There are many questions that
click into our minds regarding economic collapse in 2008. Why banks were so
fragile that they could not deal with the problems in mortgage market? What does
this tell us about the efficiency of present day regulation and how the
regulation aims should can be met and change can be brought so as to reduce the
risks of future crisis.
The evaluations and analysis tells us that the bankruptcy of Lehman Brothers and
other U.S banks had to bear the loss up to $250 billion due to the bad
experience of residential mortgages securities. The economic fall in 2008 took
up the loss share higher. The capital of banks were facing troubles in the
market for funds with other banks which led credit retrenchments, therefore,
economy was badly affected.
The cause for the contractions in credit supply and credit problems were made by
the banks such that large amounts of mortgage-backed securities which were prone
to risk, were mentioned in balance sheets of banks provided that the originate
and distribute which is a securitization model was followed. This model was
followed so that risk is transferred to the financial institutions which could
better deal and bear it. The other reason being the banks used short term market
borrowing for financing of risky assets.
The amalgamation of these reasons caused huge problems for the system. The
market for housing started to decline and was getting worsened. This put a
negative on mortgage backed securities by increasing the risk and it was getting
hard to cover the securities through short term loans. As a result, banks had to
sell off the assets as they were not able to finance them anymore. The fall in
prices of assets added fuel to the fire; as a consequence, the banks’ capital
was deteriorated and they were unable to obtain short term loans.
Banks refused to give any loans further so as it to refrain from bankruptcy and
remain solvent. The borrowers were facing problems from not gaining funds from
the banks. This cycle slowed sown the economy as a whole. The regulators
instructed and set standards for keeping of substantial amount of capital by the
banks so that the economy remains safeguarded against the slow growth and
disturbances in financial sector. Another set of problems which would be
neglected was the matters relating to corporate governance and managerial
clashes within the banks. In other words, agency problems would arise. The
challenge of adequate internal controls by the bank management is dire need of
time.
An essential role is played by the “Agency problems” in constructing banks’
capital arrangement and structures. Equity is assumed by the banks that it would
an expensive and costly practice of financing. This has become a challenge for
the regulators to make sure that banks agree on keeping more equity even if they
don’t like. The cost funding of banks would increase if the capital ratio is
kept high. The requirement of keeping high capital ratio would benefits the
banks even in bad times. If a bank is undergoing losses, would have enough
liquidate assets. Investors are usually worried by the weak decisions by the
management about their deposits which will devalue their holdings.
In comparison, the borrowers of short term securities are better-off as they are
not worried about bad decisions taken by the management neither are they
affected. Thus, if banks intend to finance through shot term debt, then the
governance problem could easily be dealt. This would prevent the economy to be
affected by the banking problems.
The poor performance by risk management in the duration of crisis was
considerably high, that cost many firms badly. There is a requirement of
inculcating new and better practises into the financial industry. There is
considerable amount of work to done by the regulators to bring the capital
structures into reformed shape so that the financial sector remains stable and
under control. The regulators need to understand the game played by the banks
that caused the crises to arise and the system was disrupted. The challenges are
not faced by all the banks. An understanding needs to build on why and how some
firms performed well as compared to others by practising the risk management.
There are many factors influencing the good or bad outcomes.
The regulators keep the same view on the poor risk management role played during
the crisis. Many of them mentioned it as one of the pioneer reason for chaos and
commotion in financial sector. The fault remains in the policies for regulation,
capital ratio standards were not set that is why it failed to minimize and roll
over the management weaknesses. The reasons for risk management weaknesses made
by the firms were that there was lack of control over the growth of balance
sheet and off-balance sheet disclosures were overlooked. Secondly, there was a
gap of communication among senior authorities and risk management operations.
The catastrophe brought by the failure of risk management ruined the economy
financial system. One should not forget that a governance problem in banks was
also one the major reason for the crisis. Risk management is like the black box
at all large organizations and banking sector. There is requirement of improving
and implementing strong polices for risk management by the regulators.
BY : MISS MADEEHA MUNEER