A Discussion on Risk Decision Making

Executive Summary:

Businesses facing decisions about risk every day. From equipment purchases to new hires to acquisitions and closures, each business decisions are relevant with risk. The key aspect of making the right business decisions comes from determining the balance between risk and reward. Companies that expose themselves to high risks with minimal rewards can gamble themselves right out of business. At the other hand, if companies play too safe can miss out on growth opportunities, they would to survive and thrive in a competitive marketplace. During the global financial turmoil of 2007 and 2008, no major derivative clearing house in the world encountered distress while many international enterprise companies were pushed to the brink (Jayanth Rama Varma, 2009). An important reason for this is that derivative exchanges have avoided using value at risk, normal distributions and linear correlations. The global financial crisis has also taught us that in risk management is more important than sophistication and that it is dangerous to use models that are over stress to short time series of global economy. The governance and regulatory strategies also help to monitoring the global economy and keep it balance to avoiding from the crisis. However, the implementation of these regulations and feedback are also the challenges for every international enterprises and the government. This paper applies some points to find out the role of financial engineering, such as use of collateralized debt products, contracts of difference and other derivatives products and recommends some solutions to solve or improve the governance and risk management strategies. It also show some suggestions for improving the companies’ protecting system to avoid the risk and crisis during their expedition and daily operation. Table of Contents Executive Summary: Introduction Risk Theme Discussion Conclusion References

Introduction

The financial crisis of 2007–2009, also known as the Global Financial Crisis and 2008 financial crisis, is considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s (Reuters, 2009). Around the world stock markets have fallen, large financial institutions have collapsed or been bought out, and governments in even the wealthiest nations have had to come up with rescue packages to bail out their financial systems (Anup Shah, 2013). Since the subprime mortgage crisis, caused by excessive virtualization and liberalization by lax real estate finance policy, low interest rates and financial crisis, it has been spread from the United States to all over the world, from the virtual economy to the real economy, and the crisis has developed from point to comprehensive crisis, or even a country, which was hard to believe, have been became the hitherto unknown bankruptcy situation. The world's major economies are facing the crisis go to all lengths in Europe and the United States not occur even in a hundred years, and even the government began to use the ‘government intervention’ instead advocated ‘economic freedom’, so as to prevent a further decline in that market confidence. But the crisis still exists, the nightmare is far from over.

Risk Theme Discussion

Risk is inherent in everything we do, whether it be riding a bicycle, managing a project, dealing with clients, determining work priorities, purchasing new systems and equipment, taking decisions about the future or deciding not to take any action at all (Australian/New Zealand Standard, 2009). Risk can be defined as effect of uncertainty on objectives (Australian/New Zealand Standard, 2009). Risk management defined as the culture, processes and structures that are directed towards realizing potential opportunities whilst managing adverse effects (Australian/New Zealand Standard, 2004). And risk management has an important role in striking the balance between the cost of risk and risk reduction (Gordon Dickson, 1995). On the surface, the subprime problem is caused by low-income people’s mortgage in the United States. Essentially, the crisis originated in the salvation of the last crisis, which was in 2001 after the US Internet bubble burst, the Fed to stimulate the economy, dropped the interest rates to about 1 percent level, and at the same time relax controls on lending. But under the economic stimulus objectives, excessive misusing of credit and credit risk swaps, which ultimately caused the crisis worsened. And from begin to end that both regulators, financial institutions and individuals was ignoring the risk management. The main causes of the subprime are three things, which were "securitization", "leverage" and "government supervision." All of these problems can be attributed to the neglect of risk management. From the regulators' point of view, due to the long-term economic and market prosperity, liberal philosophy occupies in the minds of regulators, so that more deregulation and liberalization making financial regulators at that stage became their core values. Listed financial institutions, especially investment banks, just in pursuit of performance targets, driven by the rapid growth of one-sided pursuit of business scale and operating profits, while ignoring risks even defy the risk. Moral risks and adverse selection breeding more common during the financial industry, employing ethical standards and risk management levels declined, and even has a strict authoritative rating agencies blindly optimistic, without make an objective rating conclusion. These gradually deepened the crisis in the problem of asymmetric information, and with low-income people under the stimulation of consumer credit, the rising house prices have unrealistic fantasies for their weak financial ability, blindly loan to buy a large area of housing. Eventually, it forced to accept the tragic fate of bankruptcy. On September 15, 2008, Lehman Brothers announced for bankruptcy. It was the largest bankruptcy ever, and it still is. The bank had assets of $639 billion, which is about as much as the five subsequently largest bankruptcies combined. The size of the bankruptcy could also be described as more than one and a half time the gross domestic product of Sweden in 2009. Before declaring bankruptcy in 2008, Lehman was the fourth-largest investment bank in the US (behind Goldman Sachs, Morgan Stanley, and Merrill Lynch), doing business in investment banking, equity and fixed-income sales and trading (especially U.S. Treasury securities), research, investment management, private equity, and private banking. Lehman's demise also made it the largest victim, of the U.S. subprime mortgage-induced financial crisis that swept through global financial markets in 2008. It’s likely that the bonus system encouraged the management to take big risks. The operational errors made when excluding assets in stress tests, exceeding established risk limits and over-leveraging the balance sheet, may have been fueled by bonus prospects. A banking system without bonuses is unthinkable for many, but another way to decrease the future bonus-related risk taking could be to build in a risk-aversion parameter in the bonus criteria. For instance, no bonuses are rewarded if stress test shows large risks, even if profits are big, although this requires stress testing to be executed by independent instances. A lot of market risk could have been avoided if Lehman hadn't invested heavily in correlated assets. The credit crunch hit largely because of the subprime crisis and it affected both commercial real estate and leveraged loan assets. Because of the ties between the assets, Lehman was struck quickly by losses on many fronts. The consequences of a hit in this chain could have been less fatal if the bank had been operating more diverse and not concentrated its portfolio. They made themselves vulnerable to liquidity risks. They were depending on short term funding for long term investments, which turned out to be a fatal mistake as the credit market dried up and they were left with illiquid assets. Also if they had done better stress testing and simulations they would have not changed their focus from brokerage and financial services. The high leverage ratio affected the other risks adversely making downfall fast and unstoppable. On the other hand, financial institutions place undue reliance on financial derivatives that all risks can be passed to others through the tool of innovation, thus ignoring the inherent risks of derivatives, which eventually led to the financial risk is magnified tenfold. If the financial institution focused on risk management, only loans and credited to the balance sheet, then, this was just as bad debts for the bank and stay in the banking system. In fact, with the 1980s US savings and loan association crisis and the Japanese economic bubble burst after the financial crisis, which were due to falling real estate prices guaranteed, so that the emergence of bad debts, and finally evolved into Bank management crisis. Since that time, the financial crisis has not been enlarged by derivatives, the US financial market and financial system can be quickly corrected and recovery after the event of problems. However, this time, the crisis did not can be as lucky as the last time, 70% subordinated loans, including housing-related loans have been securitized, and the situation has been very different in the past. By the securitized underground passage, the loan market (indirect financial market) and securities (direct financing market) formed integration. If a problem occurs in the loan market, it would be directly affect the stock market. In other words, the price of related commodities on the stock market decreased, it will show some problem highlighted on the loan market, and that is the truth of the subprime problem. Therefore, it is a typical results of currency market risk through the capital markets which are disorderly zoomed by tools. It is also the financial institutions count on derivatives to against with risk, which not only does not resolve the risk, but actually magnified risks. As analyzed, it may lead to excessive securitization and irresponsible to ignore the proliferation risks in the financial markets. In the market expansion cycles, it will resulting the "bad money drives out good money" effect, a large number of "timid" Financial professionals whose focus on risk management with poor performance and were eliminated, and "bold" employees, whose superstition with securitized universal, were popular. They do not know, maybe do not want to emphasize that the first question or the easiest problem about securitization is the existence of information asymmetry. Someone with finance knowledge should know that the different investors’ original investing housing loans and securitized financial products, which were difficult to understand the true quality of products. To this end, investors can only rely on the experts’ evaluation and referral. As we all know, Implementation the evaluation is the rating agencies, but these agencies did not fully or objectively fulfill their duties. The second issue caused by Securitization was moral risk. The main reason is that, as much as the manufacturers’ securitization loan portfolio sold to the third parties, by using leverage to making more profits. As the market expands, the desire began to swell and become distorted. The third problem is that since the implementation of securitization makes debt negotiation difficulties and become a big problem. Because of this cannot be like a loan held by bank which can change in different conditions and solved with relatively liberal measures. Credit rating agencies which plays a very disgraceful role. Some slow responded of the credit rating agencies even deliberately raised its credit rating to investment products, banking, and financial risk to some extent diffusion plays a role in fueling. The occurrence of this subprime problem, which was the result of securitization the above issues for several times. More securitization will aggravate the information asymmetry phenomenon, and regulators, financial institutions, and financial market participants have to pay no heed. Housing loan securitization has become RMBS (residential mortgage-backed securities), in the lower part of the rating of RMBS securitized to CDO (collateralized debt obligation), then split CDO into CDO quadratic, and from CDO quadratic to CDO cube, the market has lost the original the law, and became a desire machine. At the same time, in this framework, also incorporates a lever mechanism. In finance, leverage (sometimes referred to as gearing in the United Kingdom and Australia) is any technique to multiply gains and losses (Brigham, E., & Houston, J, 2011). Especially the involvement of hedge funds, they will generally use leverage when buying RMBS and CDO, some even appeared to expand the original housing loans by 1000 times. In such a high leverage effect, when the original loan losses, the negative impact was immeasurable. If it must to find some regulatory problems, for some lack of financial knowledge and have not enough information people, the government authorities without proper supervision is the essence of the problems, and this is called Predatory lending. The definition of Predatory lending is "the practice of a lender deceptively convincing borrowers to agree to unfair and abusive loan terms, or systematically violating those terms in ways that make it difficult for the borrower to defend against.” America has a long history for predatory lending, but the subprime problems seem to make people feel that these arguments did not play their roles. The so-called "the law is strong but the outlaw are ten times stronger", under the huge wage gap, the talent’s quality for financial institutions to absorb higher than these regulators. In other words, the understanding by regulators about the financial innovation is lower than the product designers. Therefore, regulators cannot discover the risk seems logical. Thus, as the US real estate continues to shrink, the Fed increased pressure to raise interest rates, the subprime mortgage crisis hit the previous day by day. From another perspective, the Fed's supervision of banks is critical. If all US financial assets are supervised by the Fed, maybe the risk can be controlled within a limited range. But on the subordinated debt and derivative products by SEC regulation, as an institution of long-term supervision of equity assets, claims on assets of stakes certainly not than the Fed, the regulatory dislocation can also be seen as the key cause of the crisis. Furthermore, the disruption in financial markets since the middle of 2007 has had a marked impact on Australian financial markets and the Australian economy (Guy Debelle, 2009). While local markets have been disrupted, the degree of dislocation has, in most cases, been considerably less than in other countries. One important reason for this is that the degree of counterparty risk aversion has been less in Australian markets given that Australian financial institutions had minimal exposure to the securities that have compromised the balance sheets of other financial institutions around the world. ISO 31000 was published as a standard on the 13th of November 2009, and provides a standard on the implementation of risk management. While all organizations manage risk to some degree, the ISO Standard establishes a number of principles that need to be satisfied before risk management will be effective. Risk management can be applied across an entire organization, to its many areas and levels, as well as to specific functions, projects and activities (Australian/New Zealand Standard, 2009).

Conclusion

Although closely related to financial innovation and the global financial crisis, but the real culprit of the GFC is hidden behind these innovations greed and disregard for extreme risk control. The nature of the problem is not how to limit the pace of innovation in the financial industry, but rather how to strengthen internal risk controls and risk management of financial institutions and international enterprises. For regulators, that means holding financial institutions to better standards of probity and prudence than prevailed in the past (Malcolm Edey, 2014). Excessive leverage is a bad idea. And the financial engineering should have a correct use by financial institutions and for all the companies also should have built an impeccable risk management system to avoid the any crisis and problems during their operating. So it is investing in complex financial securities which the risk is not correctly understood. Banks around the world need have a better risk management, and enhance their capital and liquidity risk controls. Expectations about financial growth and economy sustainable need to be realistic.

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