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CHAPTER 12
CASE STUDIES IN FINANCIAL CRISES
L e a r n i n g o b j e c t i v e s
The relevant section of the chapter is provided in brackets beside the learning objective.
This chapter will assist you to:
LO 1. discuss important factors that are drivers of globalisation of the international fi nancial markets (12.1)
LO 2. examine policy, structural and management issues that may create an environment that is conducive to an evolving fi nancial crisis, and understand the effects and consequences of a fi nancial crisis on a fi nancial system and a real economy (12.2)
LO 3. identify and discuss risk management issues that were causal in the failure of Barings Bank (12.3)
LO 4. identify the underlying fi nancial system weaknesses that became the precursor to the Asian fi nancial crisis, and explain the interrelationships of fi nancial risks in this crisis (12.4)
LO 5. describe the evolution of the global fi nancial crisis, its impact on the fi nancial markets and the responses of governments and regulators to the crisis (12.5)
LO 6. analyse and discuss the question ‘Will there be another fi nancial crisis in the future?’ (12.6).
Once you understand these learning objectives you will be ready to complete the end-of-chapter review questions.
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Introduction The great depression that began in the USA in 1929 saw a collapse in the fi nancial markets,
a signifi cant economic downturn and severe social ramifi cations associated with very high levels
of unemployment. In the wake of this crisis, the USA introduced legislation that was designed
to insulate the fi nancial system from this type of crisis in the future. The Glass-Steagall Act
of 1933, in part, prohibited commercial banks from owning full-service brokerage fi rms and
conducting investment banking activities such as underwriting.
By the end of the twentieth century, the separation of commercial banking and investment
banking activities was becoming blurred and USA legislators eventually repealed the Glass-
Steagall Act. Within a relatively short period, the global fi nancial crisis occurred (see discussion
in Section 12.5). Financial historians will discuss this coincidence of events for some time.
One of the interesting observations of behavioural fi nance is the tendency for policymakers
and managers to forget the lessons of past crises. There seems to be a belief that all is well
in the markets and another crisis will not happen—particularly in the current market at the
time. Tied in with this belief of invincibility is a willingness to take greater risks in order to
continually grow an institution and increase profi t outcomes.
The case studies we examine in this chapter are:
The failure of Barings Bank o
The Asian fi nancial crisis o
The global fi nancial crisis. o
In each of these crises you will see that underlying each crisis is a failure of risk management
policy and practice. That failure sometimes is evident at a government legislative level,
prudential supervision level or executive management level within a fi nancial institution. In
many fi nancial crises, the failure of risk management policy and practice has allowed a culture
of excessive risk taking that is fundamentally motivated by a desire to increase institutional
profi ts or performance bonus payments.
We will begin our study of fi nancial crises by examining the structure of the global
fi nancial markets so that you have an understanding of the context in which modern fi nancial
crises may occur.
Review points
In the USA the Glass-Steagall Act of 1933 was designed to protect the US o fi nancial system from another major fi nancial crisis. As the distinctions between
a commercial bank and an investment bank blurred, the Glass-Steagall Act was
repealed. Within a relatively short period the global fi nancial crisis occurred.
Behavioural fi nance indicates that policymakers and managers often forget the o lessons of past fi nancial crises.
Often, fi nancial crises exhibit an underlying failure of risk management and policy o which encourages a culture of risk taking to increase profi ts and performance
bonus payments.
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12.1 Globalisation of the fi nancial markets A nation-state’s fi nancial system is an integral part of the global fi nancial system. An
important relationship exists between an effi cient fi nancial system and growth in the real
economy within a nation-state. Similarly, as production and international trade between multi-
national corporations and governments expanded, so too did the need for a global fi nancial
system to support that expansion.
Essentially, globalisation refers to the process whereby fi nancial markets are inter-
connected, interdependent and integrated. The rapid development and adoption of
technology-based information systems, communication systems and product delivery systems
have facilitated globalisation of the fi nancial markets and the standardisation of the fi nancial
instruments used in the global markets. At the same time, technology has enabled the develop-
ment of a whole new range of sophisticated fi nancial instruments that facilitate the movement
of funds between surplus units and defi cit units in different nation-states. New markets in risk
management products, in particular those using derivative products, have also evolved.
While the role of technology in the development of global fi nancial markets is critical,
it should be noted that there are a number of other important factors and relationships that
impact upon globalisation. These include:
Unrestricted movement of capital around the world. Theoretically, the global market o will encourage savings and allocate those savings effi ciently to the most productive
purposes without regard to national boundaries.
o Deregulation of nation-state fi nancial systems, including the removal of signifi cant
regulatory constraints that restrict fi nancial markets, products, participants and
pricing.
Financial innovation o , to develop new systems, products and services.
The need of corporations and governments to diversify their funding sources on a global o scale.
Increased competition between fi nancial markets and institutions for the provision of o fi nancial products and services.
Exchange rate, interest rate and price volatility within the international markets and o the associated increase in demand for risk management products.
Changing demographic and savings patterns. For example, the ageing of populations of o many economies has resulted in the accumulation and mobilisation of greater levels
of retirement savings.
The development of emerging markets, in particular, parts of Asia, South America and o Eastern Europe.
Rapid technological innovation and a more sophisticated business environment, together
with longer-term changes in the fi nancial needs of market participants, are reshaping the
fi nancial system. A progressively greater array of participants, products and distribution
channels have developed (and will continue to develop) the fi nancial system. Competition is
emerging from new providers of fi nancial services and through the increasing globalisation
FINANCIAL SYSTEM
Comprises a range of fi nancial institutions, instruments and markets; overseen by central bank; supervised by prudential regulator
GLOBALISATION
The integration of fi nancial institutions, instruments and markets into an international fi nancial system
DEREGULATION
The removal of government regulation that constrained the effi cient operation of competitive fi nancial institutions and markets
FINANCIAL INNOVATION
The development of sophisticated fi nancial products
TECHNOLOGICAL
INNOVATION
The use of new technology for the delivery of fi nancial product and information systems
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of fi nancial markets. Nation-states are striving to achieve improved market effi ciency and
performance.
To help understand the drivers for change in a modern fi nancial system, it is benefi cial
to refer to the report of an Australian review of the fi nancial system. The Wallis Report,
released in 1997, considered the international nature of fi nancial systems and identifi ed four
principal areas that directly affect an evolving fi nancial system. These are:
Changing customer needs� Technology-driven innovation� Regulation as a driver of change� The changing fi nancial landscape.�
12.1.1 Changing customer needs It is evident that changing population demographics have a major infl uence on the evolution
of a fi nancial system. A signifi cant number of nation-states are moving into an extended
period in which populations are ageing. At the same time fertility rates have fallen, which in
turn will result in higher dependency ratios; that is, a smaller workforce will need to support
a larger retired population. This will also place a greater strain on the provision of services
by government.
The resultant fi nancial system issues that are apparent include:
the need for greater asset accumulation by individuals o
the implementation of adequate superannuation and retirement savings initiatives and o strategies
a signifi cant shift to funds under management, particularly market-linked investments o
increased fi nancial advisory services for business and individuals. o
Changing work patterns are also evident, with workforces generally becoming more
educated as individuals strive to achieve higher qualifi cations to meet the expectations of the
business sector. Individuals are tending to work longer hours in an environment in which
there may be lower job security. A higher percentage of the workforce may be in part-time
employment or self-employed.
Another aspect of changing customer needs is an evolving awareness of value and an
increasing accumulation of both fi nancial assets and liabilities by the household sector. In an
information age, individuals are more aware of, and sensitive to, price competitiveness and
changes.
At the same time, two contradictory portfolio structural developments have been occurring.
First, there has been signifi cant growth in asset accumulation through superannuation saving
and property and share ownership. Second, there has been an enormous increase in household
debt to support higher living standards and more expensive lifestyles. Each of these factors is
increasing the need for fi nancial innovation, greater competition and prudent supervision of
the fi nancial system.
WALLIS REPORT
A committee report, Financial System
Inquiry Final Report, AGPS, Canberra,
March 1997 (www.treasury.gov.au)
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12.1.2 Technology-driven innovation Improvements in communications infrastructure and technology are breaking down the
physical constraints and cost barriers to the transmission, storage and use of information.
Examples of the expansion of electronic information and product delivery systems within
the fi nancial system include ATM and EFTPOS networks, Internet and telephone banking
services and the effi ciency of the payments system.
Many fi nancial institutions and markets have developed proprietary information networks
within a context of external pressure for standardisation, access, ease of use, cost effectiveness
and, importantly, secure information transmission and user authentication.
Technology is being used to gain a competitive advantage as the physical location of
customers becomes less important.
Technology enables new competitors to enter the fi nancial markets, but the capital cost
of technology is rising and driving a move towards greater rationalisation of institutions and
markets on a global scale.
12.1.3 Regulation as a driver of change Changes in the structure of, and responsibility for, regulation and prudential supervision have
been a signifi cant driver of change within the fi nancial systems of nation-states. For example,
in Australia the Reserve Bank is responsible for the soundness of the payments system and
overall fi nancial system stability. The Australian Prudential Regulation Authority (APRA)
is responsible for the prudential supervision of authorised deposit-taking institutions, the
Australian Securities and Investments Commission (ASIC) is responsible for market integrity
and the Australian Competition and Consumer Commission (ACCC) is responsible for
com petition policy and consumer protection.
Examples of some of the major regulatory changes that have occurred have been the
fl oating of exchange rates of many nation-states, the removal of barriers to the fl ow of capital
between nation-states, the removal of interest rate and product controls and the granting of
authorities for foreign banks to operate within nation-states. Other regulatory changes, such
as the implementation of the Basel II capital accord, were discussed in Chapter 3.
The global fi nancial crisis which manifest itself from mid-2007 has led many policymak-
ers to argue that further regulatory change is necessary to ensure the stability of the global
fi nancial system into the future. Whether signifi cant change occurs will be dependent upon
the political fortitude of the major developed economies, in particular the USA, the UK and
the European Union.
12.1.4 The changing fi nancial landscape The breaking down of barriers within nation-state fi nancial systems—that is, between
institutions, instruments and markets—has increased competition. Globalisation has had
a similar impact on the international fi nancial system. The traditional roles of fi nancial
institutions have become blurred as commercial banks, investment banks, insurance offi ces
and other fi nancial institutions provide a much wider range of products and services. The
changing fi nancial landscape has produced signifi cant outcomes: more competitive pricing
of fi nancial products and services, the rationalisation of market participants and product
PAYMENTS SYSTEM
Facilitates the transfer of value from one party to another for fi nancial transactions
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innovation (in particular, fi nancial risk management products). International competition
continues to grow as market participants pursue new international opportunities.
The dynamics and complexity of domestic fi nancial markets and their integration into the
global markets means that the potential for a fi nancial crisis to occur is always a concern. The
contagion implications for the global markets mean that governments, prudential regulators
and institution managers must be vigilant for factors that historically have been a precursor
to past fi nancial crises.
Review points
A modern and effi cient domestic and global fi nancial system is essential for o continued economic growth.
Factors that support the globalisation of the fi nancial markets include o unrestricted capital movements, deregulation of domestic fi nancial systems,
technological and fi nancial innovation, increased competition and development
of risk management products to manage volatility, development of emerging
markets and changing demographic patterns.
Four main drivers of change are changing customer needs, technology o innovation, regulation and changing fi nancial landscape:
Changing customer needs include increased asset accumulation, ageing s populations, superannuation and retirement savings, funds under
management, fi nancial advisory services, changing work patterns, risk
management products and increased living standards.
Technology innovation derives from improvements in communications s infrastructure and product and information delivery systems. This allows
lower-cost entry into the markets for new competitors.
Regulation is important to try and achieve a balance between stability and s competition in the markets (e.g. Basel II capital accord). New prudential
regimes have been developed (e.g. RBA, APRA, ASIC and ACCC in
Australia). Signifi cant deregulation of fi nancial institutions, instruments
and markets has allowed global capital fl ows and fl oating of most major
currencies.
Changes in the fi nancial landscape include globalisation, increased s competitive pricing of products and services, product innovation supported
by technology developments, new market competitors and a freeing of the
markets through deregulation.
12.2 Causes of fi nancial crises Throughout this text we have discussed how a modern and effi cient fi nancial system operates,
both within a domestic market and also within the global fi nancial markets. Apart from
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interspersed references to the current global fi nancial crisis, it may seem that fi nancial market
participants generally conduct themselves in an effi cient, non-volatile and rational manner.
Unfortunately this is not always the case.
A study of the history of the fi nancial markets will quickly show that the fi nancial markets
have always experienced fi nancial crises. Despite the efforts of governments, central banks
and prudential supervisors, there is absolutely no reason to expect that this will not continue
to be the case. When market participants operate in a highly competitive and profi table
environ ment, increased risk taking is often an eventual outcome. Financial crises can impact
upon specifi c organisations, nation-states, geographic regions and the global fi nancial system.
While there are many fi nancial crises that we could study, we will consider three prominent
crises that provide valuable lessons in relation to risk management, the evolution of crises and
their economic, fi nancial and social impacts:
The Barings Bank collapse� The Asian fi nancial crisis� The global fi nancial crisis.�
Before we examine the above crises, it is worthwhile to consider some of the broad factors
that often create an environment in which a fi nancial crisis may occur. These are catego-
rised as:
Macroeconomic settings o
Financial system structural and regulatory policies o
Financial institution management. o
12.2.1 Macroeconomic settings Macroeconomic settings change from time to time in response to prevailing and forecast
domestic and global economic conditions. For example, we have studied factors that impact
upon changes in interest rates and foreign exchange rates. Such changes are to be expected
and market participants continually analyse and interpret new information in order to try and
anticipate movements in macroeconomic settings.
However, occasionally existing macroeconomic settings can have an unexpected economic
or fi nancial consequence. For example, it may be argued that the current taxation regime
in Australia may have created an environment in which investors borrowed high levels of
debt to fund asset accumulation in the property and equity markets. This may have, in part,
resulted in an asset bubble, particularly in the property market. Favourable negative gearing
and capital gains tax provisions, whereby only 50 per cent of a capital gain is taxed at the
taxpayer’s marginal tax rate, may well have further exacerbated property and equity market
prices.
If macroeconomic settings become a driver for an asset bubble, then a subsequent change
in those settings increases the risk of a future economic shock when the bubble bursts, and
this may result in a fi nancial crisis. This in turn may lead to a sustained economic downturn
and resultant social problems such as high levels of unemployment.
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12.2.2 Financial system structural and regulatory policies There are many factors that may impact either directly or indirectly on the evolution of a
fi nancial crisis. These include:
Moral hazard—is said to occur when market participants are generally of the view that o they will be protected by government should they fi nd themselves in a situation where
they might fail. This is often referred to as the too big to fail syndrome. In a moral hazard
situation a fi nancial institution may accept greater business risks than is prudent in the
expectation that the government or central bank will bail it out if the institution gets
into fi nancial diffi culty.
Prudential supervision—while it is unlikely that poor fi nancial institution supervision o will be directly responsible for a fi nancial crisis within an institution, nevertheless active
and positive supervision certainly has the potential to foresee pending problems and
should offer the chance to provide timely advice and, if necessary, increase regulatory
controls. However, the role of the supervisor is not to manage a fi nancial institution,
therefore regulation needs to be balanced and not so tight as to restrict innovation,
effi ciency and growth.
Deregulation—tied in with prudential supervision is deregulation of domestic and o global fi nancial systems. As regulation has been reduced and global capital fl ows have
increased this has created a fi nancial market environment in which crisis may occur.
In particular, the fl oating of the exchange rates of major currencies and the almost
unrestricted fl ow of capital between markets has created a situation where adverse news
in one market can result in a fl ight of capital from that market and a rapid depreciation
of the currency. Deregulation has encouraged market innovation with the advent of
sophisticated funding and risk management products and techniques. While this
is a positive, a lack of understanding of the risks associated with these products and
techniques has resulted in a number of fi nancial disasters in the past.
o Corporate governance—legislative provisions should ensure the relationship between
shareholders, the board of directors and executive management are clearly defi ned.
Financial institutions, as well all other types of business and government organisations,
must be required to implement policies and procedures that ensure accountability and
transparency is an integral part of the corporate culture of an institution. This includes
responsibilities for reporting to the markets and the prudential supervisor. Clearly,
appropriate legal and accounting legislative structures need to be in place to support
corporate governance.
12.2.3 Financial institution management The failure of an individual fi nancial institution, especially a larger institution, is a major
concern to all market participants. Due to the interrelationships and dependencies that exist
between fi nancial institutions, the failure of one institution creates fear that other institutions
may also fail due to their contractual exposures to the failed institution. These contractual
exposures may include large foreign exchange (FX) transactions, payments system settle-
ments and the repayment of debt obligations.
MORAL HAZARD
The taking of excessive risk in the
belief that losses will be diminished
by regulation or insurance
CORPORATE
GOVERNANCE
Policy and practice that defi ne the
relationship between shareholders, the board and management
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Further, fear of failure of other institutions may cause depositors to withdraw their funds
from other institutions, thus causing a massive liquidity problem for those institutions as they
endeavour to obtain the liquid funds to repay the deposit withdrawals. Institutional investors
will also cease to provide funding in the capital markets.
Therefore, the potential failure of one institution has signifi cant implications for other
institutions and the ultimate stability of the fi nancial system.
Some of the major risk categories that, if poorly managed, may result in the failure of a
fi nancial institution include:
o Credit risk—this is the risk that borrowers will not repay interest and principal on
loans when due. For example, this may result from an institution maintaining poor
credit assessment policies and procedures, that is, lending to borrowers who may not
have the capacity to repay loan commitments in the future if interest rates rise. Also,
a signifi cant collapse in property market values may mean that the value of a security
may be worth less than the mortgage held over the property.
o Interest rate risk—this is the risk that interest rates may change beyond forecast levels.
A fi nancial institution is particularly exposed to interest rate changes as the cost of raising
funds is the interest rate paid, and the return on lending is mainly the interest rate received.
This risk is complicated further in that an institution will offer a range of deposit products,
issue a range of short- and longer-term securities and provide loans to customers with
different terms to maturity and a mixture of both fi xed and variable interest rates.
o Foreign exchange risk—this is the risk that the exchange rate between one currency
and another currency will change. The majority of commercial and investment banks
act as FX dealers for their clients. Client FX transactions will include import and
export contracts, international borrowing and investment and speculative transactions.
Commercial banks also carry out very large transactions in the international fi nancial
markets on their own behalf; for example issuing debt securities into the international
capital markets.
o Concentration risk—this is the risk that an institution is heavily exposed to a particular
borrower, industry sector or geographical region. For example, a bank that provides a
$100 million loan to a corporate client may well be taking on a more risky loan than
another bank that provides much smaller loans to several corporations. Similarly, a bank
that lends large amounts to one industry sector, for example the coal sector, is exposed
to a future economic downturn in that sector, or perhaps a change in government
regulation that signifi cantly affects the industry sector.
o Liquidity risk—this is the risk that an institution will not have suffi cient cash available
or access to facilities that will provide cash to meet day-to-day operating needs, plus
any prudential liquidity required to be held that has been stipulated by the prudential
regulator. For example, day-to-day liquidity requirements include suffi cient liquidity
for real-time gross settlements, other payment system transactions, advancing funds
on loan approvals and deposit withdrawals of customers. Prudential liquidity is over
and above the day-to-day liquidity requirement and is designed to ensure a bank has
suffi cient liquidity to cover unexpected liquidity demands.
CREDIT RISK
The risk that an obligor will not make future interest payments or principal repayments when due
INTEREST RATE RISK
The sensitivity of the value of assets, liabilities and future cash fl ows to a change in interest rates
FOREIGN EXCHANGE
RISK
The risk that the value of one currency relative to another currency will change
CONCENTRATION RISK
A large fi nancial or operational exposure to a single corporation, group or geographical region
LIQUIDITY RISK
Central bank—funds in the fi nancial system; corporation— funds available to meet day-to-day commitments
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o New-product risk—this is the risk associated with the offering of new products,
particularly so-called exotic fi nancial products. Product policies and procedures need to
be documented. The institution needs to ensure that product contractual documentation
is legal and will stand the test of potential future court challenges. Staff need to be fully
informed and trained. Also, electronic information and product delivery systems need to
be in place before the product is launched. This includes transaction records, accounting
systems, reporting systems and audit controls.
o Operational risk—these are actions or events that may impact upon the day-to-day
operations of an institution. For example, a fi nancial institution is absolutely reliant
upon its electronic communication, information and product delivery systems. Should
these fail for an extended period the institution will suffer signifi cant losses. Similarly,
natural disasters such as an earthquake could adversely impact upon business operations
and perhaps cause loss of life of personnel.
o Control risk (unauthorised transactions)—this is the risk that control systems designed
to generate periodic reports and exception reports may not be adequate or may not be
acted upon by management. Policies will stipulate who is responsible for monitoring
specifi c business operations. Electronic systems will generate reports from time to time
so that management can check that specifi c authorisations and delegations are being
observed. Further, if an authorisation is breached the system should automatically
generate an exception report. Management must immediately act upon these reports.
o Fraud or corruption risk—this is the risk that an employee or group of employees
will conduct transactions that are not authorised and are designed primarily to benefi t
the employee rather than the business (shareholders). Fraud is often associated with a
failure of adequate procedures and controls within an organisation. Interestingly, major
fraud is often driven by an employee trying to increase an annual performance bonus
payment.
o Capital risk—the risk that an institution will not have suffi cient capital or shareholder
funds to meet regulatory requirements (Basel II), to support growth in new business
and to write off abnormal losses from time to time. For example, a commercial bank is
required to fund each loan to a customer with a combination of equity (capital) and debt.
Unless a bank is holding suffi cient capital above the Basel II capital requirement, it is
unable to write new loan business.
It should be apparent from our brief analysis of factors that may result in an environment
in which a fi nancial crisis may occur why crises do occur from time to time and why we can
expect them to occur again in the future. The size and complexity of the fi nancial system
means that things will occasionally go wrong. Unfortunately, it is generally not obvious
when the next crisis will occur or what the particular drivers of the next crisis will be. Never-
theless, the fundamentals that underlie the evolution of a crisis environment remain the same,
namely, macroeconomic settings, fi nancial system structural and regulatory policies and
fi nancial institution management.
NEW-PRODUCT RISK
The risk of loss associated with the
introduction of a new product or service
OPERATIONAL RISK
Exposures that may impact on the normal day-to-day business
functions of an organisation
CONTROL RISK
A situation where inadequate recording,
accounting, taxation and audit policies
and procedures are in place
FRAUD OR CORRUPTION
RISK
The risk that an employee or group
of employees will conduct unauthorised or illegal activities for
their own benefi t
CAPITAL RISK
The risk that a corporation will
not have suffi cient capital to expand the business or maintain
its debt-to-equity ratio
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Review points
Financial crises can impact institutions, nation-states, geographical regions and o the global fi nancial system.
Factors that often create an environment in which a crisis may occur include: o
Macroeconomic settings—government fi scal and taxation policies and s central bank monetary policy settings impact upon an economy and
fi nancial markets. Asset bubbles (e.g. property prices) often derive from
existing taxation and interest rate settings. When a bubble bursts it can
have signifi cant adverse impacts.
Financial system structural and regulatory policies—factors that impact s either directly or indirectly on the evolution of a fi nancial crisis include
moral hazard (e.g. too big to fail syndrome), prudential supervision (active
and positive supervision should provide early warning signs), deregulation
(encourages innovation and competition, but also increased risk taking)
and corporate governance (relationship between shareholders, board and
executive management should ensure accountability and transparency).
Financial institution management—failure of a major institution may have s contagion effects for other institutions; major risks that an institution must
manage include credit, interest rate, FX, concentration, liquidity, new-
product, operational, control, fraud, corruption and capital risks.
Despite the efforts of governments, central banks and prudential supervisors o fi nancial crises will continue to occur periodically.
12.3 The collapse of Barings Bank Barings Bank was founded in 1762 and was an important global institution until its demise in
1995. As a merchant bank Barings survived a number of fi nancial crises over its long history,
but the trading actions of a single employee (Nick Leeson) in the bank’s Singapore subsidiary
would ultimately lead to the collapse of the bank. However, as discussed below, the failure of
management and risk management systems to detect Leeson’s unauthorised trading trans-
actions was a signifi cant contributory factor in the bank’s collapse.
Leeson had been appointed the head of Barings Futures Singapore (BFS). As head of the
derivatives trading of BFS he was able to control both the front-offi ce (trading) and back-offi ce
(administrative) operations of the unit. Leeson was authorised to carry out arbitrage trading
between the Singapore and Osaka futures exchanges. Essentially this involved buying option
contracts in one market and immediately selling an identical contract in the other market in
order to make profi ts from price differentials between the two markets. As this strategy did
not create an open position it was regarded as low risk.
However, Leeson engaged in unauthorised transactions which did create very large open
positions. When Leeson incurred an initial loss he opened an error account which he instructed
was not to be included in the daily management reports forwarded to senior management. At
ARBITRAGE
Taking advantage of buy and sell price differences between markets
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the end of each month he would make fraudulent entries so that the error account had a zero
balance for reporting purposes. Leeson was able to carry out the unauthorised trading and
establish the error account to hide losses because he controlled both the front-offi ce and back-
offi ce operations at BFS.
Over a two-year period, the unauthorised transactions saw the error account move in and
out of a loss position a number of times. In fact, in early February 1995 the error account was
not in a loss position. However, in the following two weeks the Asian markets fell as a result
of a major earthquake in Kobe, Japan. On 27 February 1995 the losses were £827 million,
but cumulative losses rose to £927 million with the closing out of all the unauthorised open
positions.
Subsequently Barings Bank was purchased by ING Bank for the sum of £1. Leeson was
charged in relation to breaches of Singapore securities law and served time in Changi prison.
An offi cial investigation into the failure by the UK Board of Banking Supervision found
an almost complete failure of risk management systems and controls, extending through
all levels of management at Barings to the external auditors, and various regulators and
prudential supervisors. The major failures included:
A matrix-based management reporting system whereby Leeson reported some o operations through one management structure and other operations through a different
management structure. There was no coordinated management control.
Management was not alerted when initially Leeson was reporting abnormal profi ts o from what were supposed to be low-risk trading strategies.
A lack of separation between the functions of the front offi ce and back offi ce at BFS o (discussed above).
Barings did not place limits on funding provided to Leeson at BFS, which at the end o represented twice the capital of the Barings Group.
Recommendations of a 1994 internal audit review that had identifi ed certain weaknesses o in risk management and control at BFS were not adequately acted upon.
The board report identifi ed fi ve important lessons that should be understood by managers
of fi nancial institutions:
Managers must fully understand the business they manage.� Responsibility for each business activity should be documented and communicated to � all relevant parties.
Segregation of duties is fundamental in any risk management control system.� Independent risk management systems and controls must be established for each � business function.
Executive management and an institution’s audit committee must ensure weaknesses � or problems identifi ed in internal and external audit reports are acted upon quickly.
Perhaps a fi nal issue that should be considered are the drivers that motivated Leeson to
conduct unauthorised transactions. This may be partly attributed to his personal reputation
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and ego; that is, there was an expectation that he was a star trader who could always make
money for the institution. More importantly was the performance bonus system offered by the
bank. The bank paid very large fi nancial bonuses to successful employees. The size of these
payments may well have tempted Leeson to carry out high-risk trading strategies in order
to boost the annual performance bonus. Other staff may have been inclined to look the other
way as their bonus payments were locked into the overall performance of BFS. Nevertheless,
this would not have been able to happen if robust risk management systems and controls were
in place.
Review points
Trading strategies of the head of Barings Futures Singapore resulted in o cumulative losses of £927 resulting in the sale of Barings Bank to ING for £1.
Leeson was trading derivatives on the Singapore and Osaka exchanges and o fraudulently covered up losses in an unreported error account.
Subsequent investigation found an almost complete failure of risk management o systems and controls. Problems included a matrix reporting system, the fact
that management did not question large profi ts being generated by a low-
risk activity, lack of segregation of duties between the front and back offi ces,
inappropriate limits on funding provided to BFS and failure to implement audit
recommendations.
Managers must understand their business, responsibilities and authorities must o be documented and circulated, segregation of duties is essential, independent risk
management systems and controls must be established for each business activity
and audit reports must be acted upon at the highest level of the organisation.
Inappropriate performance bonus systems may have been an important driver of o increased risk taking by Leeson.
12.4 The Asian fi nancial crisis A modern, effi cient and stable fi nancial system is essential if a nation-state is to achieve
sustained economic and social growth. This proposition was aptly demonstrated by the
so-called Asian fi nancial crisis that evolved from mid-1997.
The 1980s and early 1990s were a period of enormous economic growth and prosperity
within what was often described as the ‘tiger’ countries of Asia, in particular Hong Kong,
Singapore, Malaysia, Thailand, South Korea and Indonesia. However, the late 1990s saw the
‘bubble burst’, and the region experienced severe economic, fi nancial and social reversals.
Prior to mid-1997, Thailand maintained a fi xed exchange rate regime whereby the Thai
baht was pegged to a basket of currencies, predominantly the US dollar, the Japanese yen
and the German deutschmark. The currency came under sustained pressure and the central
bank of Thailand was unable to continue to support the fi xed exchange rate. On 2 July 1997
Thailand fl oated its currency, and this essentially became the trigger for the Asian currency
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crisis, as other fi xed exchange rate regimes, including the Philippine peso, the Malaysian
ringgit and the Indonesian rupiah, all fell victim to the foreign exchange market.
The situation rapidly evolved into a fi nancial and economic crisis, initially encompassing
Thailand, Indonesia, the Philippines and Malaysia but eventually extending to Japan, South
Korea, Russia and Brazil. The contagion effects of the ever-expanding crisis were not restricted
to these countries. Other countries in the region—Singapore, Hong Kong, Australia and New
Zealand—all experienced negative consequential effects of the crisis, as did the majority of
the global economies, including the USA.
In order to understand the fl ow-on effects of the crisis, it is important to understand the
relationships that exist between risks associated with foreign exchange, interest rates, liquidity,
price, credit and capital. For example, there is a statistical relationship between interest rates
and exchange rates. Normally, if an exchange rate depreciates signifi cantly, domestic interest
rates will rise.
The central bank will typically raise interest rates through its monetary policy initiatives
to try and encourage overseas investors back into the country, thus creating a demand for the
currency and thereby stabilising the exchange rate. The rise in interest rates will affect the
profi tability of the business sector, and therefore share prices will fall. If asset price infl ation
has also been evident, then asset prices would be expected to fall. The combined effect so far
will cause a lack of confi dence in the economy and a fall in business activity.
Higher interest rates and lower economic activity will lead to businesses defaulting on
credit, which will place pressure on the capital ratios of fi nancial institutions. Also, as with
the Asian crisis, a large portion of a country’s debt may be denominated in unhedged foreign
currencies and depreciation of the domestic currency will result in higher real interest and
principal repayments. While this is happening, liquidity in the market disappears as fi nancial
institutions and investors withdraw. All these risk factors occurred with the Asian fi nancial
crisis.
In its 1998 annual report, the Bank for International Settlements identifi ed the following
weaknesses that were common in the Asian crisis countries:
Excessive bank credit was available, which encouraged over-investment in industrial o capacity (in particular, offi ce buildings and condominiums) and an asset price boom and
eventual bust.
There was no recognition of the fragility of domestic fi nancial systems, because of o historical monetary and exchange rate stability, coupled with an extended period
of economic growth. Moral hazard risk existed in that there was an expectation that
government would always support major fi nancial institutions. Capital ratios were also
relatively low.
There was a reliance on potentially volatile external fi nance, particularly short-term o funding. Much of the external borrowing was not hedged against foreign exchange
risk, as it was perceived that such risk did not exist in the fi xed exchange rate regime.
Enormous capital infl ows were suddenly exposed to foreign exchange risk when
currencies were fl oated. At the same time, external investor confi dence dissipated and
there were signifi cant capital outfl ows, as indicated in Table 12.1 opposite.
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Central banks in the region, in an effort to support their depreciating currencies and stem
capital outfl ows, raised overnight interest rates signifi cantly. The effects on interest rates,
stock market prices and exchange rates are shown in Table 12.2 below.
The Asian fi nancial crisis caused regulators, government policymakers, academics and
market participants to exercise their collective minds to reconsider issues of signals, cause,
effect, regulation and fi nancial system architecture.
While changes in the structure, regulation and operation of the global fi nancial system
have occurred, and will continue to occur, history indicates that change is usually a very
slow process. The lessons of the Asian fi nancial crisis have prompted the Reserve Bank (RBA
Bulletin, April 1998, p. 2) to identify a list of questions to ask about a country’s fi nancial
system if there is the likelihood of a currency crisis or a wider economic crisis.
Does the country have a fi xed exchange rate and free movement of international o capital?
Is the exchange rate overvalued? o Has a country with similar economic characteristics recently experienced a currency o crisis?
Table 12 .1 Net pr i v ate c apit al f lows, A sia* ( USD billions )
1994 1995 1996 1997 (1st half) 1997 (2nd half)
24 38 77 62 –108
* India, Indonesia, South Korea, Malaysia, the Philippines, Singapore, Taiwan and Thailand. Source: Bank for International Settlements, Bis 68th Annual Report, Basel, June 1998, p. 133.
Table 12 . 2 Intere s t r ate s and exc hange r ate s dur ing the c r isis ( per cent )
Interest rates—
overnight rate peak
Interest rates—
three-month rate
peak
Stock market
indices—falls
between
1 January 1997 and
4 February 1998
Exchange rate
depreciation*—low
between July 1997
and March 1998
Hong Kong 100.0 25.0 –22.5 0
Taiwan 11.5 9.8 n.a. –19.3
Indonesia 300.0 27.7 –76.9 –84.3
South Korea 27.2 25.0 –54.6 –54.6
Malaysia 50.0 8.8 –65.3 –46.3
Philippines 102.6 85.0 n.a. –41.8
Singapore 50.0 10.3 –46.9 –21.0
Thailand 27.4 26.0 –62.8 –55.0
* Percentage change in the US dollar/local currency exchange rate since June 1997. Source: Bank for International Settlements, Bis 68th Annual Report, Basel, June 1998, p. 136.
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Is there a large budget defi cit and a lot of government debt outstanding? o Is there loose monetary policy and high infl ation? o Is the domestic economy in, or at risk of, a recession? o Is there a large current account defi cit? o Is there a large amount of foreign debt? o Is there an asset price boom (especially credit driven) occurring? o Are there a lot of bad debts in the banking system, or is there a poor system of bank o supervision?
Has there been a lot of unhedged foreign currency borrowing? o Are there poor accounting standards, few disclosure requirements or ambiguous o bankruptcy procedures?
These 12 points form a strong starting point for fi nancial crisis analysis. However, all of
the factors will not always be evident, and the existence of some factors does not by itself
imply an imminent crisis situation. Also, as with past fi nancial crises, each future crisis will
have its own particular set of defi ning characteristics.
The interesting, but unfortunate, observation of fi nancial crises is that they tend to repeat
themselves over time in one form or another. Often, the lessons learned from one crisis are
eventually thought to be irrelevant to the current market environment. This leads to an envi-
ronment where a new crisis can evolve. The reality is that the fundamentals of risk management
don’t change. Managers and regulators need to understand risk and who is actually holding
(or exposed to) risk. Within the context of the fi nancial system, risk needs to be identifi ed,
measured and managed.
Understanding the potential implications of the above points does not necessarily result
in earlier recognition of an evolving fi nancial crisis. This is demonstrated in our next case
study, where a number of these points were evident as the global fi nancial crisis evolved from
mid-2007.
Review points
A modern, effi cient and stable fi nancial system is essential for economic and o social growth within a nation-state.
Lessons of past crises are often forgotten. The fundamentals of risk management o don’t change, namely the need to understand risk, to know who is holding the
risk and that risk needs to be identifi ed, measured and managed.
Rapid growth in the Asia region led to asset price infl ation. At the same time a o number of countries had a fi xed exchange rate regime. There were large amounts
of debt borrowed overseas and this debt was exposed to FX risk if the currency
was fl oated. When pressure was exerted by the markets on the fi xed exchange
rates Thailand fl oated its currency, followed by the Philippines, Malaysia and
Indonesia, thus unleashing a collapse in the value of those currencies. The
central banks increased interest rates to try and stabilise their exchange rates.
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The higher cost of borrowing led to an economic downturn and a collapse of the
property and equity markets. Liquidity disappeared from the markets and credit
defaults increased capital write-offs signifi cantly.
The BIS identifi ed the following weaknesses: (1) excessive bank credit; (2) fragile o domestic fi nancial systems, low capital ratios and a belief the government
would always support institutions; (3) reliance on overseas borrowing that, if
the exchange rate regime changed, were exposed to FX risk; and (4) a fl ight of
capital away from the region when the crisis started.
12.5 The global fi nancial crisis In October 2008 the Australian share market fell nearly 16 per cent in a week and 40 per cent
over the following 12 months. The value of the Australian dollar relative to the US dollar
also fell from an exchange rate in June 2008 of AUD/USD0.9626 to AUD/USD0.6928 in
December 2008, a depreciation of 28 per cent. Similar scenarios were occurring in the major
fi nancial markets around the world. What had happened; how did this happen?
In mid-2007 the fi nancial markets began to realise that a signifi cant problem was embedded
in the US fi nancial system. For some years the Federal Reserve in the USA had maintained
an expansionary monetary policy stance whereby interest rates were extremely low. This
monetary policy stance was designed to stimulate economic activity within the struggling
US economy. However, the prolonged period of low interest rates meant the cost of borrowing
from fi nancial institutions in the USA was very cheap. This supported a culture of debt accu-
mulation, particularly within the housing sector to purchase property and for major lifestyle
goods such as new cars, swimming pools, televisions and overseas holidays. High personal
debt levels were also evident in most other developed economies.
Low-cost fi nance created a big demand for housing which resulted in a boom in property
prices. This fed the demand for debt as property owners were able to borrow more money
against the security of the increased value of residential properties. At the same time, housing
loan lenders, as a consequence of US government policies that encouraged fi nancial institu-
tions to provide housing loans to lower socioeconomic groups, began to lower their credit
standards; that is, lenders lent to borrowers who really did not have the long-term capacity
to repay loans. Often loans were given with a low ‘honeymoon interest rate’ that increased
signifi cantly at the end of the honeymoon period. These loans became known as sub-prime
loans. Large numbers of sub-prime borrowers began to default on loan repayments. The
number of bank foreclosures increased as lenders initiated the sale of residential properties
to recover outstanding loan amounts as borrowers defaulted on loan repayments. The extent
of property foreclosures put downward pressure on prices in the housing property market.
Further, banks became reluctant to lend.
The fall in property prices meant that lenders were not able to recover the full amount
of the loans. These losses had to be written off against equity capital. The reduction in their
capital base meant that lenders were unable to maintain previous lending levels.
Also, during the extended period of massive growth in sub-prime lending, lenders did not
retain all of their housing loans on their balance sheet. A large proportion of housing loans
HONEYMOON INTEREST
RATE
Interest rates on a loan are initially low, but rise at a future nominated date
SUB-PRIME LOANS
Loans to borrowers that under normal credit assessment standards would not have the capacity to repay
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were packaged together and sold to institutional investors, such as fund managers, insurance
companies and superannuation funds. This process is known as securitisation. Briefl y, a
large group of housing loans is packaged together by a mortgage lender such as a commercial
bank and sold to a trustee of a special-purpose vehicle (SPV). The SPV trustee pays for the
securitised housing loans with funds raised from the issue of debt securities such as bonds to
institutional investors. The SPV trustee receives the future housing loan repayments and uses
those funds to meet commitments due on the bonds issued. As shown in Figure 12.1 below,
the SPV trustee will appoint a service manager to control all cash fl ows. Also, the trustee may
arrange for certain guarantees to be put in place which will enhance the credit rating of the
initial bond issue.
SECURITISATION
Non-liquid assets are sold into a trust;
the trustee issues new securities;
cash fl ows from the original assets are
used to meet periodic payments due on the
new securities
Financial intermediary
InvestorsSpecial-purpose vehicle
Credit enhancer
Service manager
Assets
Asset-backed securities
Issue
(Trustee)
Cash flows (loan repayments—periodic)
Cash flow (asset-backed securities interest and principal repayments)
(e.g. loans)
F igure 12 .1 Ty pic al se c ur itis ation pro ce s s
The securitised housing loans are also known as collateralised debt obligations (CDOs)
as they are supported by the value of the underlying residential properties. However, as the
value of the properties fell and loan defaults increased, the value of the CDOs fell. CDOs were
sold all around the world, such that the US sub-prime market collapse affected the global
fi nancial markets. At the same time, property bubbles that were evident in the UK and parts
of Europe also burst, thus multiplying the problem. Large sectors of the property markets in
the USA and UK fell between 20 and 40 per cent.
The global fi nancial crisis, in particular the collapse of the US and UK housing markets,
had a signifi cant adverse effect on the securitisation market. Securitised assets that were
previously regarded as low risk were no longer so. Therefore, those limited number of insti-
tutions that were still able to issue securitised asset-backed securities were required to pay
a much higher risk premium. Once the current crisis is resolved, the securitisation market
should recover, albeit at lower growth rates.
The International Monetary Fund (IMF) has estimated that realised write-downs of bank
loans and security issues between mid-2007 and mid-2009 amounted to USD1300 billion.
The IMF estimates that another USD1500 billion will be written off in 2010.
A number of fi nancial institutions began to fail, including commercial banks, investment
banks, hedge funds and insurance companies. In some instances, government support was
provided, in the form of additional capital, special loan arrangements or in arranging a
COLLATERALISED DEBT
OBLIGATIONS
Securities, such as bonds, issued
through the process of securitisation with
a form of collateral, such as property
mortgages, attached
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merger with a stronger institution. Other institutions were allowed to fail, the most notable
being Lehman Brothers in the USA. The failure of a number of fi nancial institutions around
the world resulted in loss of confi dence in fi nancial institutions generally. In particular, banks
were no longer willing to lend to each other. The sub-prime crisis became a global credit crisis
as institutions cut back on their lending in the inter-bank market and also normal lending to
individuals and corporations.
Central banks tried to relieve the credit crisis by pumping massive amounts of liquidity
(additional funds) into the fi nancial system. However, the loss of confi dence was such that the
increased liquidity had only a limited effect. Central banks in the USA and UK extended their
initiatives further by taking equity positions in some larger banks that were at risk of failing
as a result of a signifi cant loss of capital. Further, in the USA, the Treasury Department estab-
lished an arrangement to buy up to USD700 billion worth of toxic housing-related CDOs. It
was argued that this arrangement would allow funds to fl ow back into the fi nancial system
and allow bank lending to recover. Losses incurred through buying the toxic CDOs will be
borne by the US taxpayer.
As a result of the turmoil in the fi nancial markets global economic activity slowed consid-
erably. This had a signifi cant impact on manufacturing and service export countries such as
China and India. Hundreds of container ships sat idle in the waters of Asia. A number of major
countries including the USA, UK and major euro-zone countries experienced an economic
recession, that is, two periods of negative economic growth.
The selected data in Table 12.3 below give an indication of the fall in economic funda-
mentals and the subsequent monetary policy interest rate responses to the escalating global
fi nancial crisis.
Signifi cant volatility was also evident in the foreign exchange markets. For example,
Table 12.4 overleaf shows the volatility of the AUD/USD exchange rate between June 2007
and December 2009.
Table 12 . 3 E c onomic and monet ar y polic y d at a —June 2 0 0 7 and June 2 0 0 9
USA UK Hong Kong New Zealand Australia
Unemployment
June 2007 4.6% 5.4% 4.2% 3.7% 4.3%
June 2009 9.5% 7.8% 5.4% 6.0% 5.8%
Gross domestic product (1996 = 100)
June 2007 140.0 137.0 150.4 139.8 n/a
June 2009 136.8 131.6 150.7 137.9 n/a
Offi cial interest rates
June 2007 5.31% 6.68% 3.80% 8.00% 6.25%
June 2009 0.22% 0.48% 0.05% 2.50% 3.00%
Share price indices (1990 = 100)
June 2007 455.3 308.3 719.9 386.1 490.3
June 2009 278.4 198.2 607.7 254.9 309.0
Source: Reserve Bank of Australia, RBA Bulletin, adapted from various issues.
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An important response of most major nation-states to the evolving crisis was the imple-
mentation of massive economic stimulus packages. It is estimated that these packages have
been in excess of USD2000 billion globally. The packages have taken different forms, but
essentially involved strategies specifi cally designed to stimulate consumer spending in order
to stabilise business activity and falling employment rates. For example, in the USA the
stimulus package included a cash for clunkers plan, whereby owners of older cars were given
fi nancial incentives to buy new cars. The old cars were then scrapped.
In Australia, the government stimulus packages amounted to more than $40 billion. The
majority of individual taxpayers received cash payments which were available to spend in
the economy. While spending certainly held up during the crisis period, many people used the
funds to reduce existing debt levels. Some of the package was directed at specifi c capital
spending projects, for example improvements to schools. At the same time, the government
provided guarantees for bank deposits as well as wholesale debt issues of the commercial
banks. These initiatives were designed to encourage depositors to deposit funds with the banks
and also re-establish the confi dence of institutional investors to purchase paper issued by
the banks.
Regulators seek to achieve a balance between stability and competition in the fi nancial
markets. In the aftermath of the global fi nancial crisis regulatory change is to be expected.
To date, regulatory changes within Australia include the shifting of the Australian Securities
Exchange (ASX) authority to supervise trading on the stock exchange to the Australian
Securities and Investments Commission (ASIC). Also, fi nancial institutions regulated by the
Australian Prudential Regulation Authority (APRA), including commercial banks, building
societies, credit unions and insurance offi ces, must establish a remuneration committee and
a remuneration policy that sets out the pay of senior executives, risk and fi nancial control
personnel and all other staff whose activities could impact upon the soundness of the institu-
tion and whose remuneration has a major performance bonus component.
The Australian government has a longstanding banking policy known as the four pillars
policy, whereby the four major commercial banks are not permitted to merge with each other.
It certainly has been argued by some experts that this policy may, within the context of the
international markets, have constrained the growth of the major banks and therefore limited
their exposure to the derivative markets and the huge losses suffered by many larger global
banks during the fi nancial crisis. At the end of 2009, only 11 banks worldwide retained their
AA credit rating, including the four major Australian banks.
FOUR PILLARS POLICY
A government policy in Australia that
prevents any merger between the major
four commercial banks
Table 12 . 4 AUD / USD exc hange r ate s —June 2 0 0 7 to De cember 2 0 0 9
AUD/USD exchange rate Percentage change
June 2007 0.8487
December 2007 0.8816 +3.9
June 2008 0.9626 +9.2
December 2008 0.6928 -28.0
June 2009 0.8114 +17.1
December 2009 0.9267 +14.2
Source: Reserve Bank of Australia, RBA Bulletin, adapted from various issues.
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The demography of most developed countries includes an ageing population. With the
ageing population rapidly approaching retirement, the global fi nancial crisis had a devastat-
ing impact. Signifi cant losses in the value of retirement savings, coupled with an economic
downturn, meant many retirees who expected to be fi nancially comfortable in retirement
no longer were in that position. Over time, this will place greater longer-term demand on
pension payments by governments.
At the time of writing, this crisis is yet to be fully played out. You will read much more
about the ongoing crisis in the fi nancial press. Eventually, governments and central banks
will more fully understand how this crisis evolved, the effectiveness of their responses and
what policy and regulatory structures need to be established to ensure this form of a fi nancial
crisis does not occur again. I say ‘this form of a crisis’ because other fi nancial crises will occur
in the future; history is full of examples.
Particularly in times of global fi nancial crisis, there is the possibility that a nation-state may
default on debt obligations. In the early stages of the crisis Iceland experienced severe fi nancial
stress as have some eastern European countries. Recently, a Dubai state-owned corporation
advised the markets that it may not be able to meet the repayment of a USD3.5 billion bond
commitment. It may be argued that Dubai is a classic example of how the fi nancial markets
may supply excessive credit that is not adequately supported by underlying economic funda-
mentals or asset values, thus creating the potential for sovereign risk to occur. The risk of a
sovereign default rattled the fi nancial markets, but fortunately the Dubai state-owned corpo-
ration was bailed out by the United Arab Emirates.
By the end of 2009, many commentators forecast that the global fi nancial crisis was abating
and that 2010 would see the beginnings of a global economic recovery. However, the global
fi nancial crisis had so weakened many nation-state economies that a new crisis evolved in the
form of sovereign debt risk. A number of countries have accumulated massive state debt levels.
Debt must be either repaid or refi nanced, including debt owed by a government.
By May 2010, the markets became very concerned that a number of European Union
countries, including Greece, Portugal, Spain, Italy and Ireland, may not be able to repay
their signifi cant debt commitments. Again, the markets were in turmoil with excessive
volatility in the foreign exchange market and the stock markets. The European Central
Bank negotiated a bail out package with other EU members, but there remains concern
that the package will be insuffi cient, unless each debt-laden country implements very severe
fi scal cutbacks.
At the time of writing about this unfolding global fi nancial crisis, the markets remain in
turmoil and are very volatile. At the same time, other high debt countries, including the USA
and the UK, are still a potential crisis waiting to happen.
Review points
An extended period of expansionary monetary policy in the USA and o government policies that encouraged lending to lower socioeconomic groups,
coupled with a culture of consumption through debt accumulation, created an
environment in which a property bubble and lower lending standards occurred.
SOVEREIGN RISK
A risk that a foreign government will default on its obligations
continued
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By mid-2007, large numbers of sub-prime housing loan market borrowers began o defaulting on loan repayments. This caused a collapse in the property market
requiring lenders to write off large amounts of capital.
A large proportion of housing loans had been securitised as collateralised debt o obligation throughout the global markets. As these structures began to fail,
confi dence was lost in the fi nancial system.
Financial institutions sought government bail-outs and some failed. This o increased uncertainty in the markets and credit almost ceased to be available.
Corporations were unable to refi nance high levels of debt accumulated during
the previous long period of economic growth. Further government bail-outs
occurred, but many corporations failed. Trillions of dollars have been written off.
An economic recession was experienced in most developed economies and o unemployment rates increased signifi cantly. Central banks pumped liquidity into
the system to try and activate the credit markets.
Governments implemented stimulus packages in different forms to encourage o economic activity.
Sovereign debt risk has become a concern to the markets, resulting in further o market volatility. Many governments now hold large amounts of public debt that
will need to be repaid.
As the global fi nancial crisis recedes, regulators will introduce new prudential o regulators that should address the major weaknesses identifi ed during the crisis.
12.6 The next fi nancial crisis? As mentioned above, there will be future fi nancial crises within institutions, nation-states,
geographical regions and globally. If government policymakers and market regulators knew
where the next crisis would evolve then, presumably, they would adjust the regulatory settings
so that this did not happen.
The three fi nancial crises we have examined demonstrated an institutional, regional and
global crisis scenario. Each crisis was different, but each crisis also had underlying funda mental
issues and problems that were not recognised until after the crisis had been established.
Often, fi nancial crises are essentially a failure to understand, identify, measure and manage
risk. Risk is intertwined and interrelated. The existence of one risk will change the dynamics
of other risk exposures. All too often, there is a lack of understanding of who is ultimately
holding risk and the impact on an institution and the fi nancial markets if the ultimate
risk holder fails. For example, with the global fi nancial crisis, CDOs simply moved the risk
exposure associated with sub-prime loans from one party to another party. Everyone made
money along the way, including the mortgage brokers, the banks, the credit rating agencies
and the fund managers, but the risk was still in the fi nancial system. The process of risk
shifting was also often made easier by implicit or explicit guarantees given by governments,
often with limited or inadequate regulatory oversight.
An interesting observation in many fi nancial crises is the remuneration of risk. Individuals
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and institutions are frequently rewarded for creating, rather than managing, risk. Risk has
become a commodity that can be sold in the markets for a profi t. As demonstrated in the example
of the global fi nancial crisis, at every level of the fi nancing process, from the initial granting of
sub-prime loans to the fi nal transfer of those loans as CDOs, performance bonuses were being
paid. For an extended period market participants failed to understand that the global fi nancial
system is inextricably intertwined; that is, nation-states and institutions are affected by events
that occur in other nation-sates and institutions. Unfortunately, nation-state regulators and
prudential supervisors also failed to recognise who was holding the risk. The massive accumu-
lation of risk within a relatively few large institutions should have been a clear warning signal.
Where will the next fi nancial crisis occur? We don’t know. However, now that you under-
stand the essentials of how the fi nancial markets function, you have the capacity to continually
monitor and analyse events as they occur in the markets and perhaps you will be able to
mitigate the fi nancial, economic and social impacts of the next crisis.
Review points Financial crises will occur again in the future. o In a dynamic and competitive market, the failure of regulators and institution o managers to understand, identify, measure and manage risk establishes an
environment where excessive risk is taken in order to maximise profi t.
Financial institutions, markets and nation-state’s fi nancial systems are o inextricably intertwined in the global fi nancial system. As such, a failure in one
major institution will have ramifi cations for a domestic fi nancial system and
probably the global fi nancial system.
The profi t motive, greed and inappropriate remuneration arrangements are often o an underlying driver of many past fi nancial crises.
When, where and how will the next fi nancial crisis occur? We don’t know, but o learning the lessons of past crises should allow governments, regulators and
institution managers to mitigate the next crisis.
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REAL-WORLD CASE STUDY University of NSW corporate law professor Justin O’Brien raised an interesting
point about the global fi nancial crisis at the Australian Securities and Invest-
ments Commission’s summer school seminar this week: laws were broken on
the margins as the boom that detonated the crisis grew, but the behaviour that
primed the crash was, in the main, totally legal.
It was not illegal acts that pushed the world’s fi nancial system to the brink of
collapse in September and October 2008, nor a worldwide ethical decline. Instead, an
ethical hole in the heart of the system that had existed for years became potentially
fatal as the markets went global.
O’Brien’s contention is that technocratic re-regulation of the fi nancial system that
is now under way will not fi x that problem. The hole in the system’s heart can exist
‘irrespective of the utility of reducing leverage ratios, restricting proprietary trading
or the capacity of banking licences from holding stakes in alternative asset classes,
such as hedge funds and private equity’, he says in the paper delivered at the ASIC
seminar.
He [O’Brien] asks two questions. The fi rst is whether ethical behaviour can be
inferred solely from compliance with legal obligations … The second—if ethical
behaviour requires more than legal compliance, who adjudicates it, on what basis and
using what measures? … One of O’Brien’s conclusions is that ethical behaviour needs
to be defi ned, encouraged and enforced by the professions that combine to create the
global markets, not by external regulators.
Source: M. Maiden, ‘An ethical black hole remains at the heart of the market’, The Age, 6 March 2010.
Discussion and analysis O’Brien contends that changes to the regulation of fi nancial system � participants (fi nancial institutions, instruments and markets) will not mitigate
a future global fi nancial crisis, but rather a change in ethical standards is
required. Critically analyse and discuss O’Brien’s contention. (In your answer
consider the possibility of a balance between both options.)
In the fi nancial markets, where success is measured in fi nancial terms and is � the basis of annual performance bonuses to personnel, is it possible to devise
a global regime of ethical behaviour that will adequately address the problems
exposed in the global fi nancial crisis? Discuss your reasons.
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S U M M A RY L E A R N I N G O B J E C T I V E � •• Discuss important factors that are drivers of globalisation of the international
fi nancial markets.
A modern and effi cient domestic and global fi nancial system is essential for continued economic • growth. Factors that support the globalisation of the fi nancial markets include unrestricted capital • movements, deregulation of domestic fi nancial systems, technological and fi nancial innovation, increased competition and development of risk management products to manage volatility, development of emerging markets and changing demographic patterns. Four main drivers of change are changing customer needs, technology innovation, regulation, and • changing fi nancial landscape.
Changing customer needs issues include increased asset accumulation, ageing populations, s superannuation and retirement savings, funds under management, fi nancial advisory services, changing work patterns, risk management products and increased living standards. Technology innovation derives from improvements in communications infrastructure and s product and information delivery systems. This allows lower-cost entry into the markets for new competitors. Regulation is important to try and achieve a balance between stability and competition in s the markets (e.g. Basel II capital accord). New prudential regimes have been developed (e.g. RBA, APRA, ASIC and ACCC in Australia). Signifi cant deregulation of fi nancial institutions, instruments and markets has allowed global capital fl ows and fl oating of most major currencies Changes in fi nancial landscape include globalisation, increased competitive pricing of products s and services, product innovation supported by technology developments, new market competitors and a freeing of the markets through deregulation
L E A R N I N G O B J E C T I V E � •••• Examine policy, structural and management issues that may create an environment
that is conducive to an evolving fi nancial crisis, and understand the effects and
consequences of a fi nancial crisis on a fi nancial system and a real economy.
Financial crises can affect institutions, nation-states, geographical regions and the global fi nancial • system. Factors that often create an environment in which a crisis may occur include:•
Macroeconomic settings—government fi scal and taxation policies and central bank monetary s policy settings impact upon an economy and fi nancial markets. Asset bubbles (e.g. property prices) often derive from existing taxation and interest rate settings. When a bubble bursts it can have signifi cant adverse effects. Financial system structural and regulatory policies—factors that impact either directly s or indirectly on the evolution of a fi nancial crisis include moral hazard (e.g. too big to fail
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syndrome), prudential supervision (active and positive supervision should provide early
warning signs), deregulation (encourages innovation and competition, but also increased risk
taking) and corporate governance (relationship between shareholders, board and executive
management should ensure accountability and transparency).
Financial institution management—failure of a major institution may have contagion effects for s
other institutions; major risks that an institution must manage include credit, interest rate, FX,
concentration, liquidity, new-product, operational, control, fraud, corruption and capital risks
Despite the efforts of governments, central banks and prudential supervisors fi nancial crises will •
continue to occur periodically.
L E A R N I N G O B J E C T I V E � •••••• Identify and discuss risk management issues that were causal in the failure of
Barings Bank.
Trading strategies of the head of Barings Futures Singapore resulted in cumulative losses of £927 •
resulting in the sale of Barings Bank to ING for £1.
Leeson was trading derivatives on the Singapore and Osaka exchanges and fraudulently covered •
up losses in an unreported error account.
Subsequent investigation found an almost complete failure of risk management systems and •
controls. Problems included a matrix reporting system, the fact that management did not question
large profi ts being generated by a low-risk activity, lack of segregation of duties between the front
and back offi ces, inappropriate limits on funding provided to BFS and failure to implement audit
recommendations.
Managers must understand their business, responsibilities and authorities must be documented •
and circulated, segregation of duties is essential, independent risk management systems and
controls must be established for each business activity and audit reports must be acted upon at
the highest level of the organisation.
Inappropriate performance bonus systems may have been an important driver of increased risk •
taking by Leeson.
L E A R N I N G O B J E C T I V E � •••••••• Identify the underlying fi nancial system weaknesses that became the precursor to the
Asian fi nancial crisis, and explain the interrelationships of fi nancial risks in this crisis.
A modern, effi cient and stable fi nancial system is essential for economic and social growth within •
a nation-state.
Lessons of past crises are often forgotten. The fundamentals of risk management don’t change, •
namely the need to understand risk, to know who is holding the risk and that risk needs to be
identifi ed, measured and managed.
Rapid growth in the Asia region led to asset price infl ation. At the same time a number of •
countries had a fi xed exchange rate regime. There were large amounts of debt borrowed overseas
and this debt was exposed to FX risk if the currency was fl oated. The pressure exerted by
the markets on the fi xed exchange rates caused Thailand to fl oat its currency, followed by the
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Philippines, Malaysia and Indonesia, thus unleashing a collapse in the value of those currencies.
The central banks increased interest rates to try and stabilise their exchange rates. The higher cost
of borrowing led to an economic downturn and a collapse of the property and equity markets.
Liquidity disappeared from the markets and credit defaults increased capital write-offs signifi cantly.
The BIS identifi ed the following weaknesses: (1) excessive bank credit, (2) fragile domestic •
fi nancial systems, low capital ratios and a belief the government would always support institutions,
(3) reliance on overseas borrowing that, if the exchange rate regime changed, were exposed to
FX risk, and (4) a fl ight of capital away from the region when the crisis started.
L E A R N I N G O B J E C T I V E � •••••••••• Describe the evolution of the global fi nancial crisis, its impact on the fi nancial markets
and the responses of government and regulators to the crisis.
Loose monetary policy in the USA and government policies that encouraged lending to lower •
socioeconomic groups, coupled with a culture of consumption through debt accumulation, created
an environment in which a property bubble and lower lending standards occurred.
By mid-2007, large numbers of sub-prime housing loan market borrowers began defaulting on •
loan repayments. This caused a collapse in the property market requiring lenders to write off large
amounts of capital.
A large proportion of housing loans had been securitised as collateralised debt obligations •
throughout the global markets. As these structures began to fail, confi dence was lost in the
fi nancial system.
Financial institutions sought government bail-outs and some failed. This increased uncertainty •
in the markets and credit almost ceased to be available. Corporations were unable to refi nance
high levels of debt accumulated during the previous long period of economic growth. Further
government bail-outs occurred, but many corporations failed. Trillions of dollars have been
written off.
An economic recession was experienced in most developed economies and unemployment rates •
increased signifi cantly. Central banks pumped liquidity into the system to try and activate the
credit markets.
Governments implemented stimulus packages in different forms to encourage economic activity. •
Many governments now hold large amounts of public debt that will need to be repaid. Sovereign
debt risk has become a concern to the markets, resulting in further market volatility.
As the global fi nancial crisis recedes, regulators will introduce new prudential regulators that •
should address the major weaknesses identifi ed during the crisis.
L E A R N I N G O B J E C T I V E � •••••••••••• Analyse and discuss the question ‘Will there be another fi nancial crisis in the future?’
Financial crises will occur again in the future.•
In a dynamic and competitive market, a failure of regulators and institution managers to •
understand, identify, measure and manage risk establishes an environment where excessive risk
is taken in order to maximise profi t.
439C A S E S T U D I E S I N F I N A N C I A L C R I S E S C H A P T E R 1 2
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Financial institutions, markets and nation-state’s fi nancial systems are inextricably intertwined in • the global fi nancial system. As such, a failure in one major institution will have ramifi cations for a domestic fi nancial system and probably the global fi nancial system. The profi t motive, greed and inappropriate remuneration arrangements are often an underlying • driver of many past fi nancial crises. When, where and how will the next fi nancial crisis occur? We don’t know, but learning the lessons • of past crises should allow governments, regulators and institution managers to mitigate the next crisis.
K E Y T E R M S ARBITRAGE 423
CAPITAL RISK 422
COLLATERALISED DEBT OBLIGATIONS 430
CONCENTRATION RISK 421
CONTROL RISK 422
CORPORATE GOVERNANCE 420
CREDIT RISK 421
DEREGULATION 415
FINANCIAL INNOVATION 415
FINANCIAL SYSTEM 415
FOREIGN EXCHANGE RISK 421
FOUR PILLARS POLICY 432
FRAUD OR CORRUPTION RISK 422
GLOBALISATION 415
HONEYMOON INTEREST RATE 429
INTEREST RATE RISK 421
LIQUIDITY RISK 421
MORAL HAZARD 420
NEW-PRODUCT RISK 422
OPERATIONAL RISK 422
PAYMENTS SYSTEM 417
SECURITISATION 430
SOVEREIGN RISK 433
SUB-PRIME LOANS 429
TECHNOLOGICAL INNOVATION 415
WALLIS REPORT 416
Q U E S T I O N S True/False questions
Answer TRUE or FALSE to the following statements. To assist in your review, you might also write brief notes explaining your response.
1. Most fi nancial crises have resulted from poor prudential supervision of fi nancial institutions.
2. Globalisation of the fi nancial markets has occurred in response to past fi nancial crises.
3. Emerging demographic changes are an important driver of change in the structure and functions of the fi nancial markets.
4. Macroeconomic settings primarily infl uence the economy and business and therefore are not an important factor in the development of fi nancial crises.
5. Moral hazard is said to exist where an institution takes excessive risk in the belief it will ultimately be protected by government.
6. Corporate governance refers to the role of prudential regulators in the supervision of fi nancial institutions.
7. Concentration risk may be evident if a fi nancial institution provides a large loan facility to a multinational corporation.
440 F I N A N C I A L M A R K E T E S S E N T I A L S
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8. A matrix-based management reporting system is designed to ensure managers are fully aware of all
aspects of business operations.
9. Performance bonuses paid to employees was an important factor in the Barings Bank collapse.
10. The Asian fi nancial crisis was primarily caused because many Asian countries had a fi xed exchange
rate regime.
11. Contagion effects of the Asian fi nancial crisis only extended to the tiger economies of the Asia
region.
12. The extended period of expansionary monetary policy in the USA was an underlying driver of the
sub-prime housing crisis.
13. Many sub-prime housing loan lenders shifted these assets off their balance sheets through issuing
collateralised debt obligations.
14. Economic stimulus packages have largely been ineffective in reducing the impacts of the global
fi nancial crisis.
15. Regulatory responses to the global fi nancial crisis almost certainly will mean that this type of crisis
will not occur again.
Essay questions
Write short essay-type responses to the following questions. Make sure that you are able to explain in your own words the points you raise in relation to each question.
1. The evolution of nation-state fi nancial systems into an integrated global fi nancial system has
occurred, and continues to occur, due to a number of specifi c factors. Identify and discuss the
factors that have infl uenced the development of the global fi nancial system.
2. It may be argued that inappropriate macroeconomic settings may support the development of a
fi nancial crisis within a nation-state. Discuss this contention.
3. The structure and regulation of a nation-state’s fi nancial system may impact either directly or
indirectly on the evolution of a fi nancial crisis. Discuss this proposition under the headings of:
(a) moral hazard
(b) prudential supervision
(c) deregulation
(d) corporate governance
4. In the past, many fi nancial institutions have failed due to poor risk management systems and
controls. Ultimately, the management of a fi nancial institution is the responsibility of the board of
directors and executive managers. Within the context of the above statements, identify and briefl y
discuss eight major risk categories that need to be managed by a fi nancial institution.
5. The dynamics and complexity of fi nancial markets and their integration into the global markets mean
that the potential for a fi nancial crisis to occur is always a concern. The contagion implications for
the global markets mean that governments, prudential regulators and institution managers must
be vigilant for factors that historically have been a precursor to past fi nancial crises. Discuss this
statement.
441C A S E S T U D I E S I N F I N A N C I A L C R I S E S C H A P T E R 1 2
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6. An investigation into the failure of Barings Bank identifi ed a number of major weaknesses.
(a) Briefl y discuss the main events as they occurred with the Barings Bank fi nancial collapse.
(b) Explain the problems of the matrix-based reporting system operating at the time of the crisis.
(c) The risk management systems and controls were inadequate. Discuss three examples where this occurred.
7. After the failure of Barings Bank, the UK Board of Banking Supervision identifi ed fi ve important lessons that should be understood by directors and managers of fi nancial institutions. List these fi ve lessons and briefl y discuss their importance within the context of fi nancial risk management.
8. The so-called Asian fi nancial crisis provided some valuable lessons about nation-state and global fi nancial systems. What are some of those lessons?
9. An analysis of many past fi nancial crises indicates that they tend to repeat themselves over time in one form or another. Often, the lessons learned from one crisis are eventually thought to be irrelevant to the current market. This may lead to an environment where a new crisis can evolve. Discuss this statement.
10. The sub-prime housing loan crisis in the USA evolved into a global fi nancial crisis. Discuss the main events that led to this situation.
11. Within the context of the global fi nancial crisis, explain the following:
(a) the infl uence of government policies in the USA that encouraged sub-prime lending practices
(b) the relationship between the global property bubble and a culture of debt-funded consumption
(c) the contagion effect of collateralised debt obligations and securitisation
(d) the use of economic stimulus packages to reduce the impact of the global fi nancial crisis.
12. Having regard to your understanding of the structure, regulation and operation of the global fi nancial markets, analyse and discuss the likelihood of another global fi nancial crisis occurring during the next decade.
442 F I N A N C I A L M A R K E T E S S E N T I A L S
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