The growth of a global business is accompanied by increasing complexity as well as an increase in the number and types of risks faced by corporations. Unpredicted extreme events such as terrorist attacks and natural disasters continue to occur, further adding to the problems corporations face. The global economic crisis of 2008-2009 is an example of how extreme events have affected businesses throughout the globe.
Although the crisis had been predicted by some, its timing and impact were greater than what had been foreseen before 2008. The analysis of the global financial crisis by many researchers and financial analysts have brought to light the inadequacy of good management practices and in some cases the application of poor management practices. This study analyses the management practices prior to the financial crisis and the actions managers have taken since the crisis.
Risk management practices
Of all areas of management, perhaps the area that was most affected by the global financial crisis is risk management. Indeed, the crisis brought to light several weaknesses of risk management practices. The credit crisis affected most global financial institutions. Nevertheless, some financial institutions performed better than others, indicating differences in risk management practices. In the United States, for instance, three of the four most affected financial institutions have since either collapsed (Lehman Brothers) or been taken over (Merrill Lynch and Wachovia).
Of the five big investment banks, only Goldman Sachs and Morgan Stanley survived, but after transformation into commercial back holdings (Anderson & Landon, 2007). These examples of differences in performance of financial institutions pinpoint the need to create a strong enterprise risk management (ERM) framework (Economist Intelligence Unit, 2008).
Risk management practice entails not only formal rules and regulations but also a risk management culture. Indeed, the rules and regulations are not enough to bring into line the incentives of the individuals with the members of the enterprise. To a certain extent, a strategic risk management culture should incorporate broad business goals into risk-aware decision-making. Risk management should not be left to an independent function but rather it should penetrate the culture of the organization in its entirety to ensure its effectiveness in minimizing risk. In other words, the culture of risk should begin from the top management level and trickle down to the most junior of employees.
Goldman Sachs provides an example of an institution with a risk culture. The institution inherited this culture from its days as a partnership and this culture has enabled it to align the individual incentives with those of the firm. The persons involved in risk control in the institution are given as much prestige, status, and compensation as those directly involved in profit-focused businesses (Bordo & Jeanne, 2002). The risk control partners are also involved in the institution’s decision-making processes. Besides having a culture of risk management, risk reporting is equally important as a sound management practice.
The structure put in place for risk reporting matters a lot. In the Goldman Sachs institution, the Chief Financial Officer (CFO) is in direct charge of risk and is closely involved with each sector’s risk department. The risk officers in all sectors report directly to him on all issues related to risk, from liquidity risk to credit risk as well as market and operational risk. Moreover, the institution has shared expertise on financial markets and risk management among the members of its board of directors and audit committee. This expertise is important in helping top management to uphold the firm’s overall risk exposure when markets and securities become very complex and dynamic (Bordo & Jeanne, 2002).
Risk modeling and extreme risk management
The global financial crisis also brought to light various serious problems in modeling risk exposures. Most of the financial institutions incurred subprime-related mortgage losses that had not been predicted by their risk models prior to the onset of the credit crisis. It is usually difficult to predict extreme and rare occurrences or their potential impact. Predictions are therefore normally based on historical data and supplemented with confidence intervals of possible results (Embrechts, 2008).
However, models can give an artificial sense of safety if they permit undue interpretation of information, or encourage false assumptions about the underlying numbers. If the fundamental variables change, then historical data cease to be of much help. For instance, it is argued that the originate-to-distribute (OTD) banking model led to the creation of the subprime mortgage market. The mortgages available to borrowers with poor credit quality increased substantially and, thus, the group of borrowers in the market transformed significantly. Yet, most of the models did not offer much guidance on the probability of high defaults by the new market participants (Embrechts & Küppelberg, 2008).
Similar challenges were also encountered in the evaluation of tail risks. Although non-payment of finance borrowers happens to be individual during normal times, they have a tendency to be combined during economically complicated periods including crises (Borio & Lowe, 2002). But because extreme crises occur occasionally, it is not easy to predict this correlation using historical data. Therefore, if the available data is inadequate and unreliable, risk managers should find alternative ways of evaluating risk instead of relying on model estimates. The alternative risk assessment techniques may include qualitative judgments, which can either complement or replace quantitative analysis.
A major difference between the financial institutions that weathered the credit crisis and those that did not is the degree to which the business arm and the risk arm were integrated. Firms that survived the credit crisis had integrated the two arms of a firm very well as compared to firms that were adversely affected by the crisis. In addition, the level of communication between these two arms was very high in the firms that survived the crisis. For instance, the UBS senior management did not realize that the bank was accumulating exposure to US mortgages as far as its internal hedge funds, collateralized debt obligations (CDO), and treasuries were concerned (Garber, 2000). This unrevealed risk accumulation increased the negative impact of the crisis on the back yet such an impact could have been avoided by better risk intelligence through a holistic management framework. It is therefore important for firms to create multiple lines of defense to cover the risk.
Garber (2000) argues that “effective risk management requires more than navigation around the high rocks in the water,” (p. 67). Because of the increasing complexity of the global economic and financial systems, even highly skilled and experienced managers may have a limited perspective of the different risks their firms are facing. The inter-relationship among different types of risks during crises requires risk managers to know for sure the exposures across all arms of the firm. There is a necessity for a full firm risk examination that can lead to risk growth. A holistic evaluation of risk will reveal the characteristics of a firm including the management styles and approaches, operations and processes, industry issues, and emerging risks among others.
Regulation and enterprise risk management
In the wake of the global financial crisis, there has been growing pressure on policymakers to tighten regulations that govern the activities of market participants, most especially the financial institutions. The financial crisis came at a time when a more principles-based approach was gaining popularity in the United States. Nevertheless, because principles-based regulations tend to be similar to deregulation, such changes would go against the trend in the current global business climate. Thus, legislators across the globe are more likely to call for a more rules-based approach rather than a principles-based approach. This approach would however cause innovative financial services providers to suffer (Borio, 2008). In spite of this, the scope of risk is wide, and therefore good risk management must necessarily cut a wide swath.
Enterprise risk management needs to cover a wide range of risks, including daily operational risk, emerging risks, and unexpected events. One of the lessons the credit crisis taught the financial institutions is that in their effort to adhere to Basel II, the institutions may have been forced to neglect the process for identifying new risks or the management of new emerging risks. Instead, most resources were devoted to basic compliance procedures. Compliance however does not necessarily mean complete avoidance of risk. Regulation will always be a step behind because people will always find new creative ways to bend the rules and therefore more often than not regulation is usually a reactionary rather than a preventive measure.
Effective management of funding liquidity, capital, and balance sheet
The importance of having a firm-wide perspective is evident in the variations in the enforcement of active controls over consolidated balance sheets, liquidity, and capital positions. Firms that align their treasury functions with risk management processes were better able to cope with the credit crisis than their counterparts. Moreover, these firms incorporated information from all departments during liquidity planning, including actual and contingent liquidity risk.
They also created internal pricing mechanisms that offered incentives for individual business lines to control activities that might otherwise have led to the growth of their balance sheet or unanticipated declines in the capital. Particularly, such firms had changed business lines appropriately so as to create contingent liquidity exposures to reflect the cost of obtaining liquidity in the dynamic market environment (Farlow, 2003).
Firms that performed better during the financial crisis also actively manage their contingent liquidity needs. For instance, some firms avoided business lines such as CDO warehousing because the perceived contingent liquidity risk was greater than the potential returns. When putting into effect their plans, these firms showed greater discipline in complying with the limits during the changing market environment. On the other hand, the firms that performed poorly during the crisis had weaker controls over their potential balance sheet growth and liquidity. These firms had also not aligned their treasury functions with risk management processes and did not have complete access to the flow of information across all business lines. They also lacked an understanding of the dynamic contingent liquidity risk of new and existing businesses.
In other cases, the firms based their contingency funding plans on incomplete information because they did not take into consideration the addition of the risk of certain exposures to their balance sheets. The contingent liquidity needs, for instance, of syndicated leveraged loan deals were also not considered. In addition, the firms did not create incentives for their business lines to manage such potential risks prudently (Farlow, 2003).
Incentives are the backbone of every corporation, more so when it comes to executives. Understanding incentives is thus a major step in addressing any organizational puzzle. Nevertheless, there have been doubts about the current practices in corporate governance, included those related to executive pay. The agency theory has long been used to explain compensation in a typical firm. The theory argues that principals (shareholders), whose primary goal is to maximize the firm’s bottom line delegate duties to rational, risk-averse but self-centered agents (managers).
Based on this assertion, several “best practices” were developed such as the independence of the board, separation of chairman and CEO positions, and use of compensation tools that are based on outcomes (Boddy, 2006). However, many of the firms that collapsed as a result of the global financial crisis implemented these best practices. Of these best practices, the outcomes-based compensation package stands out the most.
The majority of the firms that failed following the credit crisis provided executive compensation packages in the form of a variable, performance-based annual incentive in the form of cash and equity awards. A major challenge of stock options and other similar tools is that executives who are awarded stock options benefit when the stock price rises but they do not incur any loss of real wealth when the stock price falls (Baker & Wurgler, 2007).
Use of a range of risk measures
The majority of the firms that did not experience huge losses during the financial crisis made use of a wide range of risk measures to analyze credit and market risk across different business lines. Some firms paid great attention to the interrelationship between market sensitivities of derivative exposures and historical and forward-looking scenario analysis. Such firms used developments and strategies that could be altered to reflect new circumstances, and they understood the weaknesses of individual risk measures. The risk measures used include multiple tools, notional measures, value-at-risk, and basis risk (Geithner, 2008).
Firms that survived the credit crisis used multiple risk tools so as to obtain different perspectives on risk. On the other hand, firms that experienced significant losses depended mainly on a single tool, a limited set of tools, or rigid applications that were difficult to adjust in times of crisis. Such firms used an automatic risk evaluation approach when they made a decision to accept the estimates of the initial risk systems without cheque outs based on the other methods and expert judgment (Geithner, 2008).
As a result of uncertainty surrounding the accuracy of assumptions underlying their risk measures, some firms revisited simple notational limits to emphasize potential risky concentrations (Geithner, 2008). These strategies are not based on suppositions and give the management a simpler perspective on the potential scale of the risks. On the other hand, other firms faced difficulties that arose from their reliance on net measures of risk or measures of risk that depend on certain assumptions about correlation, market liquidity, and other factors that may not be true in a given occurrence. A good number of the enterprises that experienced considerable losses could not count all their exposures. For instance, some firms said that their risk measures assigned zero net risk to negative basis trades (Coudert & Gex, 2006).
In such kind of trade, an investor holds a long position in a corporate bond combined with purchased credit protection on the bond in the form of a credit default swap (CDS). The investor that engages in a negative basis trade earns the spread between the two when the CDS cost is lower than the yield received on the bond. The evaluation of zero risk was based on the assumption that the correlation between bond prices and CDS prices would emulate historical relationships. This assumption failed to take into consideration the fact that the market liquidity risk can cause a breakdown in the historical price relationship when the number of business sales made on that pose to be of significant importance.
VaR(Value-at-risk) strategies were a major pointer for most of the firms that sought to understand their sensitivity to variations in the market conditions. Although many firms reported that their VaR systems generally operated as expected across all business lines, many firms recognized weaknesses in their specific implementation of VaR and mentioned plans to change their VaR methodology (Geithner, 2008).
However, firms argued that VaR, as a backward-looking measure of risk reliant on historical data, cannot fully capture extreme shocks that surpass recent or historical trends. For instance, some firms’ original assessment of the actual potential losses they had to face was skewed downward by their VaR measures’ underlying assumptions and reliance on chronological data from more benign periods. Firms suggested that VaR calculations based on new market data were from about 10 percent to about 200 percent higher compared with VaR calculations conducted using data sets reflecting earlier, and more favorable, market conditions.
The increase in the majority of the firms’ VaR calculations ranged between thirty and eighty percent. Thus, many enterprises resorted to changing the volatility estimates in their VaR methodologies to make them more sensitive to volatility spikes (Bussiere & Fratzscher, 2002). To this end, firms may use shorter horizon price histories or give greater weight to more recent observations and may update the volatility estimates more frequently, for instance, on a daily basis.
Some profit and loss volatility and losses that were not predicted by VaR models were attributed to the basis risk in hedge positions that were not captured in VaR models. As a result, some firms are reconsidering what should be treated as a true hedge for risk management objectives. To illustrate this, certain enterprises may miscount original risk in their managing strategies in the packaging business and CDO warehousing; as a result, such enterprises may face considerable miscount of the risk of the super-senior points they retained (Westphal & Zajac, 2001).
In sum, the recent global financial crisis had many lessons for businesses, and most especially for management. Many business management practices that were considered as “best practices” were put into question. The management practices adopted made the difference between the firms that survived the credit crisis and those that collapsed. The importance of risk management was also highlighted by the crisis. Indeed, firms that survived the crisis attached significant importance to their risk management arms and aligned them with the other arms of their businesses.
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