Unsystematic risk can be controlled by the organization like management problems, industrial relations, business or financial or default risk. Banking organizations also have to face these risks. These risks must be managed well in order to grow and sustain in the market. If these risks are not managed properly then banks can collapse like Lehman Brothers collapsed in the year 2008.
Lehman Brothers was one of the largest investment banks in USA. It was established in 1850. During the initial years it operated in the field of cotton trading. Later, it started the business of investment banking. It faced many financial crisis during its long tenure like the great depression in 1930’s but it collapsed and became bankrupt during the financial crisis which occurred due to subprime crisis. The collapse of the Lehman Brothers is the biggest example of inefficient handling of the financial risk.
Financial risk can be defined as the risk which arises due to the use of debt in the capital structure of the organization. This risk happens due to increase of financial leverage. If the company uses debt in the capital structure then it is bound to make fixed payments to the creditors. Compulsory payment of fixed charges in turn lowers the earning per share (Kevin, 2006, p.58). The EPS of a company varies due to the financial risk. ...
Lehman Brothers were in the business of investment banking were correct trade-off between risk and return is very important. The investment bank has to decide on the amount of risk it can undertake and whether the return associated with the risk is justified. During 2002 and 2003 the real estate industry was booming in USA. Every investment bank was involved in subprime mortgage loans which were considered profitable during that time. Previously the Lehman Brothers use to purchase assets to sell them in the market but to gain to follow the other investment banks Lehman Brothers abandoned their previous strategy and stared using them for their operation to gain more profit. The main investments of Lehman Brothers were in real estate, equity and loans. The main problem of Lehman Brothers was that they made many investments which were not liquid. The capital structure of the Lehman Brothers consists of more debt than equity. To finance new investment they used more borrowed funds. As the investments made by them were not liquid they were unable to sell them to generate cash for making the compulsory payments which exposed them to the liquidity risk. In order to make more profits Lehman Brothers got involved in the subprime loan that is giving financially risky loans without proper security. This in turn exposed them to the default risk. It conducted various stress tests to analyze the risk but excluded the additional non liquid assets therefore accurate results were not found. Its aggressive risk taking decisions also affected its reputation (Field, 2010). Once the subprime crisis occurred and the real estate bubble burst Lehman Brothers suffered huge losses. It faced liquidity problems as most of the investments were non liquid. The level of default rose to