Risk Management During Financial Crisis in the US

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’. Webster’s Dictionary (1989) defines the word risk to mean

• expose to the chance of injury or loss
• a hazard or dangerous chance
• the hazard or chance of loss
• 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 firm’s 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.

• 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
• To make an in-depth study of the deficiencies in risk management by financial institutions during the recent financial crisis
• 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.

1. What are the salient aspects of risk management by financial institutions under conditions of the financial crisis?
2. What are the deficiencies in the risk assessment and risk management techniques followed by the financial institutions during the recent financial crisis?
3. 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.

• 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.
• 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.
• 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:

• Collecting the savings of the people to provide them compensation in the form of interest for foregoing the current utility of those savings and
• 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:

1. Mechanisms or instruments that enable the potential savers to park their savings safely and profitably
2. Mechanisms which provide the needy investors or borrowers the required funds to fund their projects
3. Mechanisms that govern the payments on behalf of the customers and
4. 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
5. 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 prevent the impact of such risks hampering the returns from such investments. Risks follow the path of either that they will happen or they may not happen and the impact of the risk is largely influenced by the conditions prevalent at the time of the happening of the risk. (Ward and Chapman, 2003; Artto, and Kähkönen, 2000) The quality of the analysis of risk depends on the variability and the degree of uncertainty connected with future scenarios. (Turner, 1999) This is the reason that there has been a recommendation by many researchers that the term ‘risk’ needs to be replaced by the term ‘uncertainty’ which has more neutral quality as compared to ‘risk’. The term ‘uncertainty’ also has a larger scope than that is covered by ‘risk’. The term ‘uncertainty’ has more capabilities to replace the term risk as the variability and ambiguity connected with risk can be accommodated in uncertainty (Ward and Chapman, 2003).

Artto and Kähkönen (2000) point out the risk has a dimensional perception which implies that risk could be adverse and significant for the same may turn out to be an opportunity or less significant for someone else (Artto, and Kähkönen 2000). Risk perception is regarded as one of the major development in the area of risk management practices. Kahkonen identifies that it is possible to localize the definition of risk in a way that it could define the risk more precisely in individual cases. (Kähkönen, K. in Artto, K., Kähkönen (2000)

It is possible that the risks can be categorized in several ways based on the degree of details involved or based on a particular viewpoint selected for the purpose. The risk categorizations may take the form of a risk list or it may as well present the sources of risks, which depend on the phase or the type of the project. A typical risk categorization may take the following form as advocated by Artto and Kähkönen (2000):

• Pure Risks are the ones, which are caused by factors like natural calamities or weather conditions;
• Financial Risks take the form of either difficult cash flow situations or credit risks and the like;
• Business Risks encompass any kind of risks that may affect the progress of the project,
• Political Risks are identified as the one which covers extreme political situations like war which has a serious impact on the project process.

Turner (1999) suggested the categorization of risks as business risks, insurable risks, external risks, and internal risks depending on the impact of the risks of the location of the control over the risks. Bad weather may be cited as an example of the external risk on which the project manager does not have any control. Similarly, the business risks are those risks, which generally have to be faced by any venture to take advantage of a likely opportunity, which can be a positive outcome of business risk.

Approaches to Risk Mitigation

There are there general methods of mitigating the risks in financial institutions:

1. The firms can employ simple business practices which have the capabilities of eliminating or avoiding risks
2. The firms can try to transfer the risks to other market participants and
3. There can be an active risk management programs at the firm level

In the first of the above three methods, the practice of risk avoidance reduces the chances of the firms accumulating losses by the elimination of risks which are superfluous to the business processes. The financial institutions follow actions like underwriting standards, hedging to match the assets and liabilities, reinsurance or syndication to spread the risks and due diligence investigation. In these actions, the main objective is to make the firm get rid of the risks that are not part of the financial services provided or to absorb only an optimum level of a particular risk.

In the case of systematic risks, it is possible to reduce the risks that are not required to continue to do the business by avoiding them altogether. Similarly, in the case of operational risks, the firms can adopt different ways to reduce the different kinds of risks including fraud, oversight failure, lack of control and managerial limitations. However, it must be noted that aggressive risk avoidance measures in these areas may result in lowering the profitability to some extent but enough cost justification can be communicated to the shareholders for the reduction in the earning.

Risk transfer is another method of mitigating a substantial part of the risks. Risk transfer is achieved by the firms by transferring the assets created by the financial institutions at fair market value at the open market. The firms undertake the transfer of these assets if they find no incremental benefit in providing for the mitigation of risks associated with the keeping of such assets. Usually, there exists a market for the claims issued and are assets created by many of the financial institutions and there are individual market participants who undertake to acquire these assets for diversification of portfolios.

There is another set of risks, which are inbuilt in the operations of the financial institutions and the firms themselves must absorb these risks. In these cases, the firms should practice aggressive risk management techniques and the firms are expected to employ additional resources for managing these risks. These risks possess certain special characteristics:

1. There are the stakeholders for whom the institutions own financial responsibility. The claims of these people cannot be treated otherwise even by the people who have invested in financial institutions. Example in this connection is the defined pension plans schemes.
2. Some activities carry risks of complex nature like the case of illiquid and proprietary assets being held by the banks (Santomero and Trester, 1997).
3. The existence of moral hazard in which the stakeholders’ interests need to be protected by adopting different risk management techniques as part of the operating procedures.
4. Any risk management process is central to business purposes.

Risks Associated with Financial Services Products

Before an analysis of the risks associated with the financial services products and the ways of mitigating them, it becomes important that an overview of the financial services being provided by the financial institutions is undertaken. The financial services provided by the institutions can be categorized under the following groups (Merton 1995; Merton and Bodie, 1995):

1. Origination – involving location, evaluation, and creation of new financial claims issued by the institutions’ clients. The originator depending on his plans to retain the ownership of the new asset or sell the product he takes the position of the principal while retaining the ownership and an agent while trying to sell the asset. An example of the originating function is that of the mortgage banker.
2. Distribution – represents the act of selling newly originated products to different customers who can finance them. The institution may act as a broker or as a principal. In this case, the financial institutions do not take ownership of these assets but act to place the assets in the portfolio of the potential investors.
3. Servicing – facilitates the collecting the payments due from the issuers and settling the claimants. The service provider in this process maintains records of payments, monitors the financial contracts, and takes necessary action in case of defaults. This kind of activity is more prominent in developed nations. In this case, the same institution holds most of the assets.
4. Packaging – is of recent origin and involves the collection of individual financial assets into common pools, and then is repackaged to increase the liquidity or meet the cash flow requirements of specific customers.
5. Intermediating – is the most popular financial service undertaken by the institutions, which involves the practice of issuing and purchasing of different financial claims to a single financial entity. There are three different kinds of financial intermediating that are common; they are (i) insurance underwriting (ii) loan underwriting and (iii) security underwriting which involves the acquiring of securities as principal to distribute to different investors.
6. Market Making – is an activity where a dealer buys and sells identical financial instruments. However, the market maker does not become the principal in the transactions. A market maker becomes an intermediary when it finances the transactions by issuing its claims and acquires financial assets.

In all the above transactions, a distinction must be made between the “principal and agency activities”. This is because the accompanying “risks and incentives” vary from each other for the two positions. While a principal commits a capital risk in terms of both time and money, the agent works for someone and hence there is the risk of time only. In the agency business, the capital investment is modest whereas in the case of the principal activity there is a heavy investment of capital outlay. Since the principal owns a portfolio there is the systematic and idiosyncratic risk. In the case of an agency, there is only the idiosyncratic risk.

Risk Management by Financial Institutions

Any financial institution is subject to risks. Managing risks is a complex proposition for any financial institution. Risk management has become an increasingly important phenomenon, in the current global economic scenario where there is a close link among the financial systems of different economies. Effective risk management has been prescribed by the global financial institutions and banking regulators, as an important element in the long-term success of the financial institutions. The management of financial institutions and regulators focus on improving the ability of the organizations to manage future risks instead of evaluating the current or historical financial performance. Risk management in the case of financial institutions takes the following form.

From the above figure, it may be observed that the risk management framework in the financial institutions includes assessing, evaluating, managing and measuring risks to which the institutions are exposed. Risk management must be a continuous process providing the feedback to the management on the potential losses that are likely to occur because of the exposure to different types of risks.

The management and regulators consider the management of future risks as the best predictor of long-term success. The financial institutions, receive several benefits out of efficient risk management.

• The foremost advantage of risk management is that it serves as an early warning for potential problems of financial institutions. With a systematic process of evaluation and measurement of risks, the financial institutions will be able to identify the problems at an earlier stage, before these problems become larger and affect the efficiency in the performance of the financial institutions. An early warning signal prevents the drain of the management time and resources of the financial institutions. When the financial institutions can identify the problems earlier they have to spend only lesser time fixing problems and they can spend more time productively on their growth.
• With an efficient risk management plan in place, the financial institutions will be able to allocate their resources more efficiently. The resources here represent the cash and capital available with the financial institutions. “A good risk management framework allows management to quantitatively measure risk and fine-tune capital allocation and liquidity needs to match the on and off-balance sheet risks faced by the institutions and to evaluate the impact of potential shocks to the financial system or institution” (GTZ, 2000). The financial institutions must engage effective treasury management, as the primary objective of the financial institutions is to maximize the earnings by channelizing their investments in portfolios having the minimum risk of loss.
• A risk management system, when it functions efficiently within a financial institution, can provide to the institution better and quality information on potential consequences, which may be both positive and negative. Effective risk management can establish a proactive and forward-thinking organizational culture within a financial institution. It also helps managers in identifying and assessing new market opportunities and it enhances the ability of the managers to foster continuous improvement of existing operations of the financial institutions, resulting in the effective alignment of performance incentives with the strategic goals of the organization.

In the case of financial institutions, better risk management yields similar benefits, as they do in the case of traditional banking institutions. With the continuous growth and expansion of the financial institutions, they have to serve more customers and attract mainstream investment capital and funds for their successful operation. For achieving this, the financial institutions have to strengthen their internal capabilities to identify and anticipate potential risks. This ability will enable the financial institutions to avoid the unexpected drain of their resources and there may not be any surprises or shocks to the organization.

Creating an efficient risk management framework within the organization has to be the priority of the financial institutions; once they can identify the individual risks such as credit risk, market risk, and liquidity risk, (following sections discuss different types of risks faced by financial institutions). Financial institutions should also have clarity about the roles and responsibilities of managers and board members, concerning the risk management of the institution, which will enable the organization, build stronger organizations. “A comprehensive approach to risk management reduces the risk of loss, builds credibility in the market place and creates new opportunities for growth,” (GTZ, 2000 p. 5).

A risk management framework for a financial institution represents a consciously designed system implemented to protect the organization from unexpected and undesirable surprises (there are denoted as downside risks) and enables the organization to derive the advantages of opportunities available to the organization. The following are the potential advantages of an effective risk management framework as it applies to a financial institution. Since effective risk management will avoid most of the delinquencies in the financial institutions, a discussion on the risk management for the financial institutions becomes important.

Effective Risk Management Can:

1. Integrate the operations of the financial institutions into a set of systematic processes. This systematic process enables the identification, measurement, and monitoring of different types of risks faced by the financial institutions by helping the management to have a close watch on the organizational functions in a global way
2. Provide continuous feedback between measuring and monitoring and between internal controls and reporting. Such a framework also provides for an active oversight by the senior leaders of the organization and the directors on the operations of the financial institution. This also enables the organization and its top management to respond swiftly to changes in internal and external environments of the financial institution
3. Provide an overview of the situations in which the management can have an overview, where different risks interact with each other and they can exacerbate one another in adverse situations.
4. Allocate the responsibility for risk management and organizational preparedness to the domain of the senior management and that of the board
5. Promote efficient use of resources and decision-making in the most cost-effective way
6. Create an internal organizational culture in which there is a possibility of ‘self-supervision’, which will be able to identify and monitor risks much before the outside stakeholders or regulators could identify them.

Importance of Risk Management to Financial Institutions

Some reasons make a more sophisticated risk management framework and improved approaches are important to financial institutions. In the present day context, the financial institutions have grown to larger proportions, serving a large number of customers and broader geographic areas. They offer a wide range of financial services and products. In practice, the internal risk management of the financial institutions is found to be a step or two behind the scale and scope of their operations. This makes an effective risk management an important factor to sustain their growth. Secondly, for meeting the requirements of enlarged lending activities, financial institutions have to rely increasingly on market-driven sources of funds.

The funds are generally drawn from external investors or as deposits from the savings of clients. If the financial institutions have to preserve the access to such funding sources it requires the maintenance of good financial performance and avoid unexpected losses. Third, the organizational structures and operating environments pose exclusive problems to the management. “They may be very decentralized or too centralized (both can be a risk), tend to be labor and transaction-intensive have concentration risk in certain regions or sectors (e.g. agriculture) due to their mission and often operate in volatile and less mature financial markets.” Finally, financial institutions have to establish financial viability through operations, which are efficient and cost-effective. This calls for effective risk management to achieve better resource management without exposing the institution to undue risk.

Rationale for Risk Management

The importance of risk analysis can be found in dealing with increasingly complex financial transactions. For example in derivative transactions, several innovative products and services have developed over the period, which enlarges the risk of the financial institutions in these fields. The complexity is enhanced as a natural evolution process, although it is not a universal phenomenon. For instance, with sophisticated information and communication techniques number of people dealing with the financial institutions from different geographical locations increase, which also enhances the risk element for the financial institutions. As a concurrent development, with the increase in information and knowledge of the public, there is the demand and need for higher levels of service quality and the risk increases because of the increased complexity of the systems. Therefore, it becomes important for financial institutions to understand and meet the investors’ demand by making their policies consistent with such demands. In recent periods risk analysis is one important and powerful tool to address risk management issues by the financial institutions and to develop sound and safety policies and design strategies.

Thus, economic challenges, market uncertainties, and difficult value trade-offs among competing goals have made it difficult to arrive at a consensus on the policies to be followed to manage the potential hazards, dangers and losses to financial institutions. However, suitable policies must be developed and implemented to achieve the desired outcomes in the matter of protecting the interest of the financial institutions. It is therefore important that the use of risk analysis to improve risk management decisions and policies resorts.

The demand for risk analysis can be seen from the significance of eliminating all risks associated with an activity. Risks must be weighed in terms of (i) risks of alternative activities to that which is being considered and (ii) trade-offs between the benefits likely to accrue from the incremental efforts taken to mitigate the particular risks and the cost of such efforts in getting the resultant benefits. Here lies the demand for risk analysis. Risk analysis provides the information needed to weigh the alternatives and analyzing the tradeoffs between costs and benefits. This is more so when there is ambiguity surrounding the available information and the information is uncertain and not obvious to make a decision. Risk assessment techniques become handy in providing a means of presenting the relevant information in an organized way and estimating the impact of adverse consequences.

However, the analysis conducted using risk assessment techniques may be able to provide precision to the information only to a certain degree, because of the tentative nature of the underlying assumptions and uncertainties, which are inherent in the risk assessment. In such cases, there is the demand for risk analysis and efforts may be taken to arrive at a balance by considering what constitutes acceptable risk by using any risk assessment tools. Thus to meet the demand for risk analysis, individuals and corporate decision-makers identify levels of risk which are within the tolerance limit in the light of several other factors like cost of risk reduction, perceived risks and benefits of the technology applied, activity, or substance that poses the risk and the available alternatives for the activity or substance, (Covello et al 1988; Travis et al 1987; Travis and Hattermer-Frey, 1988).

Classification and Measurement of Risk

To manage their risks, financial institutions must have complete knowledge about the risks affecting their operations. Acquiring the knowledge about the risks involves assigning the methodologies to measure them based on a perceived and classified expression of risks. Thus, there are different steps involved in the process of identifying and measuring the risks. They are: (i) classification of risks into meaningful and observable types of risks, (ii) selection of an appropriate model-based methodology for measuring the risks belonging to the individual classification made and finally, (iii) use of the selected methodology to generate a measurement of the specific risks affecting the financial institutions. Once the financial institutions acquire the knowledge relating to the risks affecting their operations, the management can start applying various policies to assess, mitigate or transfer the risks identified by them. This section provides a review of the commonly used classification of the risks and the fundamental current risk management and measurement methods.

Out of the above classification of the financial institutions, the originators, distributors, service providers, and packagers can be considered as having the agency characteristics and the intermediaries and market makers represent principal business makers. The agency services act to provide market access to the buyers and sellers of financial instruments and hence expose the service provider to a minimum of risks. The businesses where the service providers act as principals place a significant amount of capital on the interaction between the buyers and sellers.

In fact in these areas that the financial institutions expose themselves to major risks and hence there is the need for an effective risk management program. Both the intermediary and the market maker are not covered entirely for the risks associated with their activities and hence it may be necessary that its investors may have to bear some part of the risks associated with the activities of these financial institutions. The risks borne by these institutions can be broken down into three general categories of risks, which are (i) market risk, (ii) credit risk and (iii) liquidity risk. Apart from these risks, there is a liquidity risk, which is often mentioned as a major separate risk category. There are other non-financial risks, which includes strategic and business risk, which also needs consideration by the financial institutions.

The three main categories of financial risk can be subdivided into other subcategories as depicted in the above figure. However, there may be varying classifications of the risks facing financial institutions in the literature. Since the financial institutions must have a thorough knowledge of the major risks affecting their financial standing and profitability, studying the classification becomes important and it also helps them to design and apply appropriate risk management policies to overcome the potential losses arising from the risks.

Market Risks

Market risks have a financial orientation and these risks arise because of frequent changes in the domestic financial system. The disparity in values of properties and claims against a financial institution can lead to the facing of market risk by the financial institutions. Market risks are likely to become more pertinent when the financial institutions become larger in size and operations and complex in terms of assets and liabilities possessed by them. The varying proportions of properties and claims of the financial institutions pose challenges of market risk to the financial institutions because fluctuations in the market, which affect the value of such properties and claims.

Changes in conditions of the market, in which the financial institutions are operating, though may be external to the financial institutions influence the functioning of the financial institutions favorably or unfavorably. Therefore, these are considered as market risks for financial institutions. There are three important market risks for the financial institutions and the following sections deal with these different types of market risks. Market risk can be subdivided into “equity risk, interest rate risk, currency risk, and commodity risk.”

Interest Rate Risk

Interest rate risk can be defined as the current or prospective changes in the earnings and capital caused by periodic movements in the interest rates. “Depending on the interest rate risk profile of banks, such as the extent to which individual banks are net lenders or net borrowers in the interbank market, their profitability will be affected to different degrees” (Yam, 2006). The major risk being faced by the banks and the financial institutions is the risk posed by the change in the interest rates. The interest rate risk for the financial institutions emanates from the financial intermediation services being undertaken by them.

The risk is caused by the difference in the maturity values of the assets and liabilities of the banks. The interest rate sensitivity differences often expose the equity of the banks and other institutions to changes in the interest rates, which ultimately affects the profitability of the institutions. The unexpected changes in the interest rates make the balance sheet hedging activity of the bank, which is normally undertaken based on the maturities of assets and liabilities at the expected maturity values shown in the balance sheets of the firms. When there are changes in the interest, which affect the valuation of assets and liabilities negatively the banks and other institutions are bound to get a beating of the earnings. The other forms of interest rate risks are the refinancing risk and reinvestment risks.

Techniques Used to Protect Against Interest Rate Risk

A forward contract with the interest rate changes as the base is known as ‘forward rate agreement’ (FRA). The FRA consists of an inter-bank traded contract to buy or sell interest payments on a future date and the interest is to be calculated on a notional principal. Under the forward trade agreement, the buyer gets a right to specify a certain rate of interest for an agreed term, which is set to start on a future date. The interest amount will be arrived based on an assumed principal amount. Similar to the currency forward contracts, the FRAs also are entered into with maturity periods of 1,3,6,9 and 12-month periods.

Interest rate futures, on the other hand, are largely used by the finance and treasury managers of non-financial companies in contrast to the currency futures (Bodnar & Gebhardt, 1999; Eiteman et al., 2000). The enhanced usage may be because interest rate futures are having relatively high liquidity, are simple to use and the interest rate exposures of the firms are standardized. However, Phillips, (1995) and Mallin et al., (2001) are of the view that the interest rate futures are not popular among firms to manage their interest rate risks.

The interest rate swap is a dealing between two entities wherein one party settles interest to the other on fixed dates, but with varying interest calculations. ‘Plain Vanilla’ is the common arrangement where one part of the payments is set and the other part of the payment is maintained at varying rates. This type of swap contracts has become the most popular financial arrangement in the global context.

Interest rate options are just like forward rate agreements. In the interest rate options, instead of being bound by a firm commitment to receive interest at one rate and make payment of the interest on another, a right is given to the holder to receive interest at one rate and make payment of the interest on another.

Currency Risk

Currency risk or foreign exchange risk is a natural consequence of international business dealings, where the value of the currency of one country moves up and down against that of another. International firms usually enter into some contracts that require payment in different currencies. This risk arises because of a change in the domestic currency value of a firm’s assets and liabilities caused by the changes in the rates at which the currencies of different countries are counted. The exchange rate exposure may be positive or negative (Banking and Finance, 2000).

Firms that deal in currencies of different countries face the risk of gaining or losing in the value of assets and liabilities or respect of their revenue or outflows because of sudden unanticipated changes in currency exchange rates (Sivakumar & Sarkar, 2007). Economic globalization has made the business organizations spread their wings across the geographical locations and use low-cost locations for improving their profitability and sales growth. This has necessitated the movement of foreign exchange from one country to another in the form of capital movements and the profits repatriated to the country of origin. However, due to frequent and major changes in the domestic and international financial markets, the firms have been exposed to two kinds of foreign exchange risks. These are exchange rate risks and interest rate risks. The firms adopt several measures to protect against currency fluctuations.

Techniques Used to Manage Currency Risks

One of the earliest methods adopted without involving any derivative instrument is the forward contracts in foreign currencies in which they are dealing it. However, this method of mitigating the foreign exchange risks did not prove to be effective whenever there was a favorable movement of the foreign currency and the firms are often exposed to loss of profits, which they would have otherwise earned had they not entered into the forward contracts. After the introduction of the various forms of financial derivatives, they started covering their foreign exchange exposure by resorting to financial derivatives.

Using Derivatives for Managing the Currency Risks

Out of the above methods of mitigating the foreign exchange risk, the forward contract is the oldest and most popular one used by the business firms to manage the financial risks. A forward contract is “a cash market transaction in which delivery of the commodity is deferred until after the contract has been made. Although the delivery is made in the future, the price is determined on the initial trade date.” (Investopedia, 2009) Under the forward contract, the firm agrees to buy and deliver a certain amount of a specified foreign currency at a future date. The rate at which the currency is to be delivered is decided at the present point of time. If the actual currency value on the date the amount is due is more, the firm makes a profit out of the deal and if the currency value is less than the contracted value a loss results out of the deal.

A futures contract is defined as “A standardized, transferable, exchange-traded contract that requires delivery of a commodity, bond, currency, or stock index, at a specified price, on a specified future date.” (Investor Words, n.d.) Under the futures contract, the firm is obligated to buy certain specified currencies at specified exercise exchange rates. In this type of contract, the risk to the holder of the instrument is rather high and unlimited as there is always used to exist an asymmetry in the payment pattern. The risk of the seller is unlimited as well.

Under the currency swap contract, the buyer and seller or the other parties involved in the contract are obligated to provide for predefined remittances at the appointed payment dates. A swap contract comprises a series of forwarding contracts put together for covering the foreign exchange risks. Under this system, the parties provide each other with the difference in the interest payments covering the amount contracted in the different currencies. An option “Like other options, an option on a futures contract is the right but not the obligation, to buy or sell a particular futures contract at a specific price on or before a certain expiration date. These grant the right to enter into a futures contract at a fixed price,” (Investopedia, 2010c).

Credit Risks

Generally “Credit risk is the risk that a change in the credit quality of a counterparty will affect the value of a bank’s [or other financial institution’s; note of the author] position,” (Crouhy et al. 2001). Credit risks arise due to the non-performance of a debtor and these risks usually arise either the debtor is unwilling or unable to perform according to the already committed contract terms. This has its effect on the lender who underwrote the loan, other people who advanced money to the creditor as well as the shareholders of the debtor himself. A major part of credit risk is the culmination of the systematic risks and the unusual losses associated with these risks pose a problem for the creditors despite the benefits of diversification from the whole uncertainty. This applies especially to the creditors who advance amounts in the local market against the security of the illiquid assets (Morsman, 1993).

Credit risk has a close association with the lending of the financial institutions and is an important risk that any financial institution could face. Whenever a financial institution lends money to a borrower, there is an inherent risk that the borrower may commit default in repaying the amounts to the institutions. Where there is a potential chance that the borrower fails to pay back the borrowed amount the situation is known as the credit risk. “Credit risk is simply the possibility of the adverse condition in which the clients do not pay back the loan amount” (India Microfinance News, 2010). This type of risk is the popular one among the financial institutions. Credit risk becomes important for the financial institutions, as these institutions have a diverse clientele. Financial institutions derive their funds and fund their portfolio through external borrowings or deposits from the public and by subscribing to their capital. Advancing a loan by the financial institutions also puts these sources of funds under risk.

Credit risk is inbuilt to the transactions undertaken by any investment or commercial bank. It is a fact that financial institutions can neither are too conservative in their approach towards lending, (as this approach would be a deterrent on their growth) nor can they act over-enthusiastically. If they act in an over-enthusiastic manner, the organization may face the danger of incurring potential losses. Therefore, it becomes essential that the financial institutions have to institute appropriate risk-mitigating initiatives, to ensure sustained profitability avoiding the negative impact of different risks affecting the business beyond reasonable levels. Credit risk arises because of elements affecting the operations present both within and outside the financial institution.

There are different forms of credit risk and the subcategories include the sovereign, political and country risks. All these categories include exposures to losses because of cross-border business connected with decisions of foreign governments and regulatory bodies. Settlement risk is another category of credit risk, where there is a failure of a two-way payment transaction. Settlement risk occurs when one of the persons dealing under a transaction defaults after the other party has performed his part in the transaction.

Managing credit risk form a major responsibility for the banks, as lending is the core business for the banks. Banks mainly adopt (i) portfolio diversity, (ii) conservative underwriting and account management and (iii) aggressive collection procedures as the techniques to mitigate credit risk (Dorsey, 2007). The best way banks manage their credit risk is by dividing their total amount of lending by companies, industries or geographical locations. This enables the banks to have a cushioning effect in the matter of credit risk management. If the bank experiences a higher credit risk exposure in one of the geographical locations, it will be offset by the safe lending in other areas. This way the banks can spread their credit risk over different portfolios of lending.

When the banks lend to firms in any sector, they can protect themselves against credit risk by evolving efficient procedures for risk mitigation. The focus of risk management in respect of credit risk lies in avoiding writing bad loans. If a loan appears to be doubtful, the banks take all possible efforts to realize the loan. The banks, which develop the skills for better managing credit risk, can have a higher competitive ability than the others are. Establishment of sound credit approval systems and processes supplement this ability of the banks to mitigate the credit risk more efficiently.

Since lending becomes the major activity for the banks, they establish detailed systems and procedures for assessing the risks and rewards of its credit risk settlement activities. An efficient credit analysis would help banks to mitigate their credit risk largely. This way the banks would be able to eliminate credit risk without lowering their level of activities in credit trading by making their settlement practices more efficient. The trading patterns of the banks also have an impact on the mitigation of their credit risk largely.

Liquidity Risk

Asset liability management is important for any organization, especially for financial institutions. “Asset liability management is, therefore, a process through which an organization has to match maturing of its assets (that is when they can be turned into cash) with maturing of its liabilities (that when they are falling due for poor payments)” (India Microfinance News, 2006).

“If an organization does not have sufficient assets maturing to fulfill its liabilities falling due then there is a risk that the organization may not be able to honor its committed obligation and this risk is called Liquidity Risk. Assets, maturing within one year period are termed as Current Assets, while liabilities which are falling due within one year period are called Current Liabilities,” (India Microfinance News, 2006).

“Liquidity management is, therefore, basically managing current assets and currents liabilities. If an organization’s current liabilities are more than current assets than such an organization has an immediate liquidity risk. Liquidity risk in financial institutions is considered to be one of the most sensitive issues and a risk of high priority,” (India Microfinance News, 2006).

“As liquidity problem can result in a financial institution failing to honor its obligations, it can result in loss of reputation, loss of credibility among lenders and depositors and has the potential to snowball into a big crisis” (India Microfinance News, 2006). If a financial institution is unable “to pay back savings of depositors when they come for withdrawal because they do not have enough cash then it can immediately give the wrong signal in the market,” (India Microfinance News, 2006). The news will flow in the market that either financial institution does not intend to repay the depositors or the institution is insolvent and unable to meet its financial commitments. “Spread of this news with other depositors can result in the panic situation who may also come for withdrawal and this could lead to a situation called to run on savings, where everyone wants to withdraw their savings compounding the entire problem,” (India Microfinance News, 2006). Also, defaults committed by the financial institution in making repayments to its lenders will lead to reduced confidence not only of the present lending agencies but also other prospective lending agencies. Because of this, the credit rating of the financial institution will fall, making any further rising of funds difficult for the institution.

It is also not advisable that the financial institution always keeps high liquidity with sufficient cash at all times to face emergencies. It is important to understand that liquidity entails a cost on the organization and if the financial institution decides to maintain all of its assets as a liquid, it may not be possible for it to earn any fee or interest. It is always in the interest of the organization to avoid idle assets. Since the income of the financial institution arises from lending the money, it will fail to earn the interest income if it maintains all its assets in cash form with it. Additionally, the financial institution “has to pay interest on its borrowing as well as deposits irrespective of the fact that they are deployed in loans or not,” (India Microfinance News, 2006). Therefore, “while high liquidity brings the profitability and sustainability of a financial institution down, insufficient liquidity results in the risk of defaulting on obligations” (India Microfinance News, 2006). The financial institutions must institute appropriate risk mitigation plans, within the financial institution to enable the organization to conduct its business transactions smoothly.

Operational Risk

The operational risks take the form of errors in record keeping, computing errors in calculating the payments, processing system failures and non-compliance with some regulatory requirements. The operational risks result in issues relating to processing, settling and providing, and securing delivery of trades in exchange for cash. Thus through individual operating issues pose smaller risks to the well-managed organizations, they may sometimes expose these firms to larger exposure of economic losses.

Operational risks arise from human or computer error. These risks may arise when the financial institution serves the clients during its business. Operational risks may be found in any division or product of the financial institution. “This risk includes the potential that inadequate technology and information systems, operational problems, insufficient human resources or breaches of integrity (i.e. fraud) will result in unexpected losses,” (GTZ, 2000).

Traditionally any other uncertainty, which could not be classified into the ambit of another major risk group, was included in the group of operational risk. However, the Basel Committee on Banking Supervision has provided a new definition of operational risk. This definition includes any loss occurring to the financial institution from a lack of internal control or inefficiency of systems and procedures. It also includes loss arising from the operation of external events. This definition has provided for a different category of risks connected with the operations of the financial institutions, which is the “strategic risk”.

There has been increased importance attached to operational risk in recent years, because of the proliferation of information and communication technology usage in the financial institutions and because of the recognition of the increased role of human resources in the operation of these institutions. Another feature of operational risk is that it can emerge in all the departments across the institution because of the presence of human resources and technology in all the functional areas of the financial institutions.

In the present day’s context, the financial markets and banking institutions and system has changed dramatically with the increased use of technologies. Also, enterprises across the globe have recognized the importance of human resources. Financial institutions have also adopted these larger changes and the operations of the financial institutions are carried out using modern-day technological measures. This has given rise to several operational risks to which the financial institutions are exposed. “Strong internal processes, systems, good human resource and preparedness against external events are needed for managing the operational risk. Operational risk is enhanced by increased dependence on technology, low human and business ethics, competition, weak internal systems in particular weak internal controls,” (India Microfinance News, 2006a).

The operational risks to which a financial institution is exposed can be grouped under five different categories –

1. human risks including errors, frauds, collections, and animosity,
2. Process risks including lack of clear procedures on operating such as disbursements, repayments, day-to-day operations, accounting, data recording and reporting, cash handling and auditing,
3. system and technology risks like a failure of software, computers and power failures,
4. relationship risks like client dissatisfaction, dropouts, loss to competition and poor products and
5. asset loss and operational failure due to external events, loss of property and other assets or loss of work due to natural disasters, fires, robberies, thefts, riots.

Other Categories of Risk

There are some other categories of risk, which can be listed including reputational risk and strategic risk. Reputational impairment to the financial institution causes reputational risk.

“Perceived incompetence, negligence or misconduct of the institution” is the major cause of reputational risk. Strategic risk arises because of the strategic choices of top management. The following sections discuss other categories of risk.

Systematic Risks

Systematic risk is the risk of changes in the asset values, which are the result of systemic factors. The institutions can at best hedge against most of these risks but cannot completely do away with them. The systematic risks are faced by the institutions because of the impact of the economic conditions on the values of assets owned or claims issued by the institutions. The best example of the systematic risk is the difference occurred in the worth of properties and claims because of the changes in the interest rates. Due to fluctuations in the market rate of interests, unpredictable differences occur in the worth of properties and claims. Similarly, large-scale changes in weather may influence the value of real estate assets.

The institutions that may experience a significant impact on their balance sheets due to systematic risks try to mitigate these risks by a careful estimation of the impact of the particular systematic risks and limit their sensitivity to these risk factors, which cannot be avoided. This forces those institutions which are exposed to a larger fixed income market take efforts to monitor the interest rate movements closely and adjust their exposures accordingly (Esty, Tufano, and Headly (1994) and Santomero (1997). They do it more rigorously than those firms, which have very little exposures to risks in their portfolios.

Counterparty Risks

The counterparty risks result from the failure of one of the parties to the transaction to carry out his part of the contract. The trading partner may refuse to perform either due to an adverse price movement caused by the operation of the systematic risks or due to any other political or legal constraint that was not expected to happen by the actors. The non-systematic counterparty risks can be mitigated by undertaking diversification on a wide scale. Though counterparty risk can be equated with the credit risks, it can be considered as a transient financial risk resulting from trading activity, different from the default of a debtor. There may be several other reasons for the counterparty risk to arise other than the credit issue.

Legal Risks

Legal risks are distinct from the legal impacts of other kinds of risks like credit, counterparty and operational risks dealt with above. These risks stem from the operation of new statutes, court rulings, or new regulations, which have the effect of making even the previously properly done transactions to contentious ones. These risks appear even when all the parties who performed well in the past and can perform better in the future. For example, the introduction of new bankruptcy laws may create new risks for corporate bondholders. Similarly, there may be significant impacts on real estate values due to changes in environmental regulations. There is yet another kind of legal risk, which may arise due to the institution’s management practices or the action of its employees. Accounting and other frauds, violations of securities laws and other misdeeds can result in large economic losses.

Risk Measurement Methodologies

Next to the classification of risks into different categories is choosing the appropriate model-based methodology to measure the specific risks. The purpose of risk measurement methods is to specify the risk factors and risk exposures that need to be captured and quantified for serving as inputs for the calculation of the extent of risk. The selected method specifies the particular risk factors and risk exposures that need to be captured. Capital Asset Pricing Model, Value at Risk (VaR), and Arbitrage Pricing Theory and Fama-French Three Factor Model are some of the quantitative methods used for measuring risks of financial institutions.

Capital Asset Pricing Model (CAPM)

This model developed by William F. Sharpe and John Lintner for the valuation of security. This method has been adopted for the valuation of shares of a firm by many analysts due to its simplicity and the real-world applicability. This method takes into account the association between the threat of loss and anticipated income from each security. This model assumes that based on the behavior of the risk-averse investor there is implied an equilibrium relationship between risk and expected return from the prospective investments planned by the investor.

In the market equilibrium, security will be expected to provide a return following the risk, which is inbuilt within the security and hence impossible to avoid. This risk is the one that cannot be avoided by diversifying the investment portfolio. With larger unavoidable risk inbuilt in a security, the person investing in that security will expect a larger return from that particular security. The association between anticipated income and inbuilt risks forms the basis for valuing the securities under the CAPM model. (Van Horne, 2004) This model has several assumptions for its offering the proper results. The method also has several significant repercussions. “CAPM implies that investing in individual stocks is pointless because you can duplicate the reward and risk characteristics of any security just by using the right mix of cash with the appropriate asset class”. (Moneychimp)

Value at Risk

“Value at Risk (VaR) is a technique used to estimate the probability of portfolio losses based on the statistical analysis of historical price trends and volatility. VaR is commonly used by banks, security firms and companies that are involved in trading energy and other commodities. VaR can measure risk while it happens and is an important consideration when firms make trading or hedging decisions” (Investopedia, 2010).

“Value at Risk (VAR) is a statistical measure of downside risk based on current positions and for a given position” (Jorion, 2007, p 105), and for a given position can be defined as “the worst loss over a target horizon such that there is a low prespecified probability that the actual loss will be larger” (Jorion, 2007, p 106). The various definitions include two parameters, which are required to be chosen based on specific circumstances – which are a holding period or target horizon and a prespecified probability or confidence level. Besides these two parameters, there is a need to mark the current position on the market. VaR provides a simple and easy-to-drive measure that allows aggregation of risks at the level of the whole firm. The VaR may be derived as either nonparametric, parametric or Monte Carlo VaR.

“In the nonparametric approach to VaR, no parameters of the forward distribution are estimated or assumed from theoretical reasoning. Instead, the distribution is simulated from (recent) empirical returns data. Historical simulation is the main example of a nonparametric VaR method,” (Dowd, 2002, p 57).

Nonparametric VaR does not involve the presumption of a certain type of forwarding distribution, which is an advantage. However, the problem with this measure is that the results are dependent on the sample period used. Parametric VaR approaches work based on the estimate of the parameters of the underlying distribution by fitting a distribution to the observed data.

Multifactor Model

“A financial model that employs multiple factors in its computations to explain market phenomena and/or equilibrium asset prices. The multi-factor model can be used to explain either an individual security or a portfolio of securities. It will do this by comparing two or more factors to analyze relationships between variables and the security’s resulting performance” (Investopedia, 2010a).

Factors involved in this model are calculated using the following formula.

“Ri = ai + βi(m) Rm + βi(1)F1 + βi(2)F2 +…+βi(N)FN + ei

Where:

Ri is the returns of security i

Rm is the market return

F(1,2,3…N) is each of the factors used

β is the beta with respect to each factor including the market (m)

e is the error term

a is the intercept” (Investopedia, 2010a).

“Multi-factor models are used to construct portfolios with certain characteristics, such as risk, or to track indexes,” (Investopedia, 2010a). However, it is difficult to estimate precisely the nature and number of factors that need to be included. For example, Fama and French Model suggest the inclusion of factors like “size of firms, book-to-market values and excess return on the market” (Investopedia, 2010a). The techniques will be graded on past results, which do not facilitate the accurate prediction of estimated results.

“Multi-factor models can be divided into three categories: macroeconomic, fundamental and statistical models. Macroeconomic models compare a security’s return to such factors as employment, inflation, and interest. Fundamental models analyze the relationship between a security’s return and its underlying financials (such as earnings). Statistical models are used to compare the returns of different securities based on the statistical performance of each security in and of itself” (Investopedia, 2010a).

There are different models like Arbitrage Pricing Theory and the Fama-French Three-Factor Model, which can be grouped under multi-factor models.

Possible Deficiencies in Risk Management Models

The previous sections contained the salient aspects of risk management and classification of risks into different categories. This section discusses the deficiencies of the risk management models and the additional risks the models create because of the deficiencies. These deficiencies account for all the possibilities where the risk management may not yield the desired results to the financial institution. When the financial institution relies on these models for assessing and managing their risks, these deficiencies in the models constitute new risks for the institutions. These deficiencies can be termed as “model risks” and they do not arise from the underlying phenomenon themselves but form the perceptions and reactions of the institutions on the models of risk measurement. In general, model risk can be categorized as a subtype of operational risk.

Unreliability of risk management models might arise because of two factors. First, technological and methodological imperfections might vitiate the utility of some of the risk measurement models. Secondly, changes from exogenous risk to endogenous risk result in the happening of extreme market events leading to changes in market reality and thereby affect the use of risk management to the financial institution. There have been criticisms that risk management is less than fully scientific. The discussion of model risk suggests that model risk might lead to serious deficiencies in financial risk management and the institutions must not put undue reliance on the results on any single risk model.

Inapplicability of Risk Management Modeling

Applying the risk management models under circumstances, where there is no way of using the models is the most basic model risk that the financial institutions might encounter. It many cases it may not be possible to know certain issues precisely. Essential uncertainty connected with such issues cannot be reduced to quantifiable risks and consequently, it may not be possible to mitigate them using the risk management models. In some instances, the risk management model may make the uncertainty appear as a risk quantifiable. However, in such cases engaging in any risk management model and relying on the results of such a model will prove to be another major risk. According to Derman (2003), “In terms of risk control, you’re worse off thinking you have a model and relying on it than simply realizing there isn’t one” (p. 134).

Use of Incorrect Risk Management Model

The next model risk evolves from the fact that the financial institutions are likely to make incorrect methodological decisions while engaging a specific risk management model. These methodological issues and possible missteps may lead to the application of an incorrect model.

The models may fail to provide a correct assessment of risk because of various reasons. The following are some of the reasons why these methodological issues may arise. The financial institutions might

1. chose a one-factor model where a multi-factor model would be more appropriate,
2. confuse stochastic with deterministic variables,
3. pick an unsuitable distribution,
4. overlook correlations between certain factors,
5. use outdated or otherwise currently invalid assumptions,
6. use a theoretical model that assumes frictionless markets in actual markets,
7. use a correct model that relies on mistaken data estimates, and
8. continue using a previously correct model after the market context has changed (Derman, 2003, p 134-135).

Problems With Var Model

Several criticisms have been raised against the use of the VaR model. According to Dowd, “there is compelling evidence that model risk is a major problem with VaR models,” (Dowd, 2006, p. 185). Part of the model risk arises because of some arguable deficiencies inherent in the model and part of the problems is because of the implementation issues associated with the model. Incorrect uses to which the VaR model is applied also gives rise to methodological issues. By frequent reference to three different studies, literature has shown that different VaR models or “even different implementation of similar VaR models” are likely to produce inconsistent results affecting the risk management decision of enterprises. According to the study by Beder (1995), “… the magnitude of the discrepancy among these methods is shocking, with VAR results varying by more than 14 times for the same portfolio. These results illustrate the VAR’s extreme dependence on parameters, data, assumptions, and methodology,” (Beder, 1995, p. 12).

The study by Marshall/Siegel has shown that differences in the implementation of even a single VaR model could produce significant VaR results. The third study by Berkowitz/O’Brian was based on the examination of VaR models of six commercial banks in the jurisdiction of the United States. The authors report, “Our findings indicate that banks’ 99th percentile VaR forecasts tend to be conservative, and, for some banks, are highly inaccurate,” (Berkowitz & O’Brian, 2002). These studies and others report that high sensitivity of VaR results produces considerable model risk based on the specification of VaR methodologies and implementation details.

There are more issues associated with model risk of VaR methods, which are technical are found by different studies. Artzner et al. (1999) think that VaR is “not an ideal risk measure.” Based on the findings of their study, the authors have attributed two basic reasons for rejecting the VaR measure of risks. They are:

1. ” value at risk does not behave nicely concerning the addition of risk, even independent ones, thereby creating severe aggregation problems.
2. the use of value at risk does not encourage and, indeed, sometimes prohibits diversification because the value at risk does not take into account the economic consequences of the events, the probabilities of which it controls” (Artzner et al. 1999, p. 218).

Point (a) remarks that the VaR does not possess the characteristic of subadditivity, which adds an incoherent nature to the risk measure. The second point indicates that VaR as a risk measure will not be able to recognize the concentration of risks. A similar use of VaR across different institutions is likely to create feedback effects, which might lead to “a breakdown of correlations and are a source of systemic risk.” Another criticism is that general VaR models are not able to consider liquidity risks explicitly. Despite the number of approaches to include liquidity effects in the VaR model, liquidity risk remains a serious issue.

Use of Correct Model and Incorrect Solution

The third important model risk identified by Derman (2003) is the use of a correct risk management model but arriving at an incorrect solution despite the use of the correct model. According to Derman (2003), “You can make a technical mistake in finding the analytic solution to a model. This can happen through subtlety or carelessness. … It takes careful testing to ensure that an analytic solution behaves consistently for all reasonable market parameters,” (Derman, 2003, p. 135). This model risk is self-explanatory, where organizations may not be able to make use of the incorrect solutions provided by the risk management models, even though they have engaged the appropriate model that needs to be used considering the circumstances.

Use of Correct Model and Inappropriate Use

The fourth category of model risk as identified by Derman (2003) is the use of a good model outside the intended purview of the application of the model. Dermon (2003) states, “There are always implicit assumptions behind a model and its solution method. But human beings have limited foresight and a great imagination, so that, inevitably, a model will be used in ways its creator never intended,” (Derman, 2003, p. 135). This model risk is essentially an example of implementation risk, which is similar to the situation of using a correct model to arrive at incorrect solutions to manage the risk.

Summary

Risk management enables improvement in “organizational monitoring, control and performance appraisal by top management, shareholders, debt-holders, regulators and other stakeholders.” From the perspective of the relationship between a principal and agent, risk management creates additional knowledge at various levels. It helps ensure that agents act meeting the interests of the principal. Additional transparency created by efficient risk management processes helps in reducing the overall monitoring costs. However, such reduction depends on the cost involved in instituting risk management measures. Finally, there is a need for appropriate regulations, which prescribe risk management practices for avoiding or lessening the “negative impact of a market failure at the macroeconomic level.”

Research Methodology

The objective of this chapter is to describe the methodology adopted for meeting the aims and objectives of this study. “In the discussion of the selection of a problem suggests valuable criteria:

1. novelty of the problem,
2. investigator’s interest in the problem,
3. practical value of the research to the investigator,
4. worker’s special qualification,
5. availability of the data,
6. cost of investigation, and
7. time required for the investigation,”(Watkins (1994) quoted by Reyes, (2004); Burns and Grove, (2005).

While considering all these aspects one of the most important issues in conducting social research is to find a way of getting the focus on the different aspects like the problem statement, conceptualizing the theory and choosing the research design. “Focus provides the integration of seeming diversity of the elements of the process from the presentation of the problem to the scope of research, conceptual framework, related literature, instrumentation, appropriate statistical methods to be used as well as the design and methodology used,” (Reyes, 2004, p 3).

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. However, the researcher must consider the nature of the research inquiry and the variables that have an impact on the research process. The researcher has to evaluate the appropriateness of the methodology as to its ability to find plausible answers to the research questions within the broad context of the nature and scope of the research issue. For the current research on risk management and its implications for financial institutions during the financial crisis, considering the research issue under study, the qualitative research approach of the case study was engaged. This chapter presents a description of the research method and discusses the salience, merits, and demerits of the method adopted. The justification of the research method also forms part of the chapter.

The research methodology is not just about data collection and the rules for evidence; it is more about the nature of explanation and how the explanations are produced. How knowledge is developed from these explanations depends on the methodology used. Research design, on the other hand, provides the plan and structure as to how explanations can be obtained.

This chapter explains the research methodology and design adopted. This research was conducted in two phases. In Phase 1 (exploratory study), several research questions were developed based on the review of the literature relevant to the research inquiry. In Phase 2 case studies on the 2007/2008, subprime mortgage and risk management failures in Lehman Brothers were carried out.

A descriptive research method such as the case study should be treated as complementary to the secondary research method used for collecting the required data. If properly utilized, the case study approach could provide important insights into the risk management practices and their implications on financial institutions during the financial crisis.

Problem Statement, Research Objective, and Research Questions

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 fluctuations in the financial system, which are quick and unexpected. 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.

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.

In the years leading up to the recent financial crisis, some of the regulators have recognized that and intimated 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. In this context, this thesis studied the issue of risk management under conditions of financial crisis and challenges faced by the financial institutions to mitigate risks.

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 attempted to achieve the following other objectives.

• 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
• To make an in-depth study of the deficiencies in risk management by financial institutions during the recent financial crisis
• To report on the effects of the deficiencies in managing risk effectively

The study will achieve other objectives incidental to the above objectives.

Based on the theoretical observations and findings from case studies, the research will find replies to the following research issues.

1. What are the salient aspects of risk management by financial institutions under conditions of the financial crisis?
2. What are the deficiencies in the risk assessment and risk management techniques followed by the financial institutions during the recent financial crisis?
3. What are the effects of the deficiencies in managing risks effectively by the financial institutions?

Methodological Framework

The methodological framework includes the research process, research philosophy and research approach used for conducting this research.

Research Process

The research process encompasses different elements involved in the research methodology, in which the process specifies the limits of the research. These boundaries take the form of the research philosophy and approach. The research strategy including the research techniques and data collection methods also are the components of the research process. Within the boundaries of the research process, the time spheres for completing the study are also included. The elements of research philosophy, research approach, research strategies, and data collection methods are discussed within this chapter under different sections. All the selected components under these heads are collectively known as the research design.

The design for further research can be formed by stating the research issue clearly. When the research problem is well defined, it will automatically point towards the appropriate method of investigation. However, there can be no single research method that can be used for all research issues. There are some research techniques, which are available to the choice of the researcher. In many instances, the researcher has to make many compromises, in the process of choosing a suitable research technique. For example, the researcher has to compromise in the quality of information, if he has to consider the cost of data collection and analysis. In some other cases, time constraints may be the prominent force driving the researcher to choose a particular research technique. Therefore, the design of a research process is always influenced by both budget and time factors in arriving at the research technique. The research design may be categorized into descriptive or causal. Descriptive studies will provide complete details on the research inquiry. The purpose of causal studies is to find the effect of one variable on another.

Research Philosophy

The research approach has the role of observing the progress of the research, which in turn depends on the research philosophy chosen as the basis for conducting the research. The ways of collecting information, interpreting and analyzing the information are covered by the phenomenon of research philosophy (Saunders et al., 2003).

The scope of this study is to explore the implications of risk management practices on financial institutions during the financial crisis. Based on the review of the relevant literature, a theoretical framework has been evolved to extend the knowledge on risk management principles and practices. Because of the nature of the research issue and the need for a substantial amount of information to be collected, interpreted and analyzed to present the real situation, the study adopted the research philosophy within a ‘phenomenological’ philosophical approach. According to this approach, it is a common phenomenon that all individuals hold certain assumptions, beliefs, and attitudes. However, for completing the current study the phenomenological approach cannot be adopted fully.

According to Flinders and Mills (1993), the phenomenological approach, the beliefs and attitudes are held to be the individual views forming part of the conceptualization process. This approach has a role in the creation of meaning in the surrounding world while directing the actions of an individual within the context of the world. By using this approach, the study would be able to embark on an outcome that considers the perceptions of the individuals, who were the participants to the research inquiry. The process also takes into account the meaning of their actions created by the participants based on their outlook and responses on the actions of the people in the world around them.

Ontology is one of the philosophies underlying social researches. The objective of the ontological perspective is to provide an account of the research issue in an elementary way. Mason (2002) posits that the ontological perspective necessitates the researcher to acquire the ability to understand how his perceptions influence the process of the research. According to Scott and Usher (2000), “… philosophical issues are integral to the research process… what researchers ‘silently think’ about research.” Therefore, the purpose of engaging a philosophical perspective to any social research is to understand the awareness and opinions of people, their perceptions, explanations, practices, and dealings, which reflect meaningful visions of social realism. It is the responsibility of the researcher to see how these actions would influence the outcome of the research and to assess the influence of the research philosophy on the overall research process.

‘Epistemology’ is another philosophical approach to social research, which spells out and explains different research philosophies that can be applied to the research process. Epistemology covers issues that are known to be factual. Doxology is the opposite view of Epistemology. Doxology implies issues that are believed to be factual. Thus, the goal of epistemology is the creation of a set of rules for knowing things now someone claims the existence of a factual thing or issue. Epistemology also checks on the validity of such a claim (Scott and Usher, 2000). The goal of any scientific or social research is to convert the research issue from the position of being believed to be true into the position of known values. Epistemology emphasizes the factors that enable the researcher to distinguish between valid knowledge and assumptions constituted by opinions or beliefs (Scott and Usher, 2000).

Apart from the phenomenological approach, this research follows a combined positivist epistemology and objective ontology approach. The adoption of these philosophical approaches enables that data collected are not biased with the personal perceptions of the researcher. The information and data required for completing this study will be collected from case studies of specific events where risk management has failed during the financial crisis. The sources and nature of data make objective ontology as an appropriate philosophy for this research.

Research Approach

The research follows a qualitative and deductive research approach. The salience of the research approach is explained in the following sections.

Qualitative Method

Being one of the principal methods in conducting researches in the realm of social science the qualitative method involves examining the viewpoints, outlooks, and experiences of the individuals taking part in research from the points of view of the informants. As against the quantitative research method, the qualitative research method does not make use of quantitative data and statistical analyses. Logical deductions to infer information concerning the human element forms the basis of the qualitative method. A major criticism against the qualitative method is that it always has a smaller sample size, which makes generalization difficult.

The qualitative method makes use of data collection and analysis methods, which do not involve the collection of quantitative information (Lofland & Lofland, 1984). The qualitative research method has been identified to focus on “quality” instead of “quantity” of information. Some of the researchers believe that the qualitative method uses a subjective methodology and makes the researcher substitute as the major research instrument (Adler and Adler, 1987). Past literature is abundant in qualitative research methods. The qualitative research method is also referred to as ‘naturalistic’ research (Bogdan and Biklen (1982); Lincoln and Guba (1985); Patton (1990); Eisner (1991). These researchers have identified several distinguishing features of the qualitative research method.

Patton states one of the requirements of the qualitative method is that the researcher has to locate the natural surrounding for taking up the process of data collection. It is also important that the researcher maintain emphatic neutrality throughout the research process. If the researcher is keen on deriving the optimal outcome from the qualitative research, he has to make a proper definition of the natural surrounding and its boundaries. There is the likelihood of the researcher becoming a research instrument himself. The qualitative method makes use of the inductive process for analyzing the collected information.

Eisner admires the qualitative method for using vivid reports with a communicative language and comprehensive and meaningful research report. Hoepfl (1997) states that qualitative research adopts ‘trustworthiness’ as the fundamental factor that influences its process. The qualitative research enables the researcher to acquire an interpretative temperament, which in turn helps him find out the meanings of the happenings conveyed to the people, who deal with them (the happenings). Qualitative research gives the researcher also, the ability to interpret these meanings. Lincoln and Guba (1985) found the interconnection between these characteristic features. Its emergent nature forms one of the salient features of qualitative research.

Patton (1990) observes that qualitative research suffers from a drawback in that the researcher can arrive at the research strategies after he starts with the process of data collection. This is because the researcher has to adhere to the systematic followup and understanding of the meanings of the information and data in respect of the background in which they are collected. Under the qualitative method, it becomes essential that the researcher spell out the primary questions to be examined in advance and subsequently to proceed to formulate the strategies for collecting the required data.

Deductive Approach

Deductive and inductive approaches are the usual research approaches that are used in social science researches. According to Saunders et al. (2003), the deductive technique requires the researcher to formulate different hypotheses and engage a research strategy to test the hypotheses. The deductive approach starts with the formation of a general idea on the research issue. Based on the idea generated the researcher forms hypotheses, which can be tested using appropriate research techniques and tools to support the general idea generated. If the hypotheses are supported, it implies that the initial idea generated about the research issue is correct. Social research often uses the deductive approach rather than the inductive approach.

In the inductive approach, the researcher starts the process with data collection and once the data is collected, he develops a theory based on the analysis of the data collected earlier. Creswell (1994) observes that the inductive approach investigates research topics, which are relatively noticeable and exciting as well as contentious.

Saunders et al. (2003) identify the goal of the inductive approach is to get a better understanding of meaning attached by human beings to events. The inductive approach also provides an in-depth knowledge of the research context. The inductive approach also comprises the process of data collection for a qualitative study. When the researcher uses the inductive approach, there is the likelihood that the researcher can change the research emphasis as the approach encompasses flexible formation that facilitates changes. However, the major concern about the inductive approach is that the approach does not possess the requirement of generalization. Saunders et al. (2003) identify the purpose of the research approach as the indication of whether the commitment of “… the theory is explicit within the research design”. Mason (2002) states the goal of the research approach is “deciding what theory does for your arguments”. The appropriate research approach will help the researcher in choosing the research design, which will facilitate the research process most.

This study uses a deductive research approach since different research questions have been developed before engaging a research strategy.

Research Design

This study follows the research design of a case study. In recent years, the roles of descriptive and qualitative research methodologies, which include case studies, participant observation, informant and respondent interviewing and document analysis have been emphasized and pursued (Scapens, 1990). In these approaches, the researcher is required to have closer involvement with the organizations under study. Based on the detailed examination of the organizations concerned, research findings are described instead of being prescribed.

One qualitative method, which seems to offer at least a partial solution to the currently unsatisfactory research, is the case study approach. In contrast to simplistic and superficial findings of the quantitative method, the case study provides the opportunity for the research to develop better theories in risk management and control systems, which are based on real-world managerial practices. Also, the case study allows the flexibility to be interpretative of the findings. The research, for example, is not restricted to his/her original theory, but most often is encouraged to come up with new theoretical discoveries.

The case study has been used as a research tool for several types of research. “Case study is an ideal methodology when a holistic, in-depth investigation is needed” (Feagin et al. 1991). Different exploratory studies in the discipline of social studies have made use of the case study method for collecting relatable information about the topics researched. The following case study as the research tool facilitates the researcher to follow well -developed techniques to meet the requirements of data collection for any kind of investigation. “Whether the study is experimental or quasi-experimental, the data collection and analysis methods are known to hide some details,” (Stake, 1995). However, the case study method has the unique capability of retrieving additional information from different perspectives drawn using multiple sources of data.

There are varying kinds of case studies, which can be engaged in conducting studies in different settings. These are exploratory case studies, explanatory case studies, and descriptive case studies. Stake (1995) took note of other forms of case studies. An intrinsic case study is one in which the researcher has a concern in the case being studied. The instrumental case study enables the researcher to explore additional information that is understandable to the normal observer. A collective case study is concerned with the study of a group of cases.

The case study method cannot be construed as sampling research. However, to derive optimum benefit from the case study, the researcher has to select the appropriate case. Case study as a research tool has often faced criticism because of its lack of the ability to provide for generalization of the findings. It is a common condemnation of the case study method that the findings cannot be applied widely in actual situations. Yin (1984) has answered the criticism by offering a well made out explanation on the distinction between “analytic generalization” and “statistical generalization”. “In analytic generalization, the previously developed theory is used as a template against which to compare the empirical results of the case study” (Yin, 1984).

Yin has led the way in making the case study as one of the prominent methods of conducting social research. After Yin (1984), several professionals and academics have provided new insights into the case study method and made it become one of the preferred research tools in social researches. Case study becomes an attractive research tool because of its ability to study the research issue in natural surroundings, which is the core element of any qualitative research. This capability makes the case study a practicable research tool.

Data Analysis

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,” which can be used in conducting qualitative research. Quantitative research uses tools like surveys for data collection. The data collection methods for the current research include the collection of secondary data and information retrieval from archival records, and other documents for completing the research. The quality of data collected determines the validity and reliability of the research findings. Thus, “qualitative modes of data analysis provide ways of discerning, examining, comparing and contrasting, and interpreting meaningful patterns or themes. Meaningfulness is determined by the particular goals and objectives of the project at hand.” (Boojihawon, 2006)

Any of the following data collection methods can be used in following the case study research approach. They are; “(i) documents, (ii) archival records, (iii) interviews, (iv) direct observation, (v) participant observation and (vi) artifacts.” Either the researcher can use a single or a combination of these or other methods for data collection and the selection of data collection method rely on the nature of research proposed to be undertaken.

There are only a few tenets, which define the mission of data collection. Each research study has to use a data collection method, which fits into the research methodology chosen by the researcher. The goals of both quantitative and qualitative research studies are to make the most of the responses from the participants and to enhance the accuracy of the results to the maximum extent possible.

Taylor-Powell & Renner (2003) explain that qualitative research depends on expressions and observations as compared to quantitative research based on numbers. Analysis of qualitative data requires creativity, discipline, and a systematic approach. They further illustrate that there is no single way to analyze the qualitative data however the basic approach is to users ‘content analysis.

Summary

This chapter presented a detailed account of the research approach, research philosophy, and research design apart from providing the methodological framework of the current research. Data and information collected from the exploratory study and the case studies are presented in the subsequent chapters. The next chapter presents the findings from the exploratory study. These will be secondary data and information collected through a review of the literature analyzed to provide an in-depth understanding of the implications of risk management in financial institutions during the financial crisis. The contents of this chapter are the findings from the case study. The analysis of the findings from the case forms part of this chapter.

Case Study, Findings and Discussion

This chapter presents case studies on the risk management approaches of Lehman Brothers and the financial institutions when they were dealing with a subprime mortgage during 2007-08. The case studies will reveal the risk management failures, which led to the downfall of the company Lehman Brothers and several other financial institutions because of poor risk management practices during the financial crisis.

Case Study of Risk Management in Lehman Brothers

This section discusses the failure in the risk management practices, which led to the bankruptcy of Lehman Brothers.

Lehman Brothers – An Overview

Lehman Brothers Inc was the fourth largest investment bank in the world, which filed for bankruptcy during September 2008. The company started as a small dry goods store in the year 1844 grew to one of the leading investment banks in the US. Lehman Brothers had a strong position in dealing with fixed-income products. Later on, it diversified into investment banking activities.

Just before 2007, Lehman Brothers was making a considerable proportion of their earnings from the business of issuing securitized assets like mortgage loans. When the collapse of the US subprime mortgage industry started, it resulted in a large-scale credit crisis. It also led to an increase in mortgage default rates, which in turn led to the disappearance of the demand for these securities. This situation has made Lehman face a situation of having billions of dollars worth of depreciating securities in its balance sheet. This has made the company to take up large write-offs and write-downs. Finally, the efforts of the company to shed its risky assets proved futile. The investors liquidated stocks of Lehman Brothers in the stock market on the consideration that Lehman might not be able to transact its business as it did before.

On September 2, 2008, the state-owned Korean Development Bank confirmed its proposed move to buy 25% of the stakes in Lehman Brothers. However, the deal did not go through. In the following weekend, Lehman Brothers put up itself for sale. An urgent meeting of the officials of Wall Street conducted by the US Federal Reserve urged them to extend necessary financial help to Lehman Brothers. “Bank of America (BAC) and Barclays (BCS)” being the contenders for the stocks of Lehman Brothers backed out on the refusal of the federal government to consider writing off the future liabilities of the company against government revenue. At the final stage, Lehman Brothers had no prospective buyers. Therefore, the company chose to file for bankruptcy protection under Chapter 11 on September 15, 2008. With the filing of bankruptcy, the long history of the company ended. The petition filed by Lehman Brothers was the huge petition for insolvency filing on record.

There were several causes for the decline of the business of Lehman Brothers. During the years 2003 and 2004, when the housing boom in the United States was in the peak, Lehman acquired five companies engaged in the business of mortgage lending. The acquisition of these companies first appeared prescient with the company earning record revenues from its real estate business. The business of the company in realty assets helped the company to record high revenue growth of 56% in the capital markets within two years between 2004 and 2006. This business growth was a record considering the growth of other entities in the same sector. In the year 2006, Lehman securitized $ 1.46 billion of mortgages, which accounted for a 10% increase over the previous year. “Lehman reported record profits every year from 2005 to 2007. In 2007, the firm reported net income of a record $4.2 billion on revenue of $19.3 billion” (Investopedia, 2010b).

During February 2007, the stock price of Lehman Brothers reached a record high of $ 86.18. This gave the company a market capitalization of $ 60 billion. “However, by the first quarter of 2007, cracks in the U.S. housing market were already becoming apparent as defaults on subprime mortgages rose to a seven-year high” (Investopedia, 2010b). “On 14 March 2007, one day after the firm’s stock had its biggest one-day drop in five years on concerns that rising defaults would affect Lehman’s profitability, the firm reported record revenues and profit for the first fiscal quarter” (Teng, 2010). The CFO of the company reported that the company has taken care of the rising risks posed by the increased home delinquencies. He further reported that the rise in the delinquencies would have little impact on the profitability of Lehman Brothers. The CFO also reported that he did not anticipate the problem of the subprime market affecting the rest of the housing market or affecting the US economy.

The share prices of Lehman dropped drastically during mid-2007 when two of the hedge funds operated by Bear Stearns failed. The company announced the closure of many other offices in three states. “Even as the correction in the U.S. housing market gained momentum, Lehman continued to be a major player in the mortgage market” (Investopedia, 2010b). In 2007, the company underwrote a high volume of mortgage-backed securities than has been done by any other firm. The company accumulated $85 billion portfolios, which was equivalent to four times the equity of the shareholders. “In the fourth quarter of 2007, Lehman’s stock rebounded, as global equity markets reached new highs and prices for fixed-income assets staged a temporary rebound. However, the firm did not take the opportunity to trim its massive mortgage portfolio, which in retrospect, would turn out to be its last chance” (Investopedia, 2010b).

“Hurtling Toward Failure Lehman’s high degree of leverage – the ratio of total assets to shareholders equity – was 31 in 2007, and its huge portfolio of mortgage securities made it increasingly vulnerable to deteriorating market conditions” (Ritholtz, 2010). “On 17 March 2008, following the near-collapse of Bear Stearns, the second-largest underwriter of mortgage-backed securities, Lehman’s share price fell 48%” (Teng, 2010). “Confidence in the company returned to some extent in April, after it raised $4 billion through an issue of preferred stock that was convertible into Lehman shares at a 32% premium to its price at the time” (Investopedia, 2010b). However, with the skepticism of the hedge fund managers, about the valuation of the mortgage portfolio, the stock prices of the company continued to fall.

During June 2008, the company reported a loss of $ 2.8 billion out of its operations for the second three months period. The company reported that it had raised another six billion US Dollars from the investing public. The company announced that it had raised its liquidity pool to an estimated $ 45 billion reducing its exposure to residential and commercial mortgages by 20% and cutting down the leverage factor of 32 to almost 25. However, none of these efforts proved useful and ultimately the company filed for bankruptcy protection under Chapter 11 in September 2008.

Risk Management Failure in Lehman Brothers

According to the report made by the court-appointed examiner in the Lehman Brothers bankruptcy case, the firm had ignored its risk management limits, since it pursued a high growth strategy. The following is an excerpt from the report.

“In 2006, Lehman made the deliberate decision to embark upon an aggressive growth strategy, to take on significantly greater risk, and to substantially increase leverage on its capital. In 2007, as the subprime residential mortgage business progressed from problem to crisis, Lehman was slow to recognize the developing storm and its spillover effect upon commercial real estate and other business lines. Rather than pull back, Lehman made the conscious decision to “double down,” hoping to profit from a counter‐cyclical strategy. As it did so, Lehman significantly and repeatedly exceeded its internal risk limits and controls,” (Wheelhouse Advisors, 2010).

Although, many analysts point out that the lack of efficient risk assessment in the recent crisis, as responsible for the downfall of Lehman Brothers, there are ample of evidence to prove that the management of the company failed to recognize the warnings about risks, which were made explicit from the risk-mitigating procedures of the company.

“During this period of aggressive growth, Lehman developed significant exposures to risky subprime lending, commercial real estate, structured products, and high-risk lending for leveraged buyouts” (U.S. Department of the Treasury, 2010). In the process, the company had made repeated breaches of its risk concentration limits in meeting the objective of achieving high earnings.

Common business sense demands that the executive leaders take the responsibility for effective risk management based on the information from different sources for their probability of making successful business decisions.

“Lehman had a risk management staff that was devoted entirely to conducting an array of ‘stress tests’ to accurately determine the potential consequences of an ‘economic shock’ about their assets and investments. Lehman substantially reduced their decision-making effectiveness when they disregarded, according to the report, its risk managers, its policies, and its risk limits. The report also suggests that management removed their Chief Risk Officer and its head of the Fixed Income Division, because of their opposition to managements growing accumulation of illiquid and risky investments” (Cotton, 2010).

Another reason for the bankruptcy of Lehman Brothers is the model risk. The company mostly used the Value at Risk (VaR) model invented by J.P. Morgan Chase & Co. While this model

allows the traders to make real money with their business, it reduces the worries of the top management about the risk that the traders are taking to make their earnings. The model makes several mathematical assumptions, which are “provably false in real life,” and provides an assessment of 99% confidence limit of the loss likely to occur at each trading point at most 1% of the time.

“One big problem with this approach to managing risk is that it does not tell you what can happen the other 1% of the time when the VAR limit is exceeded. But the top managers of the investment banks were lulled into believing that the other 1% did not matter: After all, they came to believe, if it was only a 1% probability, how dangerous could it be. However, since VAR was calculated from daily price movements, that 1% was quite important. The other problem with VAR is that, in most cases, it depends on an assessment of the “volatility” of the security concerned – how much that security bounces around. However, volatility is by definition low in quiet markets and much higher in turbulent markets” (Hutchinson, 2008).

Hence, the assessment of risk is low in quiet markets, which encourage the traders to accumulate assets and then the risk zooms up when the market turns another way, at which point, the traders may not be able to unwind the previously established positions. Therefore, the use of VaR as a risk measurement model may not ensure “a culture of risk management at every level.” When the company indulged in using more leverage to augment the funding, the risk becomes significant.

Case Study of 2007/2008 Subprime Mortgage

The subprime mortgage crisis can be considered as one of the most serious economic disturbances affecting the United States during the period after the Great Depression of the 1930s. The issues relating to rewards and pitfalls of subprime financing are fundamental to the elements of risk-bearing, sharing, and transfers, in the realm of financial markets and institutions affecting the world economies. The purpose of the analysis is to provide a critical review and understanding of the rewards and pitfalls of effective risk management policies so that the designing of new and efficient policies to reduce the adverse impact of the current crisis and to prevent the occurrence of such future events. The case study analyzes the subprime financing as a major financial market innovation and provides a list of issues raised and lessons learned in the process of innovation from the perspective of risk management.

Subprime Lending – A Financial Innovation

Innovations in the financial market are most likely to occur in the context of the following fundamental conditions.

1. The market should consist of borrowers and investors who are previously underserved. Subprime borrowers who were otherwise denied prime credits were keen on using subprime financing to finance the purchase of vehicles. The investors worldwide with a glut in savings could not earn higher returns for their investments and this, in turn, made them turn to subprime lending to earn relatively higher rates of returns.
2. The advancement in technology and expertise acted as the catalyst to create sophisticated subprime mortgage creation using state-of-the-art tools ensuring the design of security and management of financial risks.
3. The regulatory environment that prevailed in the United States was not only benign but also helped the origination of subprime lending. Despite the presence of a complex network of federal and state regulations, only a few of these regulations impeded the growth of subprime financing. “Furthermore, the existing system of commercial bank capital requirements provided banks with strong incentives to securitize many of the subprime mortgage loans they originated.” (Spence, Amez, & Buckly, 2009)

Financial innovations have most of the time been proved to be risky undertakings. This is all the more so when the innovations resulted in the creation of new classes of loans and securities which are risky. Even though each of the innovations led to some sort of a crisis, modified forms of innovations such as subprime auto financing have proved to be of significant benefits even in today’s economic scenario. Therefore, it is reasonable to assume that subprime financing innovations, when reformed and refined would be able to help the subprime borrowers with enough opportunities to meet their financing needs.

Lessons Learned From Financial Crisis Caused by Subprime Lending

There have been several issues connected with the subprime financing and its impact on the economy as a whole and the financial markets and institutions. These issues can be categorized as:

• Issues directly associated with subprime lending
• Issues connected with the securitization of subprime mortgages
• Issues connected with the operations of financial markets and institutions, which were engaged in subprime lending

Issues Directly Associated with Subprime Mortgage Lending

Issues directly associated with subprime mortgage lending include:

1. Subprime financing has helped several young and minority households to acquire homes much needed to improve their status and other important social purposes. The increased purchase of homes has stimulated the lending by the investment banks through various intermediaries.
2. Intense competition in the market should generally work out to the advantage of uninformed borrowers by protecting their interest, but subprime lending has worked in the opposite direction and revealed a serious market failure in this respect. There is a strong need for improvements in regulations, even considering the exhaustive regulatory measures, as they exist today. However, it must be ensured that there is no creation of destructive regulations, which would work to end all the subprime lending activities.
3. Traditionally there has been reluctance among the lenders, dealers and other service providers to modify the terms of the loans, even when requested by the borrowers. Contractual limitations also acted to restrict the chances of any modifications. Now under different circumstances, the lenders and borrowers are found to be amenable to governmental reform plans characterized as one-time emergency plans, when the damage is already done. It was unfortunate a large number of subprime borrowers were beyond such help. Unfortunately, in the case of subprime financing, the resultant default rates are high despite some modifications carried out.
4. The costs imposed by the subprime loan foreclosures are limited because the defaulting borrowers simply surrender the houses when they are unable to meet the payments. This would work to reduce the credit rating of the borrowers, disabling them to access a new mortgage for several future years. However, steps can be taken to reduce even these costs to the borrower.

Issues Connected With Securitization Of Subprime Loans

1. According to the report by President’s Working Group on Financial Markets (2008), the incomplete disclosures and the process of securitization have duped the investors to purchase high-risk subprime mortgage securities and only renowned and sophisticated institutional investors have purchased these mortgage (President’s Working Group on Financial Markets, 2008). The meaning and significance of the term “subprime” is also clear to understand the ramifications of the subprime transactions, which existed even from the late 1990s. Therefore, it is reasonable to assume that the securitization process cannot by itself be considered as a source of a subprime mortgage crisis, more particularly in the case of auto financing
2. The credit rating agencies also had a major role to play in the subprime lending crisis. The agencies systematically under-estimated the risk of subprime mortgage pools, depending too much on the FICO scores. The rating agencies also erred by underestimating the degree of risk on Collateralized Debt Obligations (CDOs), which were backed, by subprime securitization tranches.
3. One of the most important reasons for the investors to suffer huge losses is linked directly with their tendency to concentrate the risks by leveraging their positions with borrowed funds. Furthermore, many of the investors depended on short-term loans to finance subprime lending transactions.

Issues Connected with Operations of Financial Markets and Institutions

The breakdown in the financial market trading and liquidity allowed the market prices of many subprime mortgages to fall considerably lower levels than their fundamental values. This has resulted in a serious subprime crisis for both home loans as well as for automobile financing. The opaque nature of the instruments covering the undervalued subprime securities and CODs discouraged the investors from purchasing these instruments. The investment banks also remained silent in reporting the declines in their investment portfolios, which added to the liquidity issues connected with subprime mortgage securities.

Credit Rating Agencies and Their Role in Subprime Crisis

It is being argued that the credit rating agencies are responsible for turning the risky house mortgages into securities, which were considered suitable for investors. Normally the investors had no means of verifying the quality of the securities, which in this case is the house mortgages. To determine whether a mortgage is safe the details of the owner of the property, the income of the owner and his/her credit history need to be studied. However, in the absence of such details, the investors relied on the ‘AAA’ rating given by rating agencies like Moody’s. Over the period starting from the year 1996 Moody’s and its principal competitors, Standard & Poor’s and Fitch Rating have started this business of rating the mortgage securities, which were believed by the investors as an unquestionable basis for investments. For the rating agencies, it was a new business and more profits. By turning the house mortgages as a source of funding, the agencies transformed mortgages – which otherwise had no means of recognition – as a strong base for writing new loans by the mortgage banks.

With the support of the ratings by the credit rating agencies, the volume of such loans tripled to $ 2.5 trillion in the year 2006 being mortgages issued to subprime borrowers. Almost all the entire subprime loans were converted into securitized pools, and sold to Wall Street, with heavy trading going on such securitized pools.

The most important point here is that the investors had no knowledge, nor they had any means of making their judgments on the quality of these mortgages, the equity covered by the properties, and many other usual investment considerations. Al they did before investing is to rely on the credit ratings offered by the renowned rating agencies. Thus, the credit agencies have assumed the role of the de-facto watchdog of the mortgage industry.

However, the credit rating agencies deny accepting the fact that they should have been more vigilant in rating these mortgages by offering an argument that it was the mortgage holders who have defaulted are to be blamed, as most of them obtained the loans by telling lies to the financial institutions originally sanctioned the loans. However, the fact remains that the rating agencies have erred in rating the mortgages with more credible ratings. This is evident from the fact that Moody’s, Standard & Poor’s and Fitch Rating have downgraded the ratings of a large number of mortgage securities after the housing collapse. The rating agencies contend that even though it is true that the credit rating agencies did not have access to the individual loan files of all the borrowers to verify the information provided by the borrowers, the investment banks provided them with spreadsheets containing data on borrowers’ credit histories based on which the ratings have been made. Most of the ratings were based on the expertise of the rating agencies as statisticians and an aggregate basis. Therefore, they argue that there was no means of verifying the credibility of each borrower before awarding the ratings.

Moreover, in the United States, many classes of investors are not allowed to make investments in any non-investment grade bonds. This has forced the issuers to urge the rating agencies to grade various bonds covering the subprime mortgages. The rating agencies are free to charge such issuers for their rating services. This also has increased the number of ratings given by the rating agencies. Though it was a smart way to carry on the business, such smartness has created conflicts among different agencies (Roger Lowenstein, 2008).

In the case of structured finances like bank loans, the situation is much worse and complicated, because few banks would come again and again to the rating agencies for grading the securities to which they are getting exposed and for such rating the banks pay hefty fees to the rating agencies like for example Moody’s. However, the banks will only pay the fees when the agency offers the rating as desired by the banks. In case of a strained relationship with Moody’s for example, the client bank can try its luck with the competitor Standard & Poor for getting the desired rating. This practice is being described as ‘rating shopping’. This is another factor that needs to be considered in the role of credit rating agencies in the subprime mortgage crisis.

Risk Management Failures in Subprime Lending

The subprime crisis is an example of illustrating the implications of various risks of financial risk management.

First, the risk management models adopted by the financial institutions have not served their purposes and led to a serious financial crisis during 2008. According to Danielsson (2008), “… the current crisis took everybody by surprise despite all the sophisticated models, all the stress testing, and all the numbers” (Danielsson 2008, p. 4). The investment bankers Merrill Lynch in their annual report for the year 2007 stated,

“As a result of the unprecedented credit market environment during 2007, in particular the extreme dislocation that affected U.S. subprime residential mortgage-related and ABS CDO positions, VaR, stress testing and other risk measures significantly underestimated the magnitude of actual loss. Historically, these AAA-rated ABS CDO securities had not experienced a significant loss of value” (Merrill Lynch, 2008, p. 62-63).

This goes to prove that the risk management models have not performed as expected. The remarks by Merrill Lynch mention two issues – “reliance on rating/rating agencies and the role of historical simulation in assessing the risks of new products.”

As per the discussion earlier, the ratings provided by the rating agencies were very unreliable. The investors who used the ratings as inputs in their risk assessment models were misled in arriving at the extent of risk. There might be different reasons for the agencies to provide unreliable ratings. They are (i) the agencies used different proprietary models for rating asset-backed securities and most of these models suffered from some common deficiencies affecting their risk assessments. (ii) Secondly, the problematic issue as pointed out by Danielsson. He argues that rating agencies

“… underestimated the default correlation in mortgages, assuming that mortgage defaults are fairly independent events. Of course, at the height of the business cycle that may be true, but even a cursory glance of history reveals that mortgage defaults become highly correlated in downturns. Unfortunately, the data samples used to rate SIVs often were not long enough to include a recession,” (Danielsson 2008, p. 2).

(iii) the third issue is the conflict of interest among the rating agencies. According to Rosner (2007),

“The problem was that the rating agencies faced a huge conflict of interest. Not only were they vouching for the securities’ credit soundness, but they were also being paid large fees by the issuers of the securities to do so. … the more deals they could justify rating highly, the better their earnings – and the less incentive they had to rate conservatively,” (Rosner, 2007, p. 15).

Relying on these unreliable ratings will have significant consequences in risk assessment. Crockett states

“Asset-backed commercial paper was regarded as among the most liquid of instruments. So liquid that the issuing banks charged very little for the liquidity enhancement features they offered and did not regard the contingent liability they faced as requiring much if any set-aside capital. The liquidity originated in the fact that the borrowing entities were highly creditworthy, and the valuation of the underlying collateral was regarded as well-founded (using ratings provided by rating agencies)” (Crockett, 2008, p. 15).

Taleb & Martin (2007) state “The recent subprime mortgage debacle illustrates the risks faced by low-probability, high-impact events,” (p. 188). Any type of risk measurement model will not be able to predict the extent of risks because of the “uncertainty, complexity and tight coupling” involved in the creation of such models.

The subprime mortgage crisis outlined the importance of endogenous risk and how the endogenous risk makes risk, management models unreliable. Danielson remarks that one cannot ignore endogenous risks during the financial crisis and therefore the risk assessment models fail if there are endogenous risks. According to Adrian and Shin (2008), mark-to-market accounting and risk management systems combine to generate “balance sheet-driven pro-cyclical leverage of financial institutions.” Leverage is a major element, which has a large influence on the reactions of the institutions in a real or perceived crisis such as the subprime mortgage crisis.

The recent financial crisis is an indication of how liquidity is endogenously affected. The subprime mortgage highlights that “liquidity in markets and for individual intermediaries is much more interdependent than often realized. Markets are dependent on back-up liquidity lines from financial institutions, and institutions are dependent on continuous market liquidity to execute their risk management strategies,” (Crockett, 2008, p. 14). Adrian and Shin (2008) point out that credit lines provided by financial institutions to vehicles invested in MBS and CDOs “made it difficult to contract balance sheets and caused banks to reduce their engagements in unrelated segments where this was possible.”

Discussion

The delinquencies in subprime mortgage loans and the number of foreclosures in the home loan market-giving rise to the need for serious economic, social and regulatory measures had a serious impact on the US economy. The credit needs of the low-income individuals are often met with ‘predatory lending’, which comprises of several financial practices. These changed financial practices represent the new dimensions of risk management. This kind of lending has become increasingly predominant in rural areas. Predatory lending usually takes the form of payday loans to check cashing and car title loans, which threaten the income and assets of the borrowers by the higher rate of interest and stringent repayment conditions.

The subprime mortgage market was nothing but an extension of this lending practice prevalent in the housing market. Subprime mortgage loans carried interest rates much higher than the prime loans to cover the additional risk exposure of the lenders in extending credit to the borrowers who had a bad loan track and were defaulters in repayments. With the increase in subprime lending, the rate of failures had also considerably increased, as most of the people, who obtained the loans, were those who did not have the adequate means to repay the loans. When such failures reached a greater proportion, “investors have started scrutinizing subprime loans more carefully and, in turn, lenders have tightened underwriting standard,” (Bernanke, 2007). Banks and financial institutions undertook certain other measures including credit spreads over subprime securitizations to control the rate of delinquencies.

Although the term ‘subprime mortgage’ was used to indicate the loans offered to those borrowers whose credibility is doubtful, the term “subprime’ does not signify the character of the loan itself but characterizes the borrower meaning the borrower has a substandard credit status. The term ‘subprime’ is one of the innovative inclusions in the financial language of the Twenty-first Century. Lack of good credit history and habitual defaults in repayments make the borrowers get into the status of subprime borrowers. Subprime mortgages were provided using several instruments.

The expansion in the subprime mortgage has made the home-ownership possible for those borrowers who otherwise would not have been able to qualify for any borrowing. There has been a sharp increase in the subprime mortgage in recent years. “In 1996, subprime lenders reported $90 billion in lending. By 2004, the subprime mortgage market had grown to $401 billion” (Carsey Institute, 2006). “Last year, 13.5 percent of mortgages originated in the U.S. were subprime, according to the Mortgage Bankers Association, compared to 2.6 percent in 2000. Overall, the subprime market was $600 billion in 2006, 20 percent of the $3 trillion mortgage market, according to Inside Mortgage Finance. In 2001, subprime loans made-ups just 5.6 percent of mortgage dollars” (Kratz 2007).

“For these mortgages, the rate of serious delinquencies – corresponding to mortgages in foreclosure or with payments ninety days or more overdue – rose sharply during 2006 and recently stood at about 11 percent, about double the recent low seen in mid-2005” (Bernanke, 2007)

With the increase in the subprime mortgage market, the concerns over the adverse effects of the predatory loans have also increased. Indirectly forcing borrowers to take loans with very higher rates of interest and processing and other fees than they were eligible and afford was one of the components of predatory lending often adopted by the lenders. “It has been estimated that as many as half of all subprime loan borrowers could qualify for conventional rate mortgages” (Fannie Mae and Freddie Mac, 2004). According to the U.S. Department of Treasury guidelines issued in 2001, “Subprime borrowers typically have weakened credit histories that include payment delinquencies and possibly more severe problems such as charge-offs, judgments, and bankruptcies. They may also display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that may encompass borrowers with incomplete credit histories”.

A highly automated origination system, which facilitated faster credit scoring and risk-based pricing algorithms, was instrumental for the rapid growth and consolidation of the mortgage industry (Collins, Belsky, & Case, 2005). The growing use of credit scores in mortgage lending and the creation of automated underwriting systems also helped the new origination system very well (Brueggeman & Fisher, 2004; Kendall & Fishman, 1996; Fabozzi & Modigliani, 2002). These were the obvious changes required to develop new risk management perspectives during the mid to late 2000s. “The advent of risk-based pricing meant that rather than charging a single rate to all qualified borrowers, the mortgage market classified borrowers into risk buckets based on factors such as their demonstrated ability to handle debt repayment, the stability of employment, the extent of documentation of their financial information and the loan-to-value ratio” (Apgar & Herbert, 2005).

How subprime lending transactions took place, fully explains the impact of changes in the risk management practices during the period. There has been a complete change in the system of originating the loans. Unlike the traditional way of originating the loans from the bank branch located in the same area, any of the three available channels – retail, correspondent or through brokers originated the loans. Retail activity resembled the traditional lending where the employees of the bank or mortgage institution reached the potential customers and complete the formalities for sanctioning the loan. Subprime lending business took place through the branch operations and sometimes institutions close the loans over the telephone or the Internet. After funding, the commercial bank may decide to hold the retail loan in the portfolio. Alternatively, it may decide to transfer the portfolio to another lender. Yet another way is to package the loans and sell them to another secondary market. This will enable the banks to shift their exposure to the buyer of the mortgage.

The subprime crisis has taken the toll with at least 25 large subprime lenders declaring bankruptcy and substantial losses being announced by many financial institutions, bond insurers, and special purpose enterprises. The impact on the US economy is significant resulting in lower levels of consumer spending, subdued levels of consumer confidence, lessened asset prices, and a significant decline in the projected growth levels and a considerable rise in the unemployment level. (AMUNC Background Paper, 2008)

When the crisis hit the subprime mortgage and credit markets the impact on the credit markets was that the markets dried up with deal volumes going to significantly low levels and this made the financial services firms start thinking on their alternative moves. One of the victims of the crisis is Lehman Brothers, which was made to file bankruptcy. Other institutions like Washington Mutual had to increase the loan-loss reserves up to $ 2.2 billion to cover the mortgage exposure. Same is the case with some of the major financial services firms with five of them (Merrill Lynch ($ 3.4 billion), UBS ($ 3.3 billion), Citigroup ($ 3.1 billion), Deutsch Bank ($ 2.4 billion) and Morgan Stanley, JPMorgan Chase and Bank of America put together $ 3 billion) made to write-down $ 17 billion collectively. (Berkshire Capital Securities, 2007)

While the impact of the subprime crisis on the traditional long-only assets market is mixed, the biggest impact was felt on the alternative investment vehicles of hedge funds and private equity.

The foremost effect of extending the subprime lending to less creditworthy customers was the increased foreclosures in the case of home loans as well as auto finance. This development was unintentional at the time, lending institutions considered granting of loans on a large scale to a large number of customers. However, this outcome was not surprising because most of the borrowers, who obtained the loans, were low-income group people and they were not in a position to meet the mortgage payments in time. Some lower-wealth brokers could not protect the mortgages by making timely mortgage payments. This led to more delinquencies and defaults in subprime loans.

Another side effect of the increase in subprime lending was the decline in the price levels of homes and used automobiles. This is because much of the home loans under subprime lending were given to under-served lower-income borrowers who concentrated buying homes in lower-income neighborhoods where the housing market is more fragile with very few takers of homes either on foreclosure or on sale. This buying pattern coupled with abusive marketing and origination practices led to the concentration of foreclosures resulting in a contagion effect where foreclosures above some threshold level could bring down prices in an area and stimulate a further cycle of foreclosures and decline.

Studies have proved beyond doubt the connection between the increase in foreclosures and the phenomenal growth in subprime lending. Cutts & VanOrder, (2003), researchers at Freddie Mac estimated the serious delinquency rate for conventional prime loans at 0.55 percent as of mid-2002. Contrastingly, the serious delinquency rate in respect of subprime loans was at 10.44 percent, which is nearly 20 times higher than that in respect of conventional prime loans. In the case of riskier loans, the delinquency rate was at 21 percent. Subprime mortgage loans were the most default-prone mortgage segment of the home loan market. The data collected from Freddie Mac suggests that delinquencies in respect of subprime loans constituted more than 50 percent of the total seriously delinquent loans, while prime loans accounted for 25 percent of the seriously delinquent loans.

The rapid growth in the subprime lending market in extending credit to risky borrowers coupled with the changes in the economic climate pushed the level of delinquency loans at the national level to a higher level. Collins, Belsky, & Case, (2004) observe that the serious delinquency rates in subprime loans and foreclosures in the segment almost doubled between the years 1998 and 2001, only to fall off slightly after 2001. Apgar and Herbert (2005) believe that “higher foreclosures among subprime loans are a natural outgrowth of the lower credit quality that characterizes the subprime market. This effect is reinforced by the fact that collateral value in the subprime market is generally weaker” (Apgar & Herbert, 2005).

There were several factors responsible for the onset of the financial crisis during 2007-2008. In general, the macroeconomic policies implemented in the United States and the rest of the industrially advanced nations were the main contributing factor for the crisis. Economic policies concerning fiscal adjustments resulted in a reduction of saving volumes in the United States. Even the country allowed a not so stringent monetary policy to be in force for a longer period. “In Japan, the mix of monetary and fiscal policies distorted the global economy and financial system” (Truman, 2009).

Easy monetary policies followed by many other countries including the Asian countries contributed their part to the global meltdown. “The impressive accumulation of foreign exchange reserves by many countries also distorted the international adjustment process, including but not limited to taking some of the pressure off of the macroeconomic policies of the United States and other countries” (Truman, 2009). With the result, there were increased activities in the housing sector not only in the United States but also in many other countries coupled with the increased availability of market credit resulting in a steep hike in the stock values and other symptoms of unorthodox financial practices, ultimately leading to the financial Tsunami. The role of inadequate financial sector supervision and regulation has also to be taken into consideration for the financial Tsunami.

Irrespective of the causes, there are some distinguishing features of the crises, which need consideration to discuss the effects and challenges the financial tsunami has created to affect the global economy in the context of risk management.

“First, the proximate origins of the crisis were in the United States” (Truman, 2009), large and the actions of the financial institutions functioned in the country were the main reason for the emergence of the crisis. “Second, if the largest economy in the world, whose currency and institutions are at the core of the global financial system, stops functioning, the fact that the resulting crisis becomes global should not be surprising,” (Truman, 2009). Finally, it is but natural that an economic shock, when started in the financial market, would first affect the real economy. Adverse impact on the real economy, in turn, would influence the financial market further, ultimately affecting the real economy again.

“The reduction in growth has not been limited to the advanced economies” (Truman, 2009). The reduction suffered is similar for developed countries, transition and developing countries and the countries located in Western Hemisphere. The expected fall in growth for the years 2008-2010 on an average is 11 percent for the advanced economies and 12.8 percent for other economies. Another lesson learned from the crisis, which is broader in scope is that the globalization of trade, financial globalization, and globalization in exchange for labor has united the countries larger than it was in the earlier century. The repercussion of extension of this unity is that any economic shock that influences a larger nation or cluster of nations in the global financial system will lead to some effect, mostly undesirable on the remaining nations.

Pitfalls of Subprime Mortgages

There were two important pressing issues from the perspectives of the borrowers, which emerged as a result of the subprime mortgage crisis, that apply equally to subprime auto financing.

1. The first one is the predatory lending practices, which arise when the borrowers are persuaded to opt for mortgage loans that did not work in their best interests. The borrowers would not have taken up those loans when there was complete disclosure of the actual terms of the loans and a clear understanding of the terms. It is the function of a well-functioning and competitive market to protect the uninformed borrowers. The problems that accompanied this issue were:
2. The mortgages were made to be quite complex with choices of fixed and adjustable rates and switching from fixed to floating rates over time
3. The mortgage brokers were in an advantageous position to receive their fees immediately on the origination of the mortgage and this prevented most of them to act in utter disregard of their future reputation
4. Frauds had started in the origination process with intentional overstating of the incomes by the borrowers, which ultimately proved to be detrimental to both the investors and the borrowers when the loans default.
5. Loan defaults and foreclosures created by the excessive subprime lending process directly hit both the borrower and the lender, which resulted in a lose-lose situation. Lack of thinking in the direction of modifying the loan terms to such level which the borrower can manage, to avoid a mortgage default was another important issue that was responsible for the economic havoc created by the subprime lending practices.

Thus, from the foregoing issues relating to subprime mortgage borrowers, the following pitfalls of subprime lending have been identified.

• The real source of income of the borrower guaranteeing the repayment of the subprime auto loan is of prime importance, which was greatly ignored while granting subprime auto loans
• The absence of regulatory and institutional infrastructure, which could have moderated the costs associated with borrower defaults. This implies the formation of a mechanism to provide for loan modifications that would avert loan defaults
• Lack of consumer protection legislation to operate, when the subprime mortgage market expanded and loans were provided to rather relatively inexperienced and uninformed consumer borrowers such as people belonging to young ages and minority communities
• Mortgage loans have been traditionally associated with unavoidable risks, which raised the possibility of large-scale loan losses. There was no anticipation of such eventual risks. There were no suitable regulations, which could govern the creation of suitable capital requirements by banks and various other financing institutions indulged in subprime lending activities. There were also no plans for dealing with distressed institutions
• The forces of mortgage market innovations and increased mortgage lending had resulted in a boom-bust automobile financing cycle, which went unanticipated by all the agencies and institutions connected with financial market operations including Federal Reserve as the controlling authority.

“Responsibility for the subprime mortgage crisis is more properly shared among the market participants—lenders, investors, and the credit rating agencies—since they all failed to recognize that their actions relating to subprime mortgage lending were creating a house price boom that almost surely would end in a crisis” (Spence, Amez, & Buckly, 2009).

Today, more than ever, organizational leaders are increasingly faced with the momentous task of steering their respective organizations to financial independence and efficiency against a backdrop of repetitive economic downturns and upheavals (Melton, 2009). The latest round of economic crisis has not fully subsided financial institutions have not fully recovered for the recession. The global economy recedes into a pronounced meltdown, if not an absolute recession (Rubin & Buchanan, 2008). The latest round of financial meltdown thought to have been occasioned by the US housing market crash and subprime mortgage lending crisis, have destabilized organizations more than any other recession since the Great Depression of the 1930s (Kotz, 2009).

In the US alone, big multinational organizations such as Merrill Lynch, Bear Stearns, AIG, and the Lehman Brothers have fallen under the heavyweight of the ongoing global financial upheavals, sending thousands of employees into unproductiveness (Lowe-Lee, 2008). According to the UN News Centre (2009), the latest economic crisis continues to push the world’s most susceptible individuals into the periphery of abject poverty, starvation, and early death. Mass layoffs and salary reductions have become the buzzwords for many organizations today.

Many organizations continue to be strong in the face of economic adversity (Blankenburg & Palma, 2009). Organizations that continue to stay stronger in this hit-economy have evidenced a strong relationship between performance and leadership. As large conglomerates such as Merrill Lynch and Bear Stearns bows towards bankruptcy suits and acquisitions, others such as Proctor and Gamble, Hewlett-Packard, Dell, Google, and Microsoft persist to register impressive performance under similar economic conditions (Long, 2009; Gladkova, 2008).

This kind of scenario calls for a paradigm shift in the way risk management is looked upon as a key determinant of the performance of the organizations. Williams (2009) posited that the world’s assiduous and conscientious managers are best known in tough economic times. During the many economic recessions that have rocked the world’s economic scene, organizations have been able to stand the test of time due to efficient risk management, which helped them to weather the economic storm (Long, 2009). Consequently, the answer to why some organizations continue to perform remarkably well while others fail in hard economic situations may inarguably lie in the efficiency of their risk management practices.

Conclusion and Recommendations

This chapter presents concluding remarks and recommendations for further research.

Conclusion

This thesis presented an overview of (i) the conceptualization of risk faced by financial institutions, (ii) risk management by financial institutions by engaging different risk management models and (iii) the implications of the risk management models in mitigating the risks of financial institutions. The case studies on Lehman Brothers and the 2007/2008 subprime crisis provided an illustrative discussion on the implications of risk management models. The purpose of the study is to assess the need for financial institutions to adopt systems for identification, assessment, and management of risks to their operations. The study observes that these risks may arise because of the influence of external and internal factors. According to the findings of the study, these risk management systems are considered important to enhance the ability of the financial institutions to respond to the rapid and unexpected changes in the financial markets.

The study finds that the phenomenon of risk management in the financial institutions center 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 in the products and services of the financial institutions. Risk management in the financial service industry has assumed greater importance in the wake of a balanced economic development of the nation. The study finds that an intrusive risk management system is 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. This requires new perspectives on risk management to cover the risks of financial institutions.

The study finds that in the years leading up to the recent financial crisis, some of the regulators have recognized that and intimated large and complex financial institutions, that they have not implemented efficient risk management systems. 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. In this context, this thesis studied the issue of risk management under conditions of financial crisis and challenges faced by the financial institutions to mitigate risks.

The research was undertaken to achieve the objective of examining risk management under conditions of the financial crisis and the challenges faced by financial institutions. The review of the literature which formed part of the research and the case studies on Lehman Brothers and 2007/2008 subprime crisis, has provided added knowledge on the salient aspects of risk management under conditions of the financial crisis. The next objective of the study was 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.

The research-based on the review of the related literature has discussed these aspects relating to risk management at length and achieved this objective of the study. The research covered the classification of the risks faced by the financial institutions and the methods of mitigating them. The research had the objective of making an in-depth study of the deficiencies in risk management by financial institutions during the recent financial crisis. The study observed that the risk management models like VaR and CAPM suffer from basic shortcomings, which make the risk management deficient to protect the financial institutions from their exposure to various risks. The study observed from the case

study of Lehman Brothers that the company used the VaR model of risk assessment, which proved ineffective in assessing the exposure of the company to different risks resulting from the financial crisis. The study achieved the objective of reporting on the implications of the deficiencies in managing risk effectively.

Based on the theoretical observations and findings from case studies, the research answered the research question on the salient aspects of risk management by financial institutions under conditions of the financial crisis and the deficiencies in the risk assessment and risk management techniques followed by the financial institutions during the recent financial crisis. The question on the effects of the deficiencies in managing risks effectively by the financial institutions was also answered through the findings from the case study on the subprime crisis, as the financial tsunami caused by subprime crisis has been the result of the failure of risk management strategies adopted by the financial institutions.

Recommendations

The research observes that the financial institutions must not neglect the negative side of the risk management while drawing the research management strategies. It is also important that the regulators must take the potential negative side effects of the modes of risk management, which they prescribe to the financial institutions. For instance, the regulators while prescribing measures like minimum capital ratios must consider the negative side effects of such a measure on the capital adequacy of the financial institutions. Prescribing concrete measures for risk mitigation by the financial institutions is beyond the scope of this paper. However, the study suggests that increased awareness of risk management at the institutional level will be of great help in improving the cognitive biases in adopting the relevant risk management model. It is the opinion of the researcher that adding further regulation in the quest of taming the financial

market risk may not produce the desired result unless there is complete awareness among the financial institutions on the necessity of understanding the implications of effective risk management to introduce effective risk assessment models in their respective organizations. It is also important that the institutions quantify the impact of various risks as a part of risk management in individual organizations. However, it needs to be understood that the quantification cannot be done with any degree of precision with the help of available risk management models.

The managers have to expect certain limitations from the existing models and they have to make suitable provision for such model risks in their risk mitigation initiatives. Finally, the experience from the subprime crisis makes it clear that historical simulations based on “normal” market environments may prove dangerously wrong when there are changed market circumstances and therefore such simulations have to be considered as having limited predictive power in helping the manager forming their risk management strategies. It is necessary to consider the fact that incentive risk arising from risk-adjusted-performance assessments can result in significant damage to the institutions’ financial standing.

Therefore, the managers have to consider these risks seriously in their risk management proposals. Finally, it has to be stated that risk management has an important role to play in helping the financial institutions to avoid accidental blow-ups. However, it is also important that the cost of providing for risk management initiatives is also an important consideration in deciding on the proper course of action. The study discussed several areas under the classification of risks, where the managers have to focus, to ensure that the institutions engage best risk management practices to protect their exposures to different types of financial risks.

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