Thi Huynh Anh Nguyen

BFF5902 INTRODUTION
Sem 1 2016
TO RISK PRINCIPLE
Assignment 2

Assignment 2

TABLE OF CONTENTS
I.

Executive summary..........................................................................................................3

II. Introduction......................................................................................................................4
2.1.

Backround of GFC...................................................................................................4

2.2.

Emergency of credit derivative...............................................................................5

III. Risk theme discussion......................................................................................................6

3.1.

Risk principles in theme..........................................................................................6

3.2.

Case study.................................................................................................................6

3.2.1.

Derivative product..............................................................................................6

3.2.2.

Interconnectivity between operational risk, liquidity risk, credit risk and

systematic risk....................................................................................................................7
3.2.3.

Role of Corporate Governance and non-regulatory compliance in risk models

10

3.2.4.
IV.

The role of ISO 3100:2009..............................................................................11

Summary.....................................................................................................................12

4.1.

Identified issues......................................................................................................12

4.2.

Recommendation....................................................................................................12

References...............................................................................................................................14

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I.

EXECUTIVE SUMMARY

Financial crisis in 2008 led to the collapses of an unprecedented large number of financial
institutions. This crisis has been viewed as the worst financial crisis with the following severe
consequences in global credit market and required the government interventions globally. For
example, the US government launched TARP to acquire or insure over $700 billion of assets
from financial institutions.
The significance of the 2007 -2008 financial crisis motivated some researchers to find out the
global roots of the crisis. A large number of bankings and financial institutions collapsed
during the global financial crisis of 20072008. This failure resulted in a freeze of global
credit markets and required government interventions worldwide. In a term of
macroeconomy, the loose monetary policies can be one of the roots of the financial crisis
affected all firms. However, many researchers argue that organizations' risk management and
financing policies had a significant effect on the extent to which companies were impacted by
the financial crisis.
This study is to focus on the role of risk management within the financial institutions. As one
of the consequences of this financial crisis, there are some of the well-known institution such
as Lehman Brothers, Bear Steam, Meryl Lynch which are no longer existed. However, all of
those companies had technically excellent risk management systems. So what are the reasons
leading to the collapses of those companies? To answer these questions, firstly, this study will
focus inside the role of derivative products which is commonly viewed as a financial risk
instrument. However, in the case of 2007-2008 financial crisis, these derivative products also
trigger this global credit crisis. Secondly, this research will examine whether there is an
interrelationship between operational risk, liquidity risk, credit risk and systematic risk.
Thirdly, we also review the role of Governance and non-regulatory compliance in risk
models. Finally, the study will discuss about the lessons learned from this financial crisis and
also the important role of ISO 31000:2009 in creating the resilient environment in the
worldwide economy.

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II.

INTRODUCTION

II.1.

BACKROUND OF GLOBAL FINANCIAL CRISIS

First of all, Global financial crisis (GFC) during the period from 2007 to 2008, commonly
known as the worst financial crisis in the world financial history since the Great Depression
of the 1930s. The GFC triggers from the growth of the bubble if real estate loans, as the result
of too much liquidity on the market by strongly expanding the monetary policy of the Fed of
Greenspan. During the period from 2001 to 2004, the interest rate was lower to 1 percent so
as to strenghten the labor market and the economic system. However, major of these loans
were subprimed and loans of low quality. At that time, securitization was used as an
innovative finance for banks in order to reduce and shift the credit risk to another party. As
the results, banks granted more loans and families got into more debts. But there was no
regulation and control for using this securitization to finance the highly volatiled mortgage
loans.
Credit derivatives has been used by many banks and insurance companies to reduce and
transfer the credit risk to another party. In reality, the subprimes debts have been securitised
in obligations, which means a process of finance by the means of finance (Iannuzzi &
Berardi, 2010). Because the banks want to miximise the amount of lending, regarless the
possibility of repayment. The mechanism led to the crisis when mortgages loans were
intensively increased and the decline in house prices. As the consequence, many families with
the debts became insovent. The financial institution suffered losses due to the inability to
finance their loan. This also led to the reduction in investors confidence.
After the collapse of real estate market, many of the financial institution also disappeared
from the financial industry as bankrupcy, mergers, acquisitions and nationalization.

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II.2.

EMERGENCY OF CREDIT DERIVATIVE

Xing and Yuqin (2012) argue that credit derivatives (CDs) have viewed as a critical cause of
the 2007-2008 financial crisis since the the US subprime mortgage occurred in the mid of
2007. Due to the connectivity between global banking and financial system, credit risk
exposures spread quickly among banks and financial institutions, resulting in the global
financial crisis. As the consequences, the original role of CDs as a credit risk transfer has
been criticized. Skeel and Partnoy (2007) indicate that CDs caused the risk of systemic
market failure.
Look back at the positive view of role of credit derivatives, CDs have been seen as the most
remarkly financial innovation, which allows the couterparties to effectively manage the credit
risk exposure. Their value is identified based on the underlying credit instrument. Through
CDs, the insurance contracts for the specific credit risk will be offered to reduce and
eliminate credit risk. The protection buyer will pay cash periodically in order to transfer the
credit exposure to a credit protection seller. Despite the effective role of shifting risk, CDs
can also create the troubles in the financial systems by minimising incentives to monitor
borrowers. This leads to moral harzard and the risks of information asymetry, that has been
attributed to the failures in financial crisis.
In terms of the relationship between credit derivatives and global financial crisis in 2008,
Alnassar et.al. (2014) suggest that there are three possible arguments for the role of CDs in
GFC 2007. Firstly, this was due to CDs market participants which were allowed to construct
the huge risk positions such as Lehman Brothers, Bear Stearns and AIG. The second reason is
the lack of transparency in the CDs market, giving the chance to participants to manipulate
the market. Finally, the connectivity between the global financial systems led to
consequences of domino impact attacked the whole worldwide economy.

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III.

RISK THEME DISCUSSION

III.1. RISK PRINCIPLES IN THEME

Risk management, even though, experienced the failure to prevent the risks during the
financial crisis, its still play an important role in the business today. After the scandals of
Enron and Worldcom, there is a growing concern about the role of risk management and the
need of appropriate risk management techniques and structure within the financial
institutions. After the financial crisis, the risk measurement and management of specific risks
such as liquidity risk, credit risk and market risk has been improved (Aebi et.al., 2012). Prior
researches only focus on the risk management of single type of risk and ignore the
interelation between those risks. Therefore, the integrated view of risks has had the growing
concern.

III.2. CASE STUDY

III.2.1. DERIVATIVE PRODUCT

Lehman Brothers, previously known as the financial emprire, was collapsed in GFC 2008 as
a triggered signal for the following consequences of using credit derivative product. The
company was one of the largest counterpaties in the CDs market. The firm had obtained the
relatively massive amount of suprime. Lehman reported the huge amount of 72 billion dollars
of CDs which are uncertainty and complexity in deciding close out position. As the
consequences, this leads to the default of Lehman Brother in 2008.

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Bear Stearns was well-known as an aggressive investment bank and also one of the large
dealers in the OTC derivative markets together with Lehman Brother and AIG. Bear Stearns
s bankruptcy in 2008 also draw an attention into the infirmities of risk management that leads
to the collapses of the financial services industry and the GFC after that.
Another case is American International Group (AIG). The company was known as one of the
world largest insurance companies. AIG operates in more than 130 countries which 50
percent of revenue is generated from oversea. Different with the two cases above, the
company positions itself in the low-risk business of life insurance and pension services.
However, during the pre-crisis period, AIG tooks a huge credit risk exposure by obtaining the
mortgage-backed securities and issueing a large number of CDs contracts, many of those was
established on the bad underlying asset such as subprime debt.
Even though they can be seen as the fastest growing financial instrument in the recent
decades, the collapses of many banking and fianancial insitution over the world have shown
the evidence of the immaturity of credit derivatives market, and CDs directly as the critical
factor to this failure. This allows the companies to issue the large amount of CDs contract
without any restrictions, resulting some maniputions and misuse of this financial instrument
based on the information asymetry.

III.2.2. INTERCONNECTIVITY BETWEEN OPERATIONAL RISK, LIQUIDITY

RISK, CREDIT RISK AND SYSTEMATIC RISK

III.2.2.1. OPERATIONAL RISK

Lack of operational risk management is viewed as one of the major factors

leading to the financial crisis in 2007 2008. According to Basel II,
opeartional risk is defined as the the risk of loss due to indequate and failed
internal processes, people and systems or from external events. The
implication of operational risk in the financial crisis can be viewed from the
investment banks perspective. The commercial banks granted loan for those
who can not pay their obligation, because they transferred the risks to

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investment banks. The investment banks bought the morgaged back security
without asking more information about the loans. Because of the poor
management which was mainly focused on the massive short term profit rather
than the sustainability of the organisation. Therefore, it is very important to
improve the effectiveness of operational risk mangement which is overlooked
and could cause the collapse of banks.

III.2.2.2. LIQUIDITY RISK

Liquidity risk is the risk that company or financial institutions are unable to
meet the short-term financial demand. For instance, in the case of Lehman
Brothers, at the time of its collapse, Lehman highly relied on the short-term
financing, mainly short term repurchase transaction (i.e. repos) and also
maintain the highly leveraged financial position. In this situation, Lehman got
the difficulty to renew the contracts and being refused to lend by banks.

III.2.2.3. CREDIT RISK

The GFC has highlighted the importance of understanding and improving the
measurement of credit risk, especially for financial institutions and banks.
According to Global Association of Risk Professionals (GARP), credit risk is
the risk of potential losses resulting from not performing financial contracts.
For the banks, loan is a large source of credit risk. However, there is also some
of other sources such as bonds, short-term debt securities and derivatives.
After GFC event, the weeknesses of the credit risk management system and
models has been heightened. The effective credit risk management is a critical
part of risk management process in financial institutions to achieve the longterm objectives.
Role of credit rating is also important in the market. When the rating is
inflated, it will contribute to promote the mortgage-related structured financial

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products. Some evidence suggest that mortgage crisis triggered the financial
crisis because of highly relying on the complex structured financial products

III.2.2.4. SYSTEMIC RISK

The great uncertainty and following recession during the financial crisis has
proved the sustantial imperfection of markets and their insufficiency of selforganisation.
Iannuzzi & Berardi (2010) suggest that the trend of globalization with
increasing complexity and rapidly changing environment makes the regulatory
system ineffective in coping with the formation of speculative bubbles. From
that view, the current systemic crisis has indicated the incapacity of regulatory
standards and the control system for both intermediates and financial market.
Futhermore, McConnell and Blacker (2013) also state that systemic risk
becomes more important for the service industry because of its cumulative
effects on the general economy.
Yang and Zhou (2013) suggest that the 2007-2008 financial crisis highlighted
the important role of systemic risk and identified the critical weaknesses in
financial regulatory system. According to Allen et. al (2009), there are at least
three types of systemic risks. The first if a common asset shock, for instance,
the decrease in real estate or stock market value. The sencond one is the
danger if contagion when the failure of one institution leads to the panics and
otherpsychological factors. The third type is the failure of chain of institutions
due to the more correlated portfolios and enhanced financial connections
between them.

III.2.2.5. INTERCONNECTION BETWEEN THESE RISKS

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Allen et. al. (2009) suggest that credit risk transfer in a network structure due to the tangible
connection (such as interbank lending) between individual firms, other types of systemic risk
can also be reflected by the comovement of credit risk of financial institution. The systemic
risk is the key to understand the occurrence of financial crises. The interconnection is when
financial problem in one organisation considerably leads to the financial distress in other
organisation. In this sense, operational risk, liquidity risk and credit risk in one institution can
causes the domino effect on the other institution through the nature of systemic risk during
the global financial crisis in 2008.

III.2.3. ROLE

OF

CORPORATE

GOVERNANCE

AND

NON-REGULATORY

COMPLIANCE IN RISK MODELS

Risk management and financing policies is a critical part of companies corporate

governance. In other word, corporate governance also had a significant impact on firm
performance during the crisis period. Kirkpatrick (2009) concludes that failures and
weaknesses in corporate governance organisation in financial services companies can
attribute to the global financial crisis in 2008. An analysis shows that firms with more
independent boards and greater institutional ownership experienced worse stock returns
during the crisis period (Erkens et. al., 2012). This may be due to independent directors and
institutional shareholders encouraged managers to increase shareholder returns through
greater risk-taking prior to the crisis. Shareholders may find it optimal to increase risk
because they do not internalize the social costs of financial institution failures and
institutional arrangements such as deposit insurance may weaken debtholder discipline. In
addition, because of their firm-specific human capital and private benefits of control,
managers tend to seek a lower level of risk than shareholders.
Generally, corporate governance will focus on the following aspects: systemic risk, risk
mangement, remuneration, strategy, board behavior and culture. In the time of crisis,
organisation had the failure to capture the systemic risk and its pervasive effects. In term of
remuneration with the bonus culture led managers to aggressively pursue the short-term
profitability rather than long-term success.

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III.2.4. THE ROLE OF ISO 3100:2009

Some would suggest that the global financial crisis in 2008 was caused by a failure of risk
management rather than the failure of top management or gorvement in effectively managing
risk.
The risk management framework of ISO 3100:2009
The core of risk management process includes five steps in traditional risk management such
as identifying, analysing, selecting the best response, implementing and monitoring. In
addition to core steps, two key function should be continually mentioned throughout the
process. Firstly, this is communication and consultation. Secondly, the process should keep
monitoring and reviewing the outcomes of risk.
The role of ISO 3100:2009
The standard has been attributing on the effective risk management, which includes the
improvement in corporate governance, financial reporting quality and stakeholders value.
In a term of corporate governance, risk management was mainly focus on the creative and
forward-thinking risk finance and risk transfer techniques for decades ago. There was just a
little attention about the broarder range of risks, beyond insurable risk, disaster preparedness.
The new focus of ISO 31000 is the sustainability through building enterprise risk
management (ERM), which emphasises on competitive learning organisation. The new
standard allows the wider organisational perspective of effective risk management. In this
sense, the organizational learning and resilience will be considerably improved.
In a term of financial reporting quality, through improving the risk management process,
some of financial risks such as audit risk, fraud risk in financial information can be reduced
and mitigated. Addtionally, risk management also take place as a safeguard for the companies
against the huge financial losses through the risk assessment and risk management plan.
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In a term of stakeholders value, the standard has addressed to the wider range of
stakeholders, including those responsible for developing the risk management policy.
Through risk managemnt, the comprehensive approach which focuses on the wide range of
stakeholders to understand their different expectation and also enhance the stakeholders
value.

IV.

SUMMARY

The cause of financial crisis can be summarised into four main reasons: fundamental,
financial industry, regulatory and behavioral. First of all, in this study we focus on the role of
risk management and complexity of using derivative products as the key factors causing the
2007-2008 financial crisis. Besides, the interconnectivity between operational risk, liquidity
risk, credit risk and systemic risk in the network structure has been explained as failure in one
institutions will affect the others due to the tangible connection between them. Secondly, we
discuss about the role of the governance and non-regulatory compliance in risk model. Good
corporate governance will include the factors of systemic risk, risk management,
remuneration, strategy, board behavior and culture. Through these factors, corporate
governance eill help to prevent and detect the potential risks within the organisation. Finally,
ISO 31000:2009 has contributed to improve and create the comprehensive approach to risk
management process and increase the resilience of the financial market. The following is
some identified issues and recommedations as the lessons we can have after the financial
crisis.

IV.1. IDENTIFIED ISSUES

Morality issue- corporate governance to spell out the rule of decision making
Iannuzzi & Berardi (2010) indicate that morality of manager is one of critical aspect to
explain the formation of speculative bubbles and financial crisis. The 2007-2008 crisis has
clearly stated the crisis of social, personal and political values. The philosophy of

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maximisation of self-interest, pursuing short term targets of maximsing profit and

shareholders value as the major causes of this financial tragedy. However, Bollard and Ng
(2012) suggest that moral hazard is unable to be totally eliminated, only reduced. Therefore,
some certain level of regulation and supervision is essential in limiting the risk-taking
behavior.

Transparency of OTC derivatives

The inherent lack of transparency of OTC market was also claimed as one of the factors
leading to the discovery of price impairment. As a consequence, the OTC derivatives and
their associated risks may be incorrectly evaluated, for instance, in the case of AIGs credit
derivatives contract premiums.

IV.2. RECOMMENDATION

Firstly, the stability of financial and economic system should be increased by improving the
transparency and regulatory standards. However, more regulation is not enough by itself, a
change in the way of decision making is needed. Given that embeding the ethics and morality
should be highlighted as one of the rule for decision makers.
Secondly, the transparency of OTC transactions should be improved in accordance with the
reduction of counterparty credit risk and systemic risk. In order to do these things, the
regulatory response and development of a new institutional framework need to be considered.
For Australia, this is the proposed regulatory framework arising from Australias G20
commitments. This new framework will lead to significant changes in the structure of
Australian OTC derivatives market.

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REFERENCES

Aebi, V., Sabato, G. & Schmid, M. (2012). Risk management, corporate governance, and
bank performance in the financial crisis. Journal of Banking and Finance, 36, 32133226.
Allen, F., Babus, A. & Carletti, E. (2009). Financial connections and systemic risk. Working
paper, University of Pennsylvania, Philadelphia.
Alnassar, W. I., Al-shakrchy, E. & Almsafir, M. K. (2014). Credit Derivatives: Did they
exacerbate the 2007 global financial crisis? AIG: Case study. Procedia Socail and
Behavioral Sciences, 109, 1026-1034.
Bollard, A. & Ng, T. (2012). Learnings from the Global financial crisis. Bulletin, 75 (3), 5766.
Erkens, D. H., Hung, M. & Matos, P. (2012) Corporate governance in the 2007 2008
financial crisis: Evidence from financial institution worldwide. Journal of Corporate
Finance, 18, 389 -411.
Gupta, K., Krishnamurti, C. & Tourani-Rad, A. (2013). Is Coporate governancce relevant
during the financial crisis? Int.Fin.Markets Inst. And Money, 23, 85-110.
Iannuzzi, E. & Berardi, M. (2010). Global financial crisis: causes and perspectives. EuroMed
Journal of Business, 5 (3), 279-297.

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Kirkpatrick, G. (2009). The corporate governance lessons from the financial crisis. Financial
Market Trends, OECD Publication.
McConnel, P. & Blacker, K. (2013). Systemic operational risk: does it existand if so, how do
we regulate it? Journal of Opeartional risk, 8(1), 59-99.
Robinson, D. & Hronsky, J. (2012). OTC Derivatives in a post-GFC world: Australias
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Skeel, Jr., David, A. & Partnoy, F. (2007). The Promise and Perils of Credit Derivatives.
University of Cincinnati Law Review, 75, 1019-1051.
Yang, J & Zhou, Y. (2013). Credit risk spillovers among financial institution around the
global credit crisis: firm-level evidence. Management Science, 59(10), 2343-2359.
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Xing, Yang, Yuqin & Zhong. (2012). The Effect of Credit Derivatives CDO to Financial
Market Stability. Journal of Business Economics, 2, 67-75.

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