Whether Global Financial Crisis Was Caused by a Failure of Risk Management - Research Paper Example

EXAMINE THE RECENT CRISIS AT MAJOR UK BANKS SUCH AS NORTHERN ROCK, BRADFORD & BINGLEY, ROYAL BANK OF SCOTLAND AND HALIFAX BANK OF SCOTLAND AND CONSIDER NWHETHER IT WAS CAUSED BY A FAILTURE OF RISK MANAGEMENT AND CONTROL' April,2009 Table of content 1.0Introduction to The Global Financial Crisis 1.1 Causes of the Global Financial Crisis 2.0 The Northern Rock 2.1 Risk Management Strategies at Northern Rock 2.2 Debt Ratio, capital structure and liquidity Ratio of Northern Rock 3.0 The Royal Bank of Scotland 3.1Risk Management Strategies at the Royal Bank of Scotland 3.2 Debt Ratio, Capital Structure and Liquidity Ratio at RBS 4.0Global Financial Crisis at BRADFORD & BINGLEY 4.1Risk Management Strategies at BRADFORD & BINGLEY 4.2 Debt Ratio, Capital Structure and Liquidity Ratio at Bradford & Bingley 5.0Global Financial Crisis at Halifax Bank of Scotland 5.1 Risk Management Strategies at Halifax Bank of Scotland 5.3 Debt Ratio, Capital Structure and Liquidity Ratio at Bradford Bingley 1.0Introduction Major Banks in the United States and Europe have recently suffered significant losses as a result of the recent credit crisis. This calls into question the adequacy of banking regulation both at the national and international scene. (Avgouleas, 2008). For example, Northern Rock, a medium-sized Mortgage provider in the UK almost collapsed as a result of the credit crunch. In like manner, Bear Stearns an upper tier US investment bank was only rescued from the crises by the Federal Reserve Bank. (Avgouleas, 2008). In addition other major investment banks such as Merrill Lynch, Citigroup, UBS, and JPMorgan have all announced negative earnings in their last financial reports as well as plans to lay off a significant number of workers. This paper carries out a comparative review of how the credit crunch affected Northern Rock in the UK and other major United Kingdom based bank. These other banks include, the Royal Bank of Scotland, Halifax Bank of Scotland and Bradford and Bingley. The first part of the paper provides an overview of the current financial crisis stressing on what caused the crisis. The second part looks at the different business models of these institutions, their risk management strategies, control procedures put in place following the crisis. Section 3 looks at the regulatory environment of both banks; the liquidity position, debt to equity ratio and the financial positions of the company. The last section provides conclusion and recommendation. 1.1Overview of the Current Financial Crisis Sub-prime loans are loans offered to borrowers with no prior track record of good credit history. (Shaffer and Hoover, 2007). Due to the risk inherent in the loans, they are often issued at very high interest rates so as to compensate for the extra risk that they carry. (Shaffer and Hoover, 2007). A sub-prime crises or credit crunch is said to exist when a significant number of sub-prime loans have been issued to unscrupulous borrowers. (Shaffer and Hoover, 2007). These crises pose difficulties to both financial institutions and the borrowers. The outbreak of the recent sub-prime crises came after warning signals of write-downs in the value of mortgages late last year. (Schumer and Maloney, 2008). House prices in the U.S witnessed an unusual growth between 1997 and 2005. For example, prices increased by approximately 85% during this period. The period 2001 and 2005 witnessed the highest rates of appreciation. (Schumer and Maloney, 2007). Sub-prime delinquencies and foreclosures were therefore mitigated by house price appreciations during these years. This is so because borrowers facing difficulties to make regular mortgage payments could depend on the appreciation of the value of their property to solve their financial problems by refinancing the mortgage and withdrawing cash from the increased equity in the house thereby sustaining the new mortgage for a while. However, house prices began to decline in 2006, and as at October 2007, prices were down by approximately 3.2% of their peak in the second quarter of 2006. Banks and financial institutions were expected to face an uphill earnings battle early this year. (Ellis, 2007). "'certainly, we will not be at the levels of profits we saw within the last 12 months". This is a quote by Mark Batty, a financial services analyst at PNC wealth Management Philadephia, which manages about $77billion of assets. (Ellis, 2007). Earnings estimates for these banks according to Wall Street are expected to rise. Goldman Sachs witnessed encouraging results because it nicely positioned itself during the sub-prime crises this summer of 2007. (Ellis, 2007). Banks However, Merrill Lynch witnessed a $3.4billion loss in mortgages. (Ellis, 2007). Banks have so far written down more than $20billion in losses arising from the sub-prime crises or credit crunch. A financial crisis is said to exist when a group of financial indicators start deteriorating. These include indicators like short-term interest rates, asset prices such as stock prices, property prices, as well as bond prices. (Calhoun, 2002). A financial crisis is often accompanied by failures of financial institutions. Financial crises have now become a long subject of interest in economics and finance and a lot of research is now being done to see how they can be better understood and resolved. (Calhoun, 2002). 2.0 The Northern Rock Northern Rock (NR) a UK based mortgage bank specializes mainly in the making of home loans (Mullineaux 2007). It employs an "originate and distribute" model in its mortgage business (Mullineaux 2007). According to Hall (2000), the run on NR, which represents the first bank run in the United Kingdom over the last 140 years, is by far the most transparent and worrying spill over effect from the U.S sub-prime crisis to authorities in the U.K. NR being the highest mortgage lender in the UK concentrated on originating and securitising mortgage loans. These mortgage-backed securities (MBS) were later sold to other financial institutions and individuals. NR therefore transferred a substantial portion of the risks of default to other financial institutions prior to the maturity of these loans (Chambers 2008). In addition, NR was capable of boosting its liquidity from this trading strategy. Chambers (2008) describes the situation as a "round-about that went round and round, but not for ever". Following the U.S sub-prime mortgage crisis, the appetite of the global financial markets for securitised bonds collapsed almost overnight1. This was due to the fact that prospective buyers now perceived these bonds as having higher risks of default. Consequently ambassadors of this philosophy ran into liquidity. 2.1 Risk Management Strategies at Northern Rock The Northern Rock like the three other UK based banks in this study faces two main types of risk, systematic risk and unsystematic risk. Systematic risk, otherwise referred to as market risk on the one hand is the risk that a firm faces as a result of movements in the market such as movements in the value of a stock index (e.g., the FTSE100 index); fluctuations in interest rates, fluctuations in currency exchange rates, as well as changes in inflation rates. Market risk is considered to be un-diversifiable and therefore investors expect a risk premium to compensate them for taking on such risk. (Bodie et al., 2002; Ross et al., 1999). Unsystematic risk otherwise known as firm specific risk or operating risk is risk that can be diversified away and therefore investors should not be compensated for taking on such risk. (Bodie et al., 2002; Ross et al., 1999). Operating risk has been defined by the Basel Committee as "the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events". (Neu and K'hn, 2003; Editorial, 2003; Rosenberg and Schuermann, 2006; Valle and Gudici, 2008). According to Neu and K'hn (2003) potential OR characteristics include among others: human resource processing errors. At NR, exposures to foreign currency risk are classified under three types, transaction, translational and economic exposures. While it is possible to eliminate transaction and translation exposure through the use of hedging instruments such as forwards, futures, options as well as other hedging strategies such as exposure netting it is not possible to hedge against economic exposure. (Shapiro, 2003; Faff and Irio, 2001; Solt and Wayne, 2001). At Northern Rock, a special Committee has been created and charged with the responsibility of risk management. According to the Company's webpage, the Risk Management Committee of NR shall assist the Board to foster a culture within the Group that emphasises and demonstrates the benefits of a risk-based approach to internal control and management of the Group. The Committee is also charged to reinforce Management's control consciousness and make appropriate recommendations to the Board on all significant matters relating to the Company's risk strategy and policies. They put in place both preventive and detective control procedures. Through the use of modern lending and continuous review they minimize risk. To mitigate, conflict of interest between owners and managers-that is the principal agent problem, several committees have been created to look into different matters of the bank. These include the remuneration committee, the nomination committee, the audit committee and the risk committee all answerable to the board of directors. Part of employees and executive compensation is performance related. The company is making use of hedging, futures and swap strategies. Currency futures contracts are contracts for specified quantities of a given currency, in which the exchange rate is fixed at the date of the contract. (Shapiro, 2003). For contracts traded on the International Monetary Market (IMM), the delivery date of the contract is determined by the board of directors of the IMM. Like forwards and options, Futures contracts can be used to eliminate currency risk as well. (Shapiro, 2003) NR currently has contracts in Euros and US$. At NR, emphasis on risk management and control is on preventive measures. 2.2 Debt Ratio, capital structure and liquidity Ratio of Northern Rock From above, it can be observed that the company uses more debt than equity in financing its activities. This is evidenced by the debt-t-equity ratio of 48:1. There are therefore a greater effects of financial risk. That is, the risk that the firm might not meet its long-term debt obligations. In such a scenario, management could easily diversify funds for empire building, and act out of the shareholders value creation concept. 2.2.1Liquidity Ratio of Northern Rock Ratio Formula Current Ratio Quick Ratio Cash Ratio Ratios 2008 2007 2006 2005 Current Ratio 0.7:1 0.5:1 1.3:1 0.9:1 Quick Ratio 0.5:1 0.5:1 0.8:1 0.8:1 Cash Ratio 0.5:1 0.5:1 0.8:1 0.7:1 The liquidity position of Northern Rock for the past four years shows that the company was in a great liquidity problem in 2007. However, following the recent bail out in the bank the institution start picking up again in 2008. For example in 2005, the current ratio was 0.9:1 it fell to 0.5:1 in 2007 and by 2008, it started improving again. 2.1.2Profitability Position of Northern Rock Ratio Formula Profit margin Return on Capital Employed Return on Equity Return on Investment Ratios 2008 2007 2006 2005 Profit Margin -12% -17% 7% 18% ROCE -8.4% -10.6% 5% 11% ROE -8.4% -10.6% 3.2% 6.7% ROI -4.4% -7.3% 2.2% 5.8% From the above calculations, it is evident that the credit crunch has affected major banks in the United Kingdom profoundly. While in the year 2005 the profitability position of Northern Rock was positive, the years into and following the financial crisis pushed the institution into a negative position. 3.0The BRADFORD & BINGLEY According to the Company (2008) report, Bradford & Bingley plc is a British bank with headquarters in the West Yorkshire town of Bingley. Partly due to the credit crunch in 2008, partly due to the credit crunch, the bank was split into two parts; the mortgage book which was nationalized, and the deposits and branch network which was sold to Abbey, owned by the Spanish bank Grupo Santander (Company Report 2008). The bank was formed in December 2000 by demutalisation of the Bradford & Bingley Building Society following a vote of the building society's members, who swapped their nominal share of the building society for at least 250 shares of the newly formed bank (Report 2008). The company launched a '400 million right issue in the middle of 2008 following the effect of the financial crisis. This was not well subscribed by customers. The credit crunch further push it shares prices to a record low and by September it was announced three hundred and fifty jobs were to go. 3.1Risk Management Strategies at BRADFORD & BINGLEY The United Kingdom banks Bradford & Binley manage its currency exposures arising from credit through hedging. By so doing it takes a position such as acquiring a cash flow or an asset or a contract that will rise or fall in value and offset the fall or rise in value of an existing position. (Moffet et al, 1995). Shapiro (2003, pp 329) states that hedging a particular currency refers to establishing an offsetting position so that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge. Banks can further use currency futures, currency swaps, currency forwards and currency options to hedge its expected future exposure to exchange rates. Translation and transaction exposure can be managed using the following hedging strategies: 3.1.1Forward market Hedge If a bank or credit company is expecting to receive a future stream of cash flows in a foreign-currency, she can sell the stream of cash flows in a forward market to lock in a minimum value of the cash flows in terms of the home currency. No matter what happens, with the exchange rate, the company will still receive its guaranteed amount of home currency cash flows. (Shapiro, 2003). The only expenditure that will be incurred will be the price paid for establishing the hedge position. On the other hand if the company has foreign-currency-denominated liabilities, it can minimize the risk by buying a forward contract to hedge against an appreciation of the foreign currency. (Shapiro, 2003).Therefore a company that is long in a foreign currency will sell the foreign currency forward while a company that is short in a foreign currency will buy the currency forward. (Shapiro, 2003). At Bradford and Binley, credit risk is manage through credit rating and credit scoring modern techniques. According to the (2008) Company's Report, the Board is responsible for determining risk strategy, setting the Group's risk appetite and ensuring that risk is monitored and controlled effectively. It is also responsible for establishing a clearly defined risk management structure with distinct roles and responsibilities. Within that structure, line Managers are responsible for the identification, measurement and management of the risks within their areas of responsibility (Report 2008). Risk in this bank is minimized through different committees put in place, the Audit committee, the executive committee, Asset, Liability Management Committee, Credit risk committee, internal audit etc. 3.2 Debt Ratio, Capital Structure and Liquidity Ratio at Bradford & Bingley From the above table, as typical of most banks it can be observed that the company uses more debt than equity in financing its activities. This is evidenced by the debt-t-equity ratio of 47:1. There are therefore a greater effects of financial risk. That is, the risk that the firm might not meet its long-term debt obligations. In such a scenario, management could easily diversify funds for empire building, and act out of the shareholders value creation concept. Debt/equity ratio is equal to long-term debt divided by common shareholders' equity. It measures the degree of a company's leverage. 3.2.1 Liquidity Position of Bradford and Bingley Ratios 2008 2007 2006 2005 Current Ratio 0.8:1 2:1 1.78:1 1.2:1 Quick Ratio 0.6:1 0.9:1 1:1 1:1 Cash Ratio 0.4:1 0.4:1 0.8:1 0.7:1 The liquidity position of Bradford and Bingley like the other three institutions has been affected by the crisis. For example,, the current ratio and acid test ratio fell from 1.2 :1 and 1:1 in the year 2005 to 0.8:1 and 0.6:1 in 2008. The same arguments hold true for the other ratios. This is enough evidence to show that, the institution needed a bail out. 3.2.2 Profitability Ratio of Bradford and Bingley Ratios 2008 2007 2006 2005 Profit Margin -11% -11% 6% 12% ROCE -8.7% -8.6% 5.5% 8% ROE -11.4% -5.6% 4.2% 4.7% ROI -14.4% -9.3% 3.2% 4.8% From the above calculation, Bradford Bingley has not been left un affected by the global financial crisis. 4.0 The Royal Bank of Scotland The Royal Bank of Scotland Group plc is the holding company of one of the world's largest banking and financial services groups, with a market capitalisation of '44.4 billion at the end of 2007. Headquartered in Edinburgh, the Group operates in the UK, US and internationally through its two principal subsidiaries, the Royal Bank and NatWest. Both the Royal Bank and NatWest are major UK clearing banks whose origins go back over 275 years. In the US, the Group's subsidiary Citizens is ranked the ninth largest commercial banking organisation by deposits. The Group has a large and diversified customer base and provides a wide range of products and services to personal, commercial and large corporate and institutional customers. The company is committed to high standards of corporate governance, business integrity and professionalism in all its activities. Throughout the year ended 31 December 2007, the company has complied with all of the provisions of the revised Combined Code issued by the Financial Reporting Council in June 2006 (the "code") except in relation to the authority reserved to the Board to make the final determination of the remuneration of the executive directors, which is explained in the paragraph headed 'Remuneration Committee'. Under the US Sarbanes-Oxley Act of 2002 (the "Act"), specify standards of corporate governance and business and financial disclosures apply to companies with all applicable sections of the Act. According to BIS paper No.33, financial markets are subject to various sources of risk: credit, market, liquidity, operational and legal risks. At the Royal Bank of Scotland, risk management is at the centre of every action management does. 4.1Risk Management Strategies at the Royal Bank of Scotland The risk that a debt issuer will default is known as credit risk; this is typically the most important form of risk for commercial banks Shapiro, 2003; Buckley, 1996; Muller and Verschoor, 2005; Solt and Wayne, 2001).Solt & Wayne (2001) argues that, in assessing credit risk, an institution needs to consider three issues: default probabilities over the horizon of the obligation, credit exposure (ie how large the obligation is when the default occurs) and the recovery rate (ie what part of the exposure may be recovered through bankruptcy proceedings or some other form of settlement) (Solt and Wayne, 2001). At the Royal Bank of Scotland, in managing credit risk emphasis is on these three variables. The Royal Bank of Scotland also makes use of detective and preventive risk management methods. The activities of the bank are structured in a way to avoid conflict of interest between owners and managers. For example, at RBS Currency risk or foreign exchange exposure or better still foreign exchange risk refers to the risk that a company's cash flows, transactions and future business operations may be affected by changes in exchange rates. (Shapiro, 2003; Buckley, 1996; Muller and Verschoor, 2005; Solt and Wayne, 2001). RBS foreign-currency-denominated assets and liabilities as well as expected foreign-currency-denominated future cash flow streams are therefore clearly exposed to exchange rate risk. (Buckley, 1996; Shapiro, 2003). Buckley (1996) also notes that home-currency-denominated expected future cash flows may also be exposed to foreign exchange risk. For example, RBS accepting deposit and offering credit in foreign countries through subsidiaries or international lending, as such its expected future cash flows will be affected by exchange rate movements between the home and the foreign currency. (Buckley,1996). To manage this risk, the company makes use of futures, SWAPs and hedging strategies. Risk management control and review is an ongoing process, a special department is charged with the responsibilities of risk minimization. International and domestic requirements and principles are strictly followed coupled with the respect of government and central bank regulation. 4.2 Debt Ratio, Capital Structure and Liquidity Ratio at RBS From above, it can be observed that the company uses more debt than equity in financing its activities. This is evidenced by the debt-t-equity ratio of 40:1. There are therefore a greater effects of financial risk. That is, the risk that the firm might not meet its long-term debt obligations. In such a scenario, management could easily diversify funds for empire building, and act out of the shareholders value creation concept. 4.2.1 Liquidity Position of RBS Ratios 2008 2007 2006 2005 Current Ratio 0.5:1 1:1 1.58:1 1.1:1 Quick Ratio 0.:0 0.9:1 1:1 1:1 Cash Ratio 0.2:1 0.1:1 0.5:1 0.4:1 The liquidity position of Bradford and Bingley like the other three institutions has been affected by the crisis. For example,, the current ratio and acid test ratio fell from 1.1 :1 and 1:1 in the year 2005 to 0.5:1 and 0.:0 in 2008. The same arguments hold true for the other ratios. This is enough evidence to show that, the institution needed a bail out. 4.2.2 Profitability Ratio of Bradford and Bingley Ratios 2008 2007 2006 2005 Profit Margin 8.8% 11% 16% 18% ROCE 4.7% 7.6% 9.5% 11% ROE 3.4% 4.6% 7.2% 4.7% ROI -1.4% 7.3% 8.2% 4.8% From the above calculation, RBS has not been left un affected by the global financial crisis. 5.0 Halifax Bank of Scotland According to the company's report, Halifax Bank of Scotland is a banking and insurance group operating as a wholly own subsidiary of the Lloyds Banking group taken over in January 2009. Because of the huge amount of losses partly due to the global financial crisis made a pre-tax loss of '10.8bn in 2008. Andy Hornby, the former chief executive of HBOS and Lord Stevenson of Coddenham, its former chairman, have already come before the Commons treasury committee to answer for the near-collape of the bank (Company Report 2008). 5.1 Risk Management Strategies at Halifax Bank of Scotland The risk management department of Halifax bank of Scotland is divided into various committees with the board of directors at the hem of risk management. Risk management is carried out at the institution with emphasis on preventive measures. The risk management committee and the internal audits are charged with the designed of internal control procedures. For foreign exchange exposures, the company uses swaps and other investment rating modern system to counter risks. A currency swap contract is a contract between two counter-parties (Parties to the contract) where one counter-party exchanges a stream of cash flows (debt-service obligations) in one currency for a stream of cash flows in another currency. By so doing both counter-parties can achieve their desired currencies. (Shapiro, 2003). By entering a currency swap contract, the company can also manage its currency exposure. The Board is the principal decision-making forum for the company. It has overall responsibility for leading and controlling the company and is accountable to shareholders for financial and operational performance. The Board approves Group strategy and monitors performance. The Board approves Group strategy and monitors performance. The Board has adopted a formal schedule of matters detailing key aspects of the company's affairs reserved to it for its decision. This schedule is reviewed annually. The roles of the Chairman and Group Chief Executive are distinct and separate, with a clear division of responsibilities. The Chairman leads the Board and ensures the effective engagement and contribution of all non-executive and executive directors. The Group Chief Executive has responsibility for all Group businesses and acts in accordance with the authority delegated by the Board. Responsibility for the development of policy and strategy 5.3 Debt Ratio, Capital Structure and Liquidity Ratio at Bradford Bingley a) Long-Term Solvency Ratios From above, it can be observed that the company uses more debt than equity in financing its activities. This is evidenced by the debt-t-equity ratio of 61:1. There are therefore a greater effects of financial risk. That is, the risk that the firm might not meet its long-term debt obligations. In such a scenario, management could easily diversify funds for empire building, and act out of the shareholders value creation concept. 3.2.1 Liquidity Position of Halifax Bank of Scotland Ratios 2008 2007 2006 2005 Current Ratio 0.9:1 1:1 1.2:1 1.2:1 Quick Ratio 0.7:1 0.9:1 1:1 1:1 Cash Ratio 0.7:1 0.7:1 0.9:1 0.9:1 The liquidity position of Halifax Bank of Scotland like the other three institutions has been affected by the crisis. For example,, the current ratio and acid test ratio fell from 1.2 :1 and 1:1 in the year 2005 to 0.9:1 and 0.7:1 in 2008. The same arguments hold true for the other ratios. This is enough evidence to show that, the institution needed a bail out. 3.2.2 Profitability Ratio of Halifax Bank of Scotland Ratios 2008 2007 2006 2005 Profit Margin 8% 11% 16% 12% ROCE 8.7% 4.6% 4.5% 8% ROE 6.4% 5.6% 4.2% 4.7% ROI 5.4% 9.3% 3.2% 4.8% From the above calculation, RBS has not been left un affected by the global financial crisis. References Buckley A. (1996). 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