Risk managment Essay
0RISK ASSESSMENT AND MANAGEMENT
Risk Assessment and management (case for Global Financial Crisis (GFC)
Table of Contents
3Linkage between business decisions and risk context
4Role of financial engineering in context shift
5How a shift in risk context can lead to crisis
5Relevant challenges for effective control of global economy
6Contextual Component/ Introduction
6Background of GFC
7Emergence of credit derivatives
7Risk Theme Discussion
7Risk principles in theme
9Identification and use of case studies of relevance to theme and any other research identified relationships
11Initially derivative products
11The interconnectivity between operational risk, liquidity risk, credit risk and systematic risk
12Role of governance and non-regulatory compliance in risk models
13Role played by ISO31000:2009
Risk Assessment and management (case for Global Financial Crisis (GFC))
Linkage between business decisions and risk context
Decisions making in risky conditions should be in a position to identify, quantify and absorb the risk whenever possible. However, decision making in risky conditions is not an easy thins as it involves forecasting about the future and that whatever decision is made, there is no guarantee that it would bring the intended results. Once risks are identified and quantified, the decisions are made by the top management of organizations so as to determine what extent risky outcomes may be tolerated (John, 2009).Once management has identified the appropriate risk categories that may have an impact on a given decisions, it then goes on to quantify the risks. This means that it is the work on management to establish the costs that would be incurred in case a risk outcome were to happen. Mathematically, this can be overwhelming for many types of risks, more so financial risk. Decisions made in an organization can help alleviate the risk situation or even increase its chances of occurring. For example, the Global Financial Crisis (GFC) that began back in 2007 was caused by various management decisions by different organizations (Eduardo 2012).
Banks, financial institutions, and insurance firms were in a reckless pursuit of profitability at the expense of cautious business management practices, and this led to significant losses due to poor investment decisions. This led to increased liquidity problems that created a global credit crisis and this consequently led to an economic slowdown (Mayer, Pence, Sherlund, S. 2009). Other factors that led to the GFC included the de-regulation of market derivatives as well as the subsequent increase in the use of over the counter derivatives, the increased use of complex credit related securities as well as derivatives for hedging and speculation and poor risk evaluation among other factors (Dermot & Deborah, 2009)
Role of financial engineering in context shift
Financial engineering is a term that describes the application of economic aspects such as forwards, futures, swaps, options and other related products so as to restructure cash flows and achieve certain financial goals especially in the management of financial risk (Finnerty, 2000).In the aspect of financial risk, organizations face other related long-term risks such as relatively inferior growth, high levels of consumer consciousness about their health, increased debt to equity ratio as well as poor projections for future growth. Fluctuating foreign currencies can lead to financial risks that if not mitigated may lead to reduced profitability as well as increase the possibility of occurrence of risks (Finnerty, 2000).
Exposures of the economy’s foreign exchange comprise of foreign income and assets and also domestic and foreign debt portfolio. Banks and other financial institutions apply various hedging instruments so as to manage any related financial risks. They use both qualitative and quantitative analysis so as to hedge its interest rate as well as the foreign exchange exposures. The qualitative analysis considers the fundamental economics of the respective organizations and then analyzes the currency so as to determine when it should be hedged (Finnerty 2000). On the other hand, quantitative analysis analyzes assets and liabilities and makes use of various weightings of different baskets so as to measure the effectiveness of the hedge applied and this is done in random simulations. The major financial engineering concepts that can be used in this case helps to analyze the risks’ portfolio and they consist of forwards, futures, swaps, options and other related products (Finnerty 2000).
How a shift in risk context can lead to crisis
A shift in risk context can lead to a crisis like the GFC. Establishing the risk context helps to define the scope of the process of risk management and ensures that a criteria is set against which the risks will be accessed. If the objectives and strategies for the risk management are unclear, then it means that a shift in the risk context may lead to extreme results (Eduardo 2012). The selection of the main objectives within an organization should be driven by a critical evaluation of external and internal factors that may impact the organization. During the commencement of risk management, a review of the risk context is very crucial as it helps in identifying the major risky areas so as to focus on them. However, a failure in systems of the risk context may create a crisis.
Relevant challenges for effective control of global economy
The effective monitoring of the global economy by the use of various processes and procedures faces various challenges. For example, plans have been set to bring people out of poverty across the globe and some countries are succeeding in bringing millions out of poverty, however, poverty and diseases continue to strike other millions of people across the world, and this becomes a challenge in controlling the economy. Limited funding also limits the effective control of the economy. Since the global recession increased cases of reduced public revenue as well as increased national debt levels have become part of the global economy (Saunders & Cornett 2006).
Contextual Component/ Introduction
Background of GFC
The Global Financial Crisis (GFC) began back in 2007 was caused by various management decisions by various organizations specifically banks, financial institutions and insurance firms (Dermot & Deborah 2009). The GFC was caused by several factors that included:
The reckless pursuit of profitability by banks, financial institutions and insurance firms at the expense of cautious business management practices and this led to significant losses due to poor investment decisions.
De-regulation of market derivatives as well as the subsequent increase in the use of over-the-counter derivatives
The increased use of complex credit related securities as well as derivatives for hedging and speculation and poor risk evaluation
Increased use of credit default swaps (CDS).
The application of ethically questionable practices of profiting off information asymmetry through the sale of products to clients with the knowledge that they are bad. A good example is the Goldman Sachs which benefited into misleading their customers to buy securities that they were not suited.
The moral hazard created by governments that guaranteed deposits and this allowed institutions to continue making losses without even conducting evaluations about their operating procedures.
When the GFC began the banking system was seizure so as to prevent the situation from getting worse (Dermot & Deborah 2009)
Emergence of credit derivatives
Credit derivatives refer to bilateral contracts which are negotiated privately and allow their users to manage credit risk exposures. Credit derivatives have in recent years emerged as a major risk management tool. For instance, banks can be concerned about the failure of certain customers from paying for their loans and thus the respective bank can be protected against this through transferring the credit risk to another party and still ensure that the loan books are kept within the bank (Mayer, Pence & Sherlund, 2009). This concept of offers an effective way of managing credit risk and offers opportunities that enhance the process of purchasing of credit synthetically. However, credit derivatives cannot eliminate all credit risks fully. Examples of commonly used credit derivatives include Credit Default Outs, Total Return Swaps (TRSs), and Credit Linked Notes (CLNs) among others.
Risk Theme Discussion
Risk principles in theme
The risk is believed to affect every decision made a decision and whether the risk will occur or not depends on the effectiveness of the risk theme or rather the risk assessment and management. Risk management is not just about risk hedging alone; instead, risk management should be a comprehensive plan for the business to ensure that the predicted risks are mitigated as far as possible. For instance, the cycle of events that led to the GFC was as a result of bad investments decisions as well as the failure by the relevant authorities to set mechanisms aimed at assessing and managing risks (Dermot & Deborah 2009). This created serious global losses that turned to be a crisis in terms of liquidity and hence triggered a global crisis. Risk theme is all about the general knowledge about risk, and how to best deal with it. There are also various risk principles in the theme that govern risk assessment and risk management. One of the major principles of risk is that risk is everywhere within and outside organizations. In the case of the GFC, we can conclude and say that risk is global and cuts across businesses (Dermot & Deborah 2009). This means that a single firm in an industry may have in place effective risk management systems and processes but still be affected by the situation in the market. Thus, a firm with healthy systems and operations can still be put in a financial crisis because of the unpredictable turbulence in the financial markets.
Another principle of risk is that risk is both a threat and an opportunity. The volatility of the market can ruin a business or make it wealthy. Also changing customer tastes can waste the entire market or even allow the company to dominate the market. Failures and losses in businesses emanate from large risks (Dermot & Deborah 2009). Likewise, large profits and lasting businesses also come from risky ventures. For instance, before the GFC, banks, and other financial institutions were venturing in risks businesses and increased levels of lending so as to improve their profitability. If things could have gone well, then a lot would have been achieved in terms of increased profitability. However, lack of effective risk assessment and management strategies, the otherwise occurred which are losses.
Another principle is that risk management is part of everyone’s job within an organization and that the task should not be left only to the top management. The payoff form effective risk management is of higher value. What matters in risk management is the impact of risk and its management on the business (Dermot & Deborah 2009)
Identification and use of case studies of relevance to theme and any other research identified relationships.
The cycle of events leading to the GFC as well as what happened after can be used as a relevant case study to risk theme. In this section, risk assessment and management will be discussed with respect to the GFC in which various bad investment decisions and failure to have in place good risk management measures led to serious outcomes of risks. The major risk that led to the GFC is the financial risk that created the liquidity crisis and a global credit crisis. The first activity than need to be addressed first in the process of risk management is the risk management strategy. Risk management plan describes how risk management will be undertaken, steps, techniques and the standards to be used as well as the various responsibilities that are related to risk management (Finnerty 2000).
Before the GFC started, the law in the U.S. gave permission to deposit taking financial institutions to trade using their capital and participate in the derivative markets and securities for their benefits as well for the advantages of the accounts belonging to clients. First, the passing of the Glass-Steagall Banking Act allowed banks to trade in securities for their profits and also earn fees from the underwriting and issuing business, as well as in the sale and distribution of securities. These activities allowed banks to expand their businesses as well as their streams of revenue through taking deposits, writing loans and also managing the wealth of clients and this made them more profitable as they also increased the appetite for risk. This can be seen as an opportunity coming out of risks, and this follows the principle that risks can be both threats and opportunities. As a result of these activities, financial institutions were able to deal with both equity and debt markets.
In addition, the U.S. also enacted the Commodities and Futures Modernization Act (CFMA) that ensured that various OTC contracts such as swaps and forwards were legitimized, and this allowed financial institutions to enter this market without being subjected to regulatory oversight that was forced to businesses trading in options and futures. This ensured that financial and insurance institutions could use swaps in both their business and client accounts. At first, the integration of these activities led to increased profitability for the financial and insurance institutions before GFC was experienced (Finnerty 2000). The use of Credit Default Swaps (CDS) was meant for risk reduction where institutions used them as hedging tools and were also used by buyers of securities so as to indemnify against financial risks. Swaps refer to the exchange of cash flows for another set of cash flows. The cash flows can be customized in various ways depending on certain specified principal amounts. Interest rate swaps are used to limit exposures to interest rate fluctuations.
Nevertheless, the use of CDS contracts for risk minimization did not last for long as banks noticed that they could as well be used as sources of income for their businesses. The buyers of the contracts started speculating that this would instead lead to increased cases of default on the underlying debt. For the first few years of unsupervised activities, various financial and insurance corporations benefited from increased profitability.
A good case to use here is the American Insurance Group (AIG) which benefited in making enormous profits. However, increased pursuance of greater profit margins as well as profit growth integrated with the lack of external and internal compliance requirements allowed parties in the organization to accept greater risk in the search of greater returns (Dermot & Deborah 2009). Yet they did not have the understanding that the risk they accepted could lead to extreme consequences. These led to various financial risks that led formed part of the factors that led to the GFC.
Initially derivative products
A financial derivative is a contract between two or more parties where payments are made based on the certain agreed-upon benchmark. A financial derivative can be created from the agreement and that the types of derivative products are limited only by imagination, and this means that there is no a definite list of derivative products. Initially, derivative financial products were a risk management device. For instance, hedge funds use financial derivatives as their top most tools for risk management.
Payments for financial derivatives may be in the from currency, anything physical such as gold and silver, securities, agricultural products such as wheat or meat, transitory commodities such as energy and communication bandwidth. Commonly used financial derivatives include futures, forward contracts, options, swaps, hedge funds, rights of use among others (Finnerty, 2000). Initially, financial derivatives were used as risk-shifting devices to reduce the exposure of risk to changes in factors such as interest rates, stock indexes, foreign exchange rates, and also weather and climatic conditions. However, due to the availability of new advanced methods of risk management, the use of financial derivatives has been limited. Forwards refer to agreements aimed at purchasing or selling products at the future/forward date. The primary assets are the product being bought or sold. The rate of the lease is the return that encourages the investor to buy and then lend the commodity (Finnerty 2000).
The interconnectivity between operational risk, liquidity risk, credit risk, and systematic risk Operational risk refers to risks that that arise from inadequate or failed internal processes and systems as well as people within the organization, for instance, failed audit systems. Liquidity risk is a type of financial risk that results from the lack of enough market for a given investment. The given investment cannot be bought or sold quickly to help minimize loss. Credit risk is a risk that arises from default cases where borrowers fail to pay for loans obtained. Systematic risk is the vulnerability of the general market to the business, for instance, aggregate income (Dermot & Deborah, 2009).All these are risks which commonly occur in businesses and corporations, and the method of assessing and managing them should always aim to balance them since if any of the risks is ineffectively managed, it could bring down the economy.
Role of governance and non-regulatory compliance in risk models
Governance refers to the oversight role and the process in which businesses and organizations manage and help mitigate risks. Compliance ensures that an organization has the right internal control systems and processes as required by regulators, governmental bodies as well as under other industry mandates. Organizations have taken steps aimed at integrating a Governance, Risk and Compliance (GRC) Framework so as to help mitigate risks and ensure that they comply with the relevant regulations. GRC ensures quality of services offered to the public especially in the service industry, eliminates cases of redundant work in various processes and initiatives, eliminates duplicative systems such as hardware, software and help in reducing costs and finally, it ensures that there all stakeholders such as employees, management, auditors and governing bodies are served with the truth (Dermot & Deborah 2009).
During the Global Financial Crisis (GFC), Banks, financial institutions and insurance firms were in a reckless pursuit of profitability at the expense of cautious business management practices and this led to significant losses due to poor investment decisions, and this led to increased liquidity problems. All this was attributed to the failure of using strong governance as well as failure to comply with the set standards for risk management.
Role played by ISO31000:2009
ISO31000:2009 provides principles and guidelines on risk management and can be applied by any public, private companies or any organization in any industry or sector (Eduardo, 2012). It can be applied to any risk irrespective of whether it has positive or negative consequences. ISO31000:2009 can be used to harmonize the process of risk management in existing as well as future standards and provides an approach that supports the standards dealing with certain specific risks; however, it does not replace the standards.
Exposure to extreme risks has led to the collapse of various brand organizations such as Lehman Brothers, Bear Stearns, and Meryl Lynch with other organizations such as AIG still surviving. These organizations were very strong brands and had excellent risk management systems, but they still succumbed to risk (Crotty, 2009). The main reason given to this is because, in most cases, the top management for most of these organizations such as AIG exposed themselves very much to risk in the pursuit of increased profitability. The paper has established various risks that commonly affect organizations, and these are financial risks, credit risk, operational risk, currency risk, and liquidity risk.
Financial engineering, credit derivatives, and financial derivatives were the most commonly used methods of risk assessment and management during the GRC period. Financial engineering refers to the application of financial aspects such as forwards, futures, swaps, options and other related products so as to restructure cash flows and achieve certain financial goals especially in the management of financial risk. Credit derivatives refer to bilateral contracts which are negotiated privately and allow their users to manage credit risk exposures. Effective and efficient risk assessment and management strategies from the best solution to dealing with risks. Liu & Jiang (2011), states that risk management is a fundamental process to the performance of any organization and involves monitoring and controlling all actual and potential hazards. Having strong internal control systems such as audit has also been proved to be an effective way of managing risks.
Crotty, J, (2009) “Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture.” Cambridge Journal of Economics, 33, pp. 563–580
Dermot H. & Deborah M, (2009) “UK Economic Policy and the Global Financial Crisis: Paradigm Lost?” Journal of Common Market Studies, 47/5, pp. 1041–1061
Eduardo P. (2012) “The preponderant causes of the USA banking crisis 2007–08.” The Journal of Socio-Economics 41 pp. 519– 528
Finnerty. J (2000), “Financial engineering in corporate finance .An overview”, Financial management, vol.17, no.4, pp56-59.
John B. (2009) “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong.” National Bureau of Economic, Working Paper 14631
Liu, S, & Jiang, M. 2011. Providing Efficient Decision Support for Green Operations Management: An Integrated Perspective. INTECH.
Mayer, C., Pence, K., Sherlund, S., (2009) “The rise in mortgage default.” Journal of Economic Perspectives 23, pp. 27–50.
Ray & Davis. P. (2008) The Evolution of the Financial Crisis of 2007-Retrieved on March 15, 2013 from 8http://dspace.brunel.ac.uk/bitstream/2438/5132/1/0825.pdf
Saunders A, & Cornett M. (2006). Financial Institutions Management. 5th edition, McGrawHill/Irwin
Tirole, J (2006). The theory of corporate finance, New Jersey: Princeton University Press.