Operational Risk Management of Lehman Brothers Company - Essay Example

? Risk Management Table of Contents Introduction 4 Identification of Risk and Analysis of Threats 5 Market, Counterparty and Credit Risk 5 Foreign Exchange Risk 6 Country Risk 6 Liquidity Risk 6 Operational Risk 7 Risk Management Framework 7 COSO Framework 8 COCO Framework 9 Risk Severity Matrix 10 Risk Management Methods of Lehman Brothers 11 Managing Market and Credit Risk 11 Managing Counterparty Risk 11 Efficient Collateral Management 11 Liquidity and Risk Modelling 12 Asset Verification 12 Sarbanes-Oxley Act of 2002 12 Restoring Faith in the Corporate Reporting Supply Chain 13 Impact of the Act on Lehman Brothers 13 Combined Code 14 Conclusion 15 Appendices 16 Reference 19 Introduction Lehman Brothers Company began in 1850 through predecessor entities. From establishing the New York Cotton Exchange, it became the fourth largest investment bank in 1868 with a network of offices in Europe, North America, the Middle East, Latin America and the Asia Pacific region. But due to the worldwide credit crunch of 2007-08, the Lehman Brothers has resulted in a tremendous downfall. On September15, 2008, it filed for Chapter 11 bankruptcy, condemned to become the biggest bankruptcy filing in U.S. history and caused a downfall of the world’s financial system (Lounsbury and Hirsch, 2010, p.71). The federal government decided to not bail the company. The firm’s share fall more than 90% and shook financial stocks. The bankruptcy was mainly due to the sub-prime mortgage crisis. However, there were other factors also that were responsible for the failure of the company such as: the overall culture of the company, the tools they utilized and the risk management department. Lehman Brothers overleveraged themselves while not preserving the minimum capital required, depending on risk tools in isolation (Alman, Cudmore, and McVeigh, 2013, p.1). The company has obtained huge amounts of subprime mortgage debt and also the lower rated assets. In 2007, despite the fact that the Lehman Brothers had closed its subprime mortgage division, it had uphold much of its subprime mortgage liability, therefore resulting in huge losses from the collapse of the subprime market. Its bankruptcy caused the investors to lose millions (Ferrell, Fraedrich and Ferrell, 2011, p.403). Lehman Brothers are exposed to various types of risk such as market and credit risk, counterparty risk, liquidity risk, country risk, operational risk and foreign exchange risk. This report will focus how they are exposed to these various types of risks, what are the threats of these risks and how they will manage these risks. Identification of Risk and Analysis of Threats Risk is the change or probability of a deviation from an anticipated outcome. In order for risk to be present there should be exposure and uncertainty. Risk is measured with the use of risk measurement framework and process (Hays and et al, 2005, p.3). It arises due to various causes such as macroeconomic or external shocks, for example foreign exchange crisis or liberalization-induced credit booms (Bank and Fund, 2005, p.213). Market, Counterparty and Credit Risk The Lehman Brothers was exposed to market counterparty and credit risk through the sudden collapse of its total return swap counterparty. The firm’s share also fall more than ninety percent due to market risk and shook financial stocks. It has been exposed to credit risk which has arisen from derivatives transactions and it has been revealed with the bankruptcy of this firm and has resulted in the credit default swap market. Loss due to credit risk has resulted in decline in the creditworthiness of borrower. During bankruptcy, the total notional value of credit default swap (CDS) trades indicating Lehman Brothers was around USD 72 billion. This has caused bilateral payments of USD 21 million among buyers and sellers of credit default swaps that allusion Lehman Brothers based on auction determined payments. Due to the firm’s bankruptcy, this was the credit loss for the sellers of the CDSs. For the buyers, this amount signifies their mixed credit exposure on the credit default swap protection sellers i.e. the amount they loss if the CDSs contracts sellers that reference Lehman Brothers would not accomplish their requirement to pay under the contracts. The default of Lehman signifies that many corporate and financial institutions who had hedged their exposure with this firm had an open risk position and had to swap their hedges. For a number of dealers, these replacement costs have caused significant losses (Klaassen and Eeghen, 2009, p.86). Foreign Exchange Risk This firm is a client driven investment firm. Lehman Brothers carry out a foreign exchange trade in order to satisfy a client, to assist customer trading. Foreign exchange (FX) trading includes various country currencies being traded, thereby facilitating international transactions to take place. The firm was counterparty in various types of derivatives trades in the interest rate, equity and FX markets. Many risks are involved in foreign exchange trading. The risk that occurs during the trading of FX is settlement risk. It takes place because of the time drop between when exchange transactions are made i.e. money flows but does not come in (Hays and et al, 2005, p.6). Country Risk Country risk is the business loss which takes place due to the troubles arising in a specific country. These troubles usually arise from economic and political unsteadiness which cause the countries to fail to pay on prior investment deals. Lehman Brothers is also exposed to country risk and was looking to develop their process for producing country risk reports in order to ensure that they are collecting correct information to scrutinize their own country risk levels (Hays and et al, 2005, p.7). Liquidity Risk Liquidity risk arises due to disparity between long term use of funds and short term sources of funds. When supply of short term funds or interest rates alters dramatically then they are not able to keep financing long term projects such as investment finance for Lehman Brothers. Its real estate investments were top notch. Liquidity risk from loan commitments took place when the commercial paper market froze due to the failure of Lehman Brothers (Cornett and et al, 2011, p.298). When it collapsed, it had 60 billion dollar in toxic bad debts and assets of 639 billion dollar in opposition to the bad debts of 613 billion dollar, which makes the Lehman Brothers the largest investment bank to collapse (Pichardo and Bacon, 2009, p.43). A New York clearing bank enquired the firm to supply more collateral in order to protect any daylight open position which have the possibility to arise. Credit rating agencies also pressurized to downgrade the company until some sound plan was declared that would restore capital and soothe funding. But Lehman had no such plans. The government also announced that no public money would flow to Lehman. This led to bankruptcy (Ryback, n.d, p.3). Operational Risk Operational risk is a risk which arises from the loss resulting from inappropriate or failed internal processes, systems or people or from external events. Lehman Brothers are exposed to operational risk due to failure of the overall culture of the company, the tools they utilized and also due to the inadequate risk management departments. There was weak supervision which leads the company to expose to operational risk. Risk Management Framework Exposures to broad market risk such as interest rate risk, stock market risk or foreign exchange risk generally can be hedged with derivatives such as swaps, forwards, futures and options. Hedging away these risk coverage minimizes asset risk. Therefore, hedging market exposure minimizes the required amount of risk capital. By hypothesizing on the direction of the market, and thus preserving a market exposure, requires more risk capital. By purchasing put options in order to cover against these market risks, Lehman Brothers can maintain its needed exposure with the minimum amount of risk capital (Chew, 2008, p.152). COSO Framework COSO framework is an operational risk management framework. It is an internal control – integrated framework which describes internal control as a process that is influenced by people to give sensible assurance regarding the accomplishment of objectives in the following groups: effectiveness and competence of operations, conformity with applicable regulations and reliability of financial reporting (Ller and Moller, 2010, p.11). It provides complete guidance on internal control which is based on five components i.e. control environment, risk assessment, control activities, information and communication and monitoring (see Appendix A). Lehman Brothers could apply the COSO framework in order to carry out the control activities, set up mechanism to identify and manage risk and also to confine and exchange the information which is needed to manage and control their operations. Control Environment: Control environment provides the basis on which people carry out their activities and their control activities. It involves the honesty and moral values of the firm. Risk Assessment: Lehman Brothers should be aware of the operational risk which it was facing. They must set business objectives, incorporated with the production and marketing; sales; and financial and other activities so that they could operate with stability across different business units. They should ascertain mechanisms in order to recognize; analyse and manage risks. Control Activities: Lehman Brothers should establish procedures and control policies and it must be executed in order to ensure that the actions which are identified by the firm which is necessary to deal with the risk towards the achievement of their objectives are successfully carried out. Information and Communication: Information and communication system could provide assistance to the company in order to capture and replace the information which is needed to perform, manage and control its operations. Monitoring: The whole process must be monitored and modifications should be made where it is necessary. In such a way, the system can respond enthusiastically, changing as conditions deserve. These five components also support the three objectives i.e. financial reporting, compliance and operations (Borodovsky and Lore, 2000, p.389). COCO Framework The Canadian Institue of Chartered Accountants had issued a framework which is known as Criteria on Control (COCO). The COCO framework is based on COSO but it takes into consideration slightely broader approach. It adds internal elements and describes the three objective types of internal control which are as follows: usefulness and effectiveness of operations; reliability of external and internal reporting; and conformity with internal policies, applicable laws and regulations. The four main components of COSO framework is purpose, capability, commitment and monitoring and learning (Moeller, 2005, p.723) (see Appendix B). By applying COCO framework, Lehman Brothers could make decisions base on the firm’s designing, assessing and reporting on control. They could also address human resource policies and deal with tools, coordination and control activities. This framework could help Lehman Brothers in reviewing external and internal environments and establishing follow-up procedures. The four components are as follows: Purpose crieteria: It present a sense of the firm’s direction. It will help the firm to address objectives, planning, policies, risks and opportunities, performance targets and indicators. Commitment crieteria: It provides a sense of the firm’s identity and enable the firm to address moral values, authority, human resource policies, accountability, responsibility and mutual trust. Capability criteria: It present a sense of the firm’s competence. By applying this criteria, Lehman Brothers could deal with knowledge, tools for managing risk, information, communication processes and coordination and control activities. Monitoring and learning criteria: It present a sense of firm’s evolution. By applying this criteria, Lehman Brothers could engage in reviewing the external and internal environments, challenging assumptions, monitoring performance against targets, assessing the effectiveness of control and estabilishing follow-up procedures (Pfister, 2009, pp.51-52). Risk Severity Matrix The matrix is structured around the likelihood and impact of the risk event. Lehman Brothers can make use of this matrix in order to classify the severity of different risks. The matrix is divided into green, yellow and red zones symbolizing minor, moderate and major risks respectively. The red zone is on the top right corner of the matrix which indicates high impact/high likelihood. The green zone is on the bottom left corner which indicates low impact/low likelihood and the moderate risk i.e. yellow zone expands down the middle of the matrix. Lehman Brothers could use this matrix for prioritizing which risks to address. Red zone risks obtain main concern followed by yellow zone risks. Green zone risks are regarded as unimportant and ignored unless their status changes (Larson, 2006, pp.212-213) (see Appendix C). Risk Management Methods of Lehman Brothers Managing Market and Credit Risk In order to manage market and credit risk, the methods which should be adopted by Lehman Brothers include re-tooling and implementing strong models to measure these risks. Models and tools should be connected with well designed governance practices to ascertain risk appetite, and to monitor and report risk. To ensure prompt response to dwindling credit and market condition, risk should be distributed by business division. Connecting management of risk of business unit with the enterprise wide governance structure should develop the ability of the firm to react efficiently to changing market condition. Managing Counterparty Risk Prime brokers should arrange for heightened attention of client to safety as well as internal controls. The risk management policy should recommend counterparty credit exposure limits, if exposure surpasses prescribed limits. Firm should assess their prime brokerage relationship and resolve whether additional diversification of such relationships among various firms is cautious. Efficient Collateral Management Dealer firm should ascertain that functions of collateral management are structured properly in light of the volume and complexity of transaction activity. Buy side firms should ascertain that they have perceptibility into all assets and positions to estimate risk exposure data across all counterparties. Liquidity and Risk Modelling Firm should execute liquidity stress testing in order to determine the maximum liquidity outflow of the firm on a continuous basis. They should also involve in transactions that are sound and transparent and should also understand the impact of leverage. Asset Verification Firm should perform reconciliation on a regular basis and should also conduct accurate follow-up procedures in order to resolve identified inconsistencies. Timely reconciliations will enable to ensure consistency with contractual terms. Some hedge funds are working with service providers in order to ascertain ways to separate assets or to circumvent the transfer of title to assets which are held as collateral under lending arrangements. Sarbanes-Oxley Act of 2002 The corporate scandals have eroded trust of investor in corporate reporting which is a main factor which contributes towards the slowdown of the performance in capital market of United States that began even before the many countries started to loosen. Responding towards the situation the Congress of United States passed the Sarbanes-Oxley Act of 2002, in order to reduce the corporate malfeasance and also to protect investors. It is seen as a foundation for rebuilding investor confidence. Corporate stakeholders of today expect more i.e. more oversight, greater assurance and clear evidence of internal controls. The investing communities’ confidence will only be returned once the gap between the expectations of investors in terms of corporate governance and what they have actually received in the past has been closed. Sarbanes-Oxley provides thrust for closing the expectation gap by expanding and altering the responsibilities of the key participants in the process of corporate reporting. It focuses on advancing the reliability and accuracy of corporate reporting. In fact, if properly embraced by management, independent accountants and audit committees, it is expected to be a catalyst for more transparent and stronger corporate reporting (Coopers, 2003, p.2). Restoring Faith in the Corporate Reporting Supply Chain The corporate reporting supply chain consists of everyone who produces corporate reporting and analysis (see Appendix D). Investors have lost faith in the reliability of the information that go by the corporate reporting supply chain. Corporate management, internal and external auditors and other professionals have a duty to rebuild the trust of investor by performing their own roles; by keeping in mind both expectations of investors and legal obligations. Sarbanes-Oxley authorized definite actions in order to improve corporate reporting by ascertaining parameters for the key participants in the chain to interrelate in order to provide investors the information on which they can consistently base their investment decisions (Coopers, 2003, p.3). Impact of the Act on Lehman Brothers Management of Lehman Brothers violated the Sarbanes-Oxley Act. They were not representing true figures of its financial standing to the adjustment of billions of dollars by the use of off-balance sheet transactions which includes the instrument Repo 105 (see Appendix E). Instead of describing the figures as loans, they were describes as sales on their financial statements, by no means mentioned that these securities should be returned to the lender. This was illegality of Repo because it has not presented the true figures as mentioned in Sarbanes-Oxley Act and therefore lack transparency for the purpose of making the investment bank look financially healthy (Stigliano, 2011, pp.9-10). It resulted in collapse of the firm and also resulted in largest bankruptcy with 613 billion dollar in debt against 639 billion dollar in total assets. Sarbanes-Oxley Act requires disclosing all off-balance sheet items but Lehman Brothers have violated the rule and the consequence is greatest failure (Stanton, 2012, p.29). Combined Code UK Combined Code is a set of principles which support the honesty, integrity and moral values of the society. Combined Code is now known as UK Corporate Governance Code which set out standards in relation to board leadership and efficiency, accountability, remuneration and relations with shareholders. It requires the Board to attain the objectives of the company and should have efficient control system to ensure the evaluation of risk and management. Segregation of duties is allowed to circumvent any fraud or mismanagement in company. Non-executive directors are liable for management scrutiny in order to avoid any mismanagement or financial mishap. The code also requires disclosures of all the information that are important for shareholders and stakeholders. So, it is clear that the Code contains broad principles and more explicit provisions (Frc, 2012, p.1). The effect of the least regulatory influence of the state over financial market was strengthened by government’s role in encouraging London as a leading financial centre and in promoting financial institutions and foreign banks to base themselves in the city because of the minimum level of legal intervention. As a result, London attracted many riskier financial operations of foreign firm such as Lehman Brothers (Sun, Stewart and Pollard, 2011, p.51). Despite the fact that the Lehman Brothers violated the law and adopted the unfair means in order to show their financial position healthy, then also they received the triple-A rating even minutes before their collapse. The consequence was that investors were overexposed to the undulate effects of the highly leveraged financial instruments (Horn, 2011, chap.7). So, it is concluded that corporate governance regulation is essential but not ample cause of efficient board conduct as it is eventually people who create and run the organization (Clarke and Branson, 2012, p.277). UK Combined Code is continuously updating after witnessing many scandals. The latest revised version was issued in October 2012 (Bsa, 2012, p.1). Conclusion This report focuses on the collapse of the Lehman Brothers Company. It takes into consideration the threats of the various types of risks associated with the company and how Lehman Brothers should manage the different types of risks. Further, it also explains the corporate governance regulations and the impact of the regulations on the company. Many lessons have been learned from the credit crunch impacts and one of them is the requirement to understand the products with which the company is dealing (Tan, 2010, chap.15). Further lessons which have been learned were that the beginning and the focus on the documentation and re-examining of backward oriented controls are not enough. Financial institutions must establish risk management procedures in such a way that risk management for duties and taxes must be future oriented. They should show correct transactions in their financial statements. At the movement a risk is recognized, it must be examined and documented what was done to reduce or to delete the risk (Bakker and Kloosterhof, 2010, p.261). 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