Risk Management During Financial Crisis in the US

IEE 454 - Risk Management

Arizona State University-Tempe

December 11, 2024

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.

Figure: Financial Risk and Major Categories

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

–

I. human risks including errors, frauds, collections,

and animosity,

II. 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,

III. system and technology risks like a failure of

software, computers and power failures,

IV. relationship risks like client dissatisfaction,

dropouts, loss to competition and poor products

and

V. 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

a. chose a one-factor model where a multi-factor

model would be more appropriate,

b. confuse stochastic with deterministic variables,

c. pick an unsuitable distribution,

d. overlook correlations between certain factors,

e. use outdated or otherwise currently invalid

assumptions,

f. use a theoretical model that assumes frictionless

markets in actual markets,

g. use a correct model that relies on mistaken data

estimates, and

h. 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:

a. ” value at risk does not behave nicely concerning

the addition of risk, even independent ones,

thereby creating severe aggregation problems.

b. 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:

A. 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.

B. 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.

C. 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.

D. 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

A. 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

B. 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.

C. 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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