments but were not able to pay the loans back. This eroded the value of the securities and caused the share market to crash. Thus, the derivates were acting as securities to guarantee the credibility of the borrowers and the credit giving risks of the banks. They lost their value and risk aversion power due to lack of regulation and assessment from the governments and the lending banks. The derivative market plays a very important role in risk management in the investment function through hedging and other instruments. Thus failure of the derivative market to hedge risks led to global economic crash (Rajan & Zingales, 2015). Financial engineering can help the organisations take risk management decisions and take advantage of the market by choosing between collaterals, swaps and so on. Modern financial engineering can help companies to study the risk and hedge their financial resources to diversify the risk over a large number of financial assets. This helps the companies to derive maximum profit from the portfolio and bring about capital maximisation of the shareholders (Jarrow & Chatterjea, 2013).

 


Governance and non-regulatory compliance in risk models or framework help organizations to manage risks and meet their business goals. The stakeholders like the management, employees, governments, financial institutions, customers and supply chains are impacted by the activities of organisations. These stakeholders actually represent the macro economic factors which direct the business strategies of the organisations (Acharya et al., 2013). Financial institutions like banks, especially the multinational banks serve a huge consumer base and enable flow of money between economies. They maintain liquidity of money so that the industrial sector can raise funds to carry on their productions and generate further revenue. The government makes laws and policies which direct lending and borrowing operations of the banks. The apex financial institutions like the Federal Reserve System in the United States of America makes laws and rules which govern the banks and their functions. The laws also have provisions the banks resort to deal with financial crisis (Grubel, 2014). The global financial crisis pointed out that the regulation from government is essential for the banks to manage their market risks and carry on their business. It also showed that even multinational banks need to abide by corporate governance to avoid bankruptcy. The government of the United States created laws to enable the middle class Americans take loans to build houses. The law triggered the banks to lend mortgages against securities having high rate of interests. The regulatory authorities slacked the credit availing requirements to ensure maximum availing of loans. The household sector or the customers availed the loans but were not able to repay them because they were insolvent themselves. The bank authorities or managements relaxed the eligibility criteria and underwriting rules to ensure maximum loan market penetration and revenue. It can be pointed out that the government, customers, management and employees are all parts of corporate governance. The interact with each other and impact the strategies of the organisations to ensure that its operations benefit them. The government did not create the strict borrowing policies to measure the credibility of the borrowers. The borrowers borrowed money from the banks and could return it back which eroded the liquidity of the banks. Thus, the lack of corporate governance from the side of these stakeholders resulted in erosion of liquidity and risk management. Thus, in other words corporate governance is essential to maintain economic stability and keep the financial crises away (Claessens & Yurtoglu, 2013).

Risk management models ensure that organisations are able to take and manage risks to earn more profit. The risk management and assessment is done by the top executives drawing strength from market information and organisational structures. The organisations like banks create their own business and risk management models. The management uses various methods to gain measure risk and ensure that the assessment is accurate and feasible. Governance risk management is the tool to examine the strategic strengths of organisations and to make sure that they take risks as per their capabilities.

 


Risk management refers to procedures which the management uses to analyse the business risks and the power of the organisations to diversify them. Risk management frameworks of organisations decide their risk taking propensity and comply to all the legal policies and laws while taking those risks. Today the risk management framework of the organisations is backed by advanced technology and enterprise risk management (DeAngelo & Stulz, 2015). The risk management and non-regulatory framework today consists of control of risk management of the organisations by the financial institutions and government bodies. The non regulatory framework tends to guide the risky investments of organisations in order to ensure that they are not hit by the risks. The financial crises in the United States show that the knowledge of the borrowers about their debt paying capability could have acted as a non regulatory check against the crisis. The risk assessment framework of the banks could have acted as non regulatory framework to ensure that the borrowers have the power to pay the debts. Both these non regulatory framework did not contribute towards ensure corporate governance of the banks which actually complemented the weak regulatory framework of the government. The failure of the two catapulted into an economic crash, erosion of global market capital and risk management by the economies (Elbahar, El-Masry & Abdelfattah, 2016).

The financial crisis made the governments and the corporate sector realise the need of governance, compliance and risk management. The organisations manage risks by entering into business relationship with firms specialised at taking risks. These risk vendors, as these firms are called adopt various models of solution for risk management like Integrated GRC Solution. Domain, Specific GRC Solutions and Point solution to GRC. These risk vendors model data warehouses designed according to the needs of the companies so that the management can take appropriate decision on risk management. The organisations today take help of data warehouses which provide them with large bodies of data to assess the business risks and make accurate strategies to manage risks (McNeil, Frey & Embrechts, 2015).

ISO 31000 is a component of the risk management standard framed by International Organisation of Standard.  Today organisations function under complex environment which presents before lot of risks. Risk management help organisations manage risks and use their resources to use efficiently in managing risks. The risk management also includes risks the operations of organisations pose to the society and to the stakeholders.  The organisation provides for risk management in various forms which can be applied in companies of varying sizes and scales of operations.

ISO 31000:2009 provides directions in general for design, application and maintenance of risk management mechanisms by organisations. The ISO 31000:2009 provide a wide range of risk management mechanisms for the organisations which require enterprise risk management. The parameter covers all strategies, management or tasks of operation  spanning all functions, processes and projects. The ISO 31000:009 encompass appointing stakeholders, risk management officers, compliance auditors within the companies and independent analysts (Curkovic, Scannell & Wagner, 2013).

The ISO 31000:2009 plays very important role to ensure organisations are able to manage risks in such ways to profit from them. This parameter allows the organisations to employ workforce to assess the risks, the consequences and benefits that can be likely derived by taking the risks. The organisations can analyse their own risk taking capability based on their financial strengths, supply chain, market penetration and so on (Riel et al., 2015).

The next important role of ISO 31000:2009 then studies the risks and the associated benefits. If the risk management team finds that the risk would benefit the company in a great way like increasing the market position of the organisation or entering a new industry, it may help the company to increase the risk, if required in order to increase the benefit. The parameter also has provisions of removing risks or changing the likelihood of the risk. This helps the companies to avoid risks which are likely to result in huge financial losses or have dire consequences on the firm. The next important role played by ISO 31000:2009 also has provisions for sharing the risks with other companies or parties. They involve entering into contracts with firms and companies which have expertise in financing risky projects. They even have provisions for the management of the companies to retain the risky position if they consider those positions as a part of their business strategies (Dallas & Director, 2013).

 


The ISO 31000:2009 provides standard of risk management which can be followed by organisations irrespective of their sizes, locations, activity or sectors. The risk management parameters are even more applicable in today’s world in order to maintain resilience in the global economy. The financial crisis of 2007-2008 which hit the United States showed how economic problem of one part of the world can create a chain of events capable of disrupting the entire global economy. The advancement of technology, intense global competition, emergence of new markets and so on have made the economies more interdependent. Today the emerging markets like China and India interact more than with the developed markets like North America and Europe. These countries are home to several multinational companies who have considerable business assets in other economies and worth billions of dollars. The less developed markets are dependent on these countries and companies for their very sustenance. These companies cater to a global consumer base and generate revenue for the governments of their home as well as host countries (Baylis, Smith, & Owens, 2013). Thus, a bankruptcy in any of these companies can create chain of events which can hit the entire global economies. The companies are increasing stressing on functioning in sustainable environment. A parameter like ISO 31000:2009 can help companies to assess and manage risks better which will help them to avert unprofitable risks. They can also save their material, human and financial resources which would have been employed to deal with the risk. Thus, such parameter can contribute making the global environment more favourable to investment by managing risks (Bremmer, 2014).  

Sustenance has emerged as a new way of operating in the global economy where companies work towards adopting environment friendly ways. The companies require to invest huge amount of money towards adopting sustainable technology which involves considerable risks. ISO 31000:2009 acts as parameters which help companies to assess the limit of risks to be taken to adopt sustainable means of operations. The companies are considered as social identities which should function in sustainable means to ensure conservation of environment. Thus, such parameters go a long way in applying sustainable ways by assessing the risk associated with them (Fletcher & Bianchi, 2014).

Risk management has emerged as a very large area spanning over all the economies. Risk management has become important due to interdependence between countries and companies. Globalisation and advanced technology have brought nations so close that a wrong risk assessment in one part and sector can affect the whole world. The financial crises show the need of government and institutional participation to ensure risk management and smooth function of all organisation even multinational banks. The governments, customers and all the other stakeholders need to examine the risks associated with investments before transforming them into action. It requires responsible corporate governance and conduct from all the stakeholders. The risk management parameters of ISO 31000:2009 help organisations to assess risks and avoid a recurrence of financial crisis 2007-2008.

 

References:

Acharya, V. V., Gottschalg, O. F., Hahn, M., & Kehoe, C. (2013). Corporate governance and value creation: Evidence from private equity. Review of Financial Studies, 26(2), 368-402.

Baylis, J., Smith, S., & Owens, P. (2013). The globalization of world politics: an introduction to international relations. Oxford University Press.

Bekaert, G., Ehrmann, M., Fratzscher, M., & Mehl, A. (2014). The global crisis and equity market contagion. The Journal of Finance, 69(6), 2597-2649.

Bremmer, I. (2014). The new rules of globalization. Harvard Business Review, 92(1), 103-107.

Carroll, A., & Buchholtz, A. (2014). Business and society: Ethics, sustainability, and stakeholder management. Nelson Education.

Claessens, S., & Ratnovski, L. (2015). What is shadow banking?.

Claessens, S., & Yurtoglu, B. B. (2013). Corporate governance in emerging markets: A survey. Emerging markets review, 15, 1-33.

Correa, R., Goldberg, L. S., & Rice, T. (2014). Liquidity risk and US bank lending at home and abroad (No. w20285). National Bureau of Economic Research.

Curkovic, S., Scannell, T., & Wagner, B. (2013). ISO 31000: 2009 Enterprise and Supply Chain Risk Management: A Longitudinal Study. American Journal of Industrial and Business Management, 3(07), 614.

Dallas, M., & Director, A. P. M. (2013). Management of Risk: Guidance for Practitioners and the international standard on risk management, ISO 31000: 2009. The Stationary Office.

DeAngelo, H., & Stulz, R. M. (2015). Liquid-claim production, risk management, and bank capital structure: Why high leverage is optimal for banks. Journal of Financial Economics, 116(2), 219-236.

Diebold, F. X., & Y?lmaz, K. (2014). On the network topology of variance decompositions: Measuring the connectedness of financial firms. Journal of Econometrics, 182(1), 119-134.

Elbahar, E., El-Masry, A. A., & Abdelfattah, T. (2016). Corporate governance and risk management in GCC Banks.

Fletcher, W. J., & Bianchi, G. (2014). The FAO–EAF toolbox: making the ecosystem approach accessible to all fisheries. Ocean & Coastal Management, 90, 20-26.

Grubel, H. G. (2014). A theory of multinational banking. PSL Quarterly Review, 30(123).

Helleiner, E. (2014). The status quo crisis: Global financial governance after the 2008 meltdown. Oxford University Press.

Jarrow, R. A., & Chatterjea, A. (2013). An introduction to derivative securities, financial markets, and risk management. WW Norton & Company.

Kapan, T., & Minoiu, C. (2016). Balance sheet strength and bank lending during the global financial crisis.

McNeil, A. J., Frey, R., & Embrechts, P. (2015). Quantitative risk management: Concepts, techniques and tools. Princeton university press.

Mensah, J. M. K. (2015). The failure of Lehman Brothers: causes, preventive measures and recommendations. Browser Download This Paper.

Rajan, R. G., & Zingales, L. (2015). The Economic Functions of Derivatives Markets. The Economics of Derivatives, 22.

Reinhart, C. (2013). Goodbye inflation targeting, hello fear of floating? Latin America after the global financial crisis.

Riel, A., Lelah, A., Mandil, G., Rio, M., Tichkiewitch, S., Zhang, F., & Zwolinski, P. (2015). An Innovative Approach to Teaching Sustainable Design and Management. Procedia CIRP, 36, 29-34.

Vazquez, F., & Federico, P. (2015). Bank funding structures and risk: Evidence from the global financial crisis. Journal of Banking & Finance, 61, 1-14.

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