FINANCIAL RISK MANAGEMENT
Management of Financial Institutions and The Banking Crisis
Risk is uncertainty. The more risk one takes, the more he or she stands to lose or gain. One cannot expect high returns without taking substantial risks.
The outcomes are thrown open to uncertainty. In general, when we talk about risk, we focus on financial risk. In financial terms, it is the risk that a company or individual could lose some or all of the original investment, possibly resulting in inadequate cash flow to meet financial obligations. All wise investments follow risk consideration. To be successful, every investor must be able to identify and understand the types ...view middle of the document...
The crisis witnessed at Northern Rock widely demonstrates how poor management can contribute to the failing of a huge financial institution. In pursuit of continuing rapid expansion and growth, the bank adopted a business model they believed would enable them to become one of the market leaders in mortgage lending. This model was based upon relying on the wholesale markets rather than the more traditional approach of the retail markets to finance the majority of its lending. This method of operating is considered high risk. Therefore, it is fundamental to understand why Northern Rock chose to implement this type of model.
Primarily, reporting to shareholders the responsibility of the bank executives is to maximize the profitability of the bank. Choosing to securitize its loans, they packaged them together and traded on the wholesale markets. By selling these packages to investors they were able to make immediate financial gains whilst also ridding themselves of potential bad debt. Operating in this way, Northern Rock had announced record profits for 2006 and further securitizations during the first six months of 2007 generated even greater profits. This model appeared highly successful, yet at the same time fraught with risk. As long as the markets continued to flourish the bank returned increased profits and also achieved their objective of continuing to grow at a phenomenal rate.
A degree of managerial ignorance, or more likely incompetence, began to emerge as the effects of the American subprime lending became apparent. It had been widely known that problems with the banks in the US were due to the phenomenon of sub-prime lending for housing. Many of the loans had turned into toxic assets as borrowers failed to meet repayments.
Similar to Northern Rock, the banks continued to give loans in this manner as they too chose to securitize their loans because this method of trading appeared so profitable. This was a highly successful mechanism to operate until the number of defaulters increased to the point where these assets began to turn illiquid. Investors started to avoid securities as it was now evident many were flawed. Moreover, Northern Rock in their quest for greater financial returns found securities that attractive they also invested in them.
With trading slowing in the financial markets, many institutions began to react to the impending crisis by taking a more cautious approach to lending. In comparison Northern Rock were so focused on returning profits and generating growth that, at a time when monetary policy was tightening faster than expected, the bank had agreed to issue a tranche of mortgages at interest rates that were lower than those it had to eventually pay in the markets to finance them (The Economist, 2007, Lessons of the fall, 20/10/2007). In hindsight, this was a disastrous decision, which contributed to the impending shortfall in cash and ultimately the need to be bailed out.
The managerial failings of...