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This Essay Is About Risk Management In The Financial Sector

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Discuss Essay About Risk Management In the Financial Sector?

 
 

Answer:

Introduction

Business and corporate bodies invest in the business because they want to take a risk and create value for the investors. The process of managing the risks determines whether an organization will be able to achieve its goals and objectives. Organizations are expected to manage both internal and external risks. Internal risks start from within the organization and are influenced by internal risk decision making processes. On the other hand, external factors are found in the operating business environment and affect all businesses operate in a given industry (Dutta and Perry, 2006, Madura, 2010, and Stowell, 2012). What happens in the global risk affects all businesses irrespective of the industry and the region they are operating in. This could be very well explained in the context of Global Financial Crisis (GFC). Global Financial Crisis is considered one of the worst finances crises to have ever happened in the world history. The global economic started in 2007 and was because of the loss of confidence by the USA investors in the sub-prime mortgages. This caused a liquidity crisis. The situation forced the US Federal Bank to inject a huge amount of capital to the financial markets. This worsened the situation further by spreading across the globe. The crisis became tense. Many homeowners could not afford to pay their loans since their value of their homes plummeted (Giacometti et al. 2008). Many people in the process could default paying their loans forcing many banks to repossess them.  Even though the crisis triggered a global financial crisis, many experts and management professionals do believe that the situation did give an opportunity to come up with better lending regulations. The credit derivatives partly contributed to the situation since it reduced the incentives to monitor the borrowers and as such fuelling the crisis. The credit widely expanded because the risk exposure had increased across.  In the light of this, the article will critically analyze operational risks, credit risks and system risks surrounding the performance of corporate bodies today. The essay will also consider the issues related to governance and compliance management models. Finally, the role of ISO31000:2009 in risk management will also be discussed.

 

Risk theme discussion

Operational risk

Operational risk is from within the company. A well designed operational risk plan can be used to develop elaborate risk management tools that will ensure business continuity and sustainability in a highly risky business environment. It is an avenue of dealing with business disasters and recovering from unexpected risks (Mengle, 2007). Operation risks are as a result of internal systems, processes, and decision-making procedure. To be able to deal with an operational risk, one must develop a risk map which identifies, examine, communicate and mitigate all the risks. A loss associated with operation risks arise from inadequate organizational procedures, systems, and policies. Employees, for example, can make an accounting error that could easily lead to a loss. In other cases, because of weak internal control measures, employees can engage in a fraud that will take many days to be realized. For example, the reasons Lehman Brothers is because of the operational risk. Maintaining its balance sheet was a disaster. The company had very weak internal financial management system (Aue and Kalkbrener, 2007). When the company wanted an emergency, it could get because it had no collateral to back up the same. Its calculations could not qualify the company even though the reports that it was giving to the staking were indicating good performance. Lehman became a victim of operational risk and consequently failure after it acquired three main mortgage lenders. Among the three lenders are BNC Mortgage and Aurora. The two lenders specialists in Alt-A which refers to those loans that are issued without much documentation. Although at first the idea of acquisition looked to be a good thing because of the record revenues from real estate business, it could not sustain for long. Once the market started trembling, money was not flowing from the real estate businesses. Between 2004 and 2006 Lehman did record the highest revenues from capital markets as 56% from 10%. In three consecutive years starting 2005, the company also made record profits. Now, the failure of the company could be blamed on its internal policies, procedures, and systems. The decisions to finance the acquisition purely is an internal decision. The decision to make a massive investment on the acquisition to gain from the lucrative real estate business was not the best (Roe, 2011). One could argue that if the company had strong internal systems, the risk could have been low and that business will have survived the economic storm.  The decision was a miscalculation since some defaults in the subprime mortgages had already been reported. This was noted in the first quarter performance report of the USA housing market. The business operations would have allowed diversification of risk to have more revenue sources in case one failed.

Credit risk

Credit risk, on the other hand, refers to that risk that will occur if the borrower will not repay the loan. The lender, in that case, stands to lose both the principle and the interests charged on the amount of money borrowed (Cruz, 2003). This risk is more common when the borrowers expect to use the cash flows to finance their debts, but they do not get that cash flow. That means that the loans will default and the banks will lack the cash to run their operations. This is the problem that was experienced in the Global Financial crisis. Many investors did borrow to invest in the real estate business based on the tip the demand for the same was going to increase something that never happened. The industry collapsed because the anticipated market was never there. Many of the investors were not able to pay back their mortgages. The outcome was that banks lacked the capital to run their operations. This risk is one of the worst to many banks that have no strong internal controls on lending. This is a risk that is always there. Whenever banks give credit cards, mortgages and loans, they should expect that risk. However, more important is the percentage of the credit risk that can be accommodated, and that cannot affect the running of the business (McNeil, Frey and Embrechts, 2005).  Consider the case of Bear Steams failure. The company did fail because of the hedge funds. Hedge funds are used to explore high-risk strategies that can generate more revenue to the business. Hedge funds are used for the defensive move and are invested in complex and aggressive but highly risk projects to maximize wealth for the shareholders. In some occasions, some companies are forced to borrow in what is commonly known as collateralized debt obligations (CDOs). Because many companies cannot finance the projects using their capital alone, they use CDOs. The highest risk is when you are not able to pay back the debt because the project failed. The collateral used will not be recovered. That is what happened to the company after massively investing the housing market. The portfolio managers could not ascertain the credit risk associated with the investment. This led to the company collapse when the housing market failed since it could not afford to pay its debts under the CDOs.

The connection that is there between the operations systems is that the higher the operational risks, the higher the chances to experience high credit risks. Take the case of Lehman has confirmed this. The operations of an organization determine how an organization is exposed to credit risk. Consider a situation where a company takes a detailed study of a business opportunity before investing (Giacometti et al. 2007). It helps the company to identify the possible risks, assess it and determine the possible impact it will have on the business. This aspect was missing when Lehman was acquiring the three leading Mortgage lenders. It did not analyze the risk situation because the internal systems did demand for the same. The same applies to The Bear Stearns since the company portfolio managers did not bother to analyze and monitor the risk that was associated with the investment.

 

Systemic risk

Finally, the system risk happens when a decision taken at a company level can trigger major instability or even the collapse of the entire industry. This could be explained in the GFC context. It is the decision to invest massively in the housing market that led to GFC. However, the impact of the systematic risk is determined by the size of the company involved. If the company facing the systematic risk is large, the loss will be enormous, and all the players in the industry will feel the impact (Wisdom, 2009). The result of poor risk management starting with operational risks, credit risks and systematic risk, is the lack of liquidity for the business. This is because many of the investments are not planned for, and the risks that might affect their performance mitigated or even eliminated if possible. Because the various companies did not good risk management policy and did not involve various stakeholders in making investment decisions, they were affected by the financial crisis, and they could not sustain themselves because they did not have more revenue sources to keep their operations running.

Role of derivatives products in the financial crisis

The objective of the credit derivatives was to help the lenders manage the credit risk and more especially when they felt that there was a risk of the borrower not paying back the money borrowed. The CD was a versatile and flexible instrument that was used by the partners to efficiently deal with the credit risk exposure (Minton et al. 2009). The intention was to minimize or eliminate the credit by providing insurance against those losses that may be incurred in the credit events and also to enhance the performance of the participants regarding profit making (Schich, 2010). A CD swap was the most common type of CD that happened between two partners over-the-counter (OTC). The CD swap was used to shift the credit risk exposure to the credit seller. It was effective in reallocating the risk and establishing mature and diversified credit exposures. The credit transfer has two major effects in the financial markets. First, it has made the process of trading in credit risk easier. Second, it has made the process of financial transactions to be more complex because it involves the use of a third party.

A better part of critics has argued that the CDs had a role in the financial crisis. This is because the lenders shifted the role of monitoring and managing the risk to the sellers. Because of the CD s, credit exposure did enhance, and many people did borrow to invest in the housing market.  Because the sellers of the CDs were the one dealing with the borrowers, it was to access the credit (Sjostrum, 2009). It did not come to the notice of the lenders that if the borrowing is not controlled will have a serious impact on the banking and insurance industry. Because of this, the CDs have been blamed for the following three main reasons: First, the major participants in the market Lehman Brothers and Bear Stearns, as well as AIG, did allow the huge construction of risk positions that lead to the systematic risk in the industry. The three participants, through the CDs, did create enormous credit exposure (Warren, 2010). Because of their size and the investing they were controlling in the industry, they were creating a huge systematic risk, and immediately the market collapsed, the impact was felt in the financial sector across the globe. Second, because of lack of transparency in Collateralized Debt Obligations (CDS), various entities in the market did manipulate the industry to portray other players as weak and therefore could operate well in the market because of the financial position (Acharya and Johnson, 2007). Finally, because of the CDs, there was greater financial connectivity among the financial institutions. This made the impact worse and a global issue because many different financial entities across the globe were involved. That is why the market failure in the U.S affected the world economy as a whole.

 

Governance and non-Compliance in risk management

Governance is an oversight role and the process through which a company identifies and mitigates various risks. On the other hand, compliance charged with the process of ensuring that the company has both internal processes and controls that ensure it meets the minimum requirements that are imposed by legal authorities and industry regulators (Ashraf et al. 2007). These two concepts are important in creating a platform for evaluating and controlling various risks following a certain process.

In risk management, governance plays a very vital role in developing appropriate frameworks on how to deal with various risks. To start with, all organizations are subjected to regulatory bodies, management boards, and other executive teams. The governance role in risk management include defining and communicating specific corporate risk control measures, the policies to follow, the possible risks that an enterprise is facing and its management (Eberlein, et al. 2007). Governance also ensures that all regulatory policies and compliance requirements are met. These are clearly outlined in the company code of ethics. Further, governance plays a significant role in evaluating the overall performance of the business using a well-balanced scorecard. In general, governance helps to integrate organizational performance with risk management. Governance, therefore, ensures that are well-controlled business activities and decisions that are guided by available potential risks (Cruz, 2002). Compliance starts immediately when the company starts to follow regulations. Compliance is meant to regulate the business in such a way that it operates within the accepted limits. Compliance is not one-time event, but a continuous process. Governance ensures that all policies and regulations are followed and that the business follows the right route to reach its goals and objectives. 

Role of ISO31000:2009

ISO 31000:2009 is a very important standard that could be used to ensuring that various risks affecting organizations regarding performance and professionalism as well as environmental obligations and societal needs are considered. The standard in the modern business environment provides clear principles and guidelines for managing risks. The standard is important because it can be applied by any given organization no matter the size. Further, the standard enhances the chances of organizations attaining their objectives through improved opportunity identification approach. Finally, it also provides a guideline on how to carry out both internal and external audit activities. This is supportive to compliance since it ensures that the company is operating within the required framework (ISO, 2017).

 

Conclusion

This essay has critically analyzed the concept of risk management in the finance sector. Particular reference has been given to the Global Financial Crisis (CFC) and the facts surrounding it. The main concepts that have been covered in this discussion include Operational risk, credit risk, and systemic risk. The other concepts also include the Role of derivatives products in the financial crisis and Governance and non-Compliance in risk management. The ISO31000:2009 standard and its role in helping bring sanity and good business management principles have also been discussed. In general, in the future, the following solutions could be applied to help manage the financial risks: First and foremost, there is the need for corporate bodies to adhere to operational, credit and systematic principles to promote good governance and proper decision-making procedures. Second, there is also need to enhance risk management processes to avoid making arbitrary decisions that can make organizations make losses. Further, it is also important for corporate organizations to consider engaging in financial re-engineering activities to ensure that resources are well utilized for optimum performance.

 

References

Acharya, V.V. and Johnson, T. C. (2007). Insider trading in credit derivatives. Journal of             Financial Economics 77:110-141.

Ashraf, D., Altunbas, Y., and Goddard, J. (2007). Who Transfers Credit Risk? Determinants of the Use of Credit Derivatives by Large US Banks, The European Journal of Finance, V.        13, Issue 5, 483-500.

Aue, F. and Kalkbrener, M. (2007). LDA at Work: Deutsche Bank’s Approach to Quantifying     Operational Risk. Journal of Operational Risk, 49–93

Cruz, M. G. (2003). Developing an Operational VaR Model using EVT. Chapter 7 in Advances    in Operational Risk: Firm-wide Issues for Financial Institutions, 2nd ed. Risk Books.

Cruz, M. G. (2002). Modeling, Measuring and Hedging Operational Risk. Chichester: John           Wiley & Sons Ltd.

Dutta, K. and Perry, J. (2006). A Tail of Tails: An Empirical Analysis of Loss Distribution Models for Estimating Operational Risk Capital. Working Paper 06-13, Federal Reserve    Bank of Boston.

Eberlein, E., Frey, R., Kalkbrenner, M. and Overbeck, L. (2007). Mathematics in Financial Risk   Management. Jahresbericht der DMV109, 165–193.

Board. (2006). Fourth Quantitative Impact Study 2006. Federal Reserve Board, Washington,        DC.

Giacometti, R., Rachev, S., Chernobai, A. and Bertocci, M. (2007). Aggregation Issues in             Operational Risk. Journal of Operational Risk, 2, 55–90.

Giacometti, R., Rachev, S., Chernobai, A. and Bertocci, M. (2008). Heavy-tailed Distributional    Models for Operational Risk. Journal of Operational Risk, 3, 3–23.

ISO (2017). International Organization for Standardization: Great things happen when the world agrees, Available on https://www.iso.org/iso-31000-risk-management.html

Madura, J. (2010). International Financial Management, Abridged 10th Ed. USA.

Mengle, D. (2007). Credit Derivatives: An Overview, Economic Review, Fourth Quarter, Federal Reserve Bank of Atlanta.

McNeil, A. J., Frey, R. and Embrechts, P. (2005). Quantitative Risk Management. Princeton          University Press.

Minton, B. A., Stulz, R., and Williamson, R. (2009). How Much Do Banks Use Credit      Derivatives to Hedge Loans? Journal of Financial Service Research 35:pp1–31.

Roe, M. J. (2011). “The Derivatives Market's Payment Priorities as Financial Crisis            Accelerator,” Stanford Law Review 63, pp539-90.

Schich, S. (2010). The role of insurance in the recent financial crisis, Insurance Markets, and         Companies: Analyses and Actuarial Computations, 1 (1), pp. 45-53.

Sjostrum, W. K. (2009). The AIG Bailout, Washington, and Lee Law Review. Vol. 66, Issue 3:      943-991.

Stowell, D. (2012). Investment Banks, Hedge Funds, and Private Equity. 2Ed, Academic Press,    USA.

Stulz, R. M. (2010). Credit Default Swaps and the Credit Crisis, Journal of Economic       Perspectives, American Economic Association 24(1), 73-92.

Warren, E. (2010). AIG Rescue, Its Impact on Markets, and the Government's Exit Strategy.           Princeton University Press

Wisdom, G. (2009). Wisdom on Value Investing: How to Profit on Fallen Angels, John Willy &     Sons, New Jersey, Canada.

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