Financial Risk Management and 2007-2008 Financial Crisis

History

The occurrence of financial crises led to major changes in terms of policies and regulations. These regulations bring changes in the market and might disrupt financial institutions operation. Kling (2009) opined that financial regulations elicit responses from the firms in the private sector seeking to maximize returns within the confines of laid out regulations. For instance, the Great Depression of the 1930s occurred as a result of regulations that allowed the borrower to pay interest only for five years, or the mortgage became due (Kling, 2009).

The 1920s saw an increase in stock prices and large amounts of lending for stock purchases. As a result, the decline in the stock price in 1929 forced many lenders to call in borrowers and loans who had to sell assets leading to economic collapse (Arner, 2009). Therefore, the borrowers were forced to pay off the existing loans or get new ones. The depression led thousands of banks to close.

In response, the U.S. government introduced the Federal Housing Administration, a thirty-year fixed-rate mortgage, and federal deposit insurance. These regulations led to the 1970s financial crises because the assets in savings and loan associations holding a thirty-year fixed-mortgage policy plummeted as a result of increasing interest rates and inflation (Kling, 2009). Similarly, the regulation Q, introduced to solve the 1970s financial crises, was the cause of the financial crises of the 1980s.

The introduction of regulation Q in 1970s did not completely resolve financial burden people were experiencing. Arner (2009) stated that the 1983 global financial crisis occurred because of excessive borrowing and lending, especially by developing countries and international banks. The lending was fuelled by the availability of funds introduced by deposits from oil-producing countries. The United States introduced high-interest rates intended to solve the inflation problems in the 1970s. As a result, developing countries, who had taken loans, could not raise the money to meet debt obligations, leading to massive defaults.

As seen in other 1970s and 1980s crises, the 2008 financial crisis was precipitated by the Asian 1997 crisis. Arner (2009) argued the financial crisis in Asia was the basis for the 2008 crisis. The author opined that when Asian countries faced economic, financial, and currency crises, they asked for support such organizations as International Monetary Funds (IMF) that came with strict policies from the Washington Consensus (Arner, 2009). In the period between 2005 and 2006, borrowers, investors, insurance companies, and lenders combined a series of low-interest rates, regulatory distractions, and freely available capital that led to the greatest financial crisis (Arner, 2009). Banks did not conduct thorough financial risk assessment, and people received loans they could not service.

Environmental Analysis

The global financial crisis of 2007-2008 occurred due to a series of mistakes and oversight from banks and lending institutions. Acharya and Richardson (2009) suggested that credit boom combined with the housing bubble were the leading causes of the 2007-08 financial crisis. The preceding five years before the crises comprised of increased debt compared to national income. Additionally, the housing prices between 2002 and 2007 increased at a higher rate, approximated at 11% every year (Acharya & Richardson, 2009). Consequently, the bubble burst led to a reduction in the consumption rate for the median families, which led to a decline in economic growth.

Furthermore, deregulation in the financial industry and laxities in enforcing banking regulations created the crisis. For instance, introduction of securitization of mortgages led to a deterioration of loan quality because financial institutions did not want to share risks with financial investors. Additionally, banks did not maintain capital against them because the assets were covered by bonds sold in short term capital markets (Acharya & Richardson, 2009). The lack of liquid finance in the banks necessitated the crisis because money was not flowing in the economy.

The increased loans on mortgages assured banks of better returns. However, they risked accruing losses if a large number of prime mortgages could default their loans at once. The decision-makers in the banks were sure that there would be no cases of defaulting loans. Also, Karanikolos et al. (2013) noted that more than 9 million U.S. homeowners had mortgages loans higher than the value of the house. Therefore, when the housing bubble burst, the insurance could not compensate the banks, which resulted in a financial crisis. The financial crises appear like a problem that could have been prevented if the relevant stakeholders were to act accordingly.

Industry Analysis

Credit crises beginning the 1930s led to the introduction of regulations in the banking and financial sector. The study by Kroszner and Strahan (2014) indicated that regulations and deregulations are accompanied by a dramatic reduction in several institutions and changes in macroeconomic that affect competition. For instance, the United States Congress passed the federal deposit insurance in 1933 after the Great Depression to restore the confidence of consumers in the financial and banking industry.

Additionally, there were capital requirements where the banks were mandated to invest an agreed minimum of equity as a way of getting a bank charter. International regulators designed the Basel II Accord that intended to create a risk-based standard that would regulate the credit, market, and operational risks (Kroszner & Strahan, 2014). These policies aimed at limiting the freedom of banks from taking financial risks that would cause another crisis.

The 2008 financial crisis had some dire consequences in the economy. There were huge market-to-market losses of $945 billion in the United States, which accounted for mortgage-related debts and securities (Ullah, Azam, & Anwar, 2009). More specifically, Ullah et al. (2009) pointed out that commercial banks experienced losses of $510 billion, while insurance firms lost $130 billion. Further analysis shows that other financial institutions lost about $160 billion during the crisis. Additionally, the financial losses were experienced globally because of the mortgage securitization concept that allowed banks to sell high-risk assets. Therefore, the financial crisis in 2008 reached a global scale because of the institutions that purchased the assets.

The global financial crisis that occurred in the year 2007-2008 resulting in devastating effects in equity markets and greatly led to increased cases of unemployment, business and buildings foreclosure, and tarnished the credibility of banks and financial institutions as well as economic growth (Ötker-Robe & Podpiera, 2013). A study by Iqbal and Kume (2014) found that the global crisis created a shortage of demand for products and services because people and businesses were uncertain about economic recovery.

The decline in demand led to increased cases of cash holdings because people were reluctant to invest, as well as a decline in debt and equity issuance. This lack of funds flowing in an economy is what led to the loss of jobs and losses within businesses resulting in the devastating effects associated with the 2008 global financial crisis.

Financial Analysis

Countries and financial institutions run computations to understand economic progress or the profits made in a given period. These computations are used to determine the progress of a business or the economic growth. Aldasoro, Borio, and Drehmann (2018) indicated some of the indicators for financial vulnerabilities as credit-to-GDP gaps, property price gaps, and economy-wide debt service ratios. These indicators are essential in pointing the debt vulnerabilities and international debt. However, the profitability of banking is determined by the return on assets and the equity multiplier. The ratios are calculated as follows:

ROE = (ROA)*(EM)

ROA= (NPM)*(TAT)

ROE = (NPM)*(TAT)*(EM)

Where;

ROE = Return on Equity

ROA = Return on Assets

EM = Equity Multiplier

NPM = Net Profit Margin

TAT = Total Asset Turnover

For instance, the calculations are applied to Monarch Bank located in Chesapeake, Virginia, for the period between 2003 and 2010. The findings are as indicated in Appendix 1.

Conclusions and Recommendations

The financial crisis exposed a myriad of issues that occur when businesses ignore set strategies. Therefore, the businesses were urged to implement strategies such as risk oversight, especially on risk management and reporting. Maingot, Quon, and Zéghal (2018) study suggested the use of enterprise risk management (ERM) as a method of taking and managing risks. ERM entails the management identifying and assessing the collective risks that affect the value and applying an enterprise-wide strategy to manage the identified risks (Maingot et al. 2018). Risk management is essential in growing shareholder value and protects the businesses in times of crisis. It identifies risks and sets clear guidelines on what to do during crises.

Additionally, risk management identifies roles, responsibilities, and accountability that help in managing risk. In a traditional setting, the board of directors in the finance industry was not responsible for risk management. However, Maingot et al. (2018) posited that regulators insist that boards should oversee the material risks, especially after the financial crises. The financial institutions in Canada did not suffer huge losses as in the United States because of the strict regulatory controls.

Institutional change theory is used to explain the expected changes when a problem occurs. There are five mechanisms for institutional change used to identify the gap existing between intentions and outcomes for implemented policies (Mykolenko & Hanna, 2018). The mechanisms are useful in analyzing alternative strategies, policies, and interests that would better serve institutions. They are layering replacement, drift, conversion, and exhaustion.

In Denmark, the government devised a special resolution regime to protect the banks, which was not implemented before the crisis. Therefore, the government came up with a new-found resolution regime, which emphasized that banks should resolve issues in a manner that reduces support from the public sector. Further, the plan suggested losses be imposed on private creditors and the owners of the financial institutions (Mykolenko & Hanna, 2018). The plan helped in preventing recklessness in lending money and sharing the risks.

Financial risks are increased when financial institutions fail to retrieve or act upon reliable information on financial misconduct. The statement means that risks and crises could be avoided if the management focused on regulating employees and creating a conducive environment that encourages reporting of incidents. For instance, Bryce et al. (2019) suggested that financial institutions should instill a high-error management climate intended to encourage internal reporting and ethical behaviors by tolerating errors. The findings of this research are essential in the financial institution because management could adopt certain measures such as high-error management climate to allow people report financial risks and misconduct.

In conclusion, this essay found the main causes of the 2007-2008 financial crisis and how the regulators reacted to minimize the expected outcomes. The lessons learned from the past financial crises enabled relevant stakeholders to take initiatives intended to help the financial sector mitigate risks. A combination of techniques such as increased internal reporting, increased regulations, and well-defined roles are essential in financial risk management.

References

Acharya, V. V., & Richardson, M. (2009). Causes of the financial crisis. Critical review, 21(2-3), 195-210. Web.

Aldasoro, I., Borio, C. E., & Drehmann, M. (2018). Early warning indicators of banking crises: expanding the family. BIS Quarterly Review.

Arner, D. W. (2009). The global credit crisis of 2008: Causes and consequences. Int’l Law., 43, 91.

Bryce, C., Chmura, T., Webb, R., Stiebale, J., & Cheevers, C. (2019). Internally reporting risk in financial services: an empirical analysis. Journal of Business Ethics, 156(2), 493-512. Web.

Iqbal, A., & Kume, O. (2014). Impact of financial crisis on firms’ capital structure in UK, France, and Germany. Multinational Finance Journal, 18(3/4), 249-280. Web.

Karanikolos, M., Mladovsky, P., Cylus, J., Thomson, S., Basu, S., Stuckler, D.,… & McKee, M. (2013). Financial crisis, austerity, and health in Europe. The Lancet, 381(9874), 1323-1331. Web.

Kling, A. (2009). Not what they had in mind: A history of policies that produced the financial crisis of 2008. Web.

Kroszner, R. S., & Strahan, P. E. (2014). Regulation and deregulation of the U.S. banking industry: causes, consequences, and implications for the future. In Economic Regulation and Its Reform: What Have We Learned? (pp. 485-543). University of Chicago Press.

Maingot, M., Quon, T., & Zéghal, D. (2018). Risk management by U.S. and Canadian financial firms during the financial crisis. International Journal of Disclosure and Governance, 15(4), 221-234. Web.

Mykolenko, O., & Strokovych, H. (2018). Institutional adaptation to abrupt changes during and following the financial crisis. Investment Management & Financial Innovations, 15(1), 154. Web.

Ötker-Robe, I., & Podpiera, A. M. (2013). The social impact of financial crises: evidence from the global financial crisis. The World Bank.

Ullah, S., Azam, K., & Anwar, K. (2009). The impact of recent global financial crisis on the financial institutions in the developing countries: Global perspectives. International Review of Business Research Papers, 5(5), 85-95. Web.

Appendix 1

The findings