Banking Risks: Lessons from the first financial crisis of the 21st Century, Manuais, Projetos, Pesquisas de Crise Econômica

Baixe Banking Risks: Lessons from the first financial crisis of the 21st Century e outras Manuais, Projetos, Pesquisas em PDF para Crise Econômica, somente na Docsity! American International Journal of Business Management (AIJBM) ISSN- 2379-106X, www.aijbm.com Volume 2, Issue 7 (July- 2019), PP 50-60 *Corresponding Author: Marco Amaral 1 www.aijbm.com 50 | Page Banking Risks: Lessons from the First Financial Crisis of the 21st Century Marco Amaral a * and Kátia Lemos b 1Management, Polytechnic Institute of Cávado and Ave, Barcelos, Portugal; 2Accounting and Taxation, Polytechnic Institute of Cávado and Ave, Barcelos, Portugal Campus do IPCA, 4750-810, Barcelos, Portugal. *Corresponding author: Marco Amaral ABSTRACT:- The last global financial and economic crisis began a decade ago, taking place in the middle of the banking sector of the United States of America (USA), which rapidly expanded to the entire world financial system. This crisis has come to bare gaps in regulation and supervision and flaws in internal controls, as well as an excessive takeover of risks by banks. As a result of inadequate risk management policy, several banks have either failed or been ransomed by their governments and financial markets have come to suffer strong tensions of confidence from their economic agents. Thus, from this financial crisis we have important lessons to be learned and so the central objective of this article is to understand its origins and reflect on its consequences. Keywords: crisis; banks; risks; failures; financial markets I. INTRODUCTION A decade after the last major global financial crisis, which began in august 2007 in the USA banking sector, it is important to understand and reflect how the recent financial crisis began and developed and what were its main consequences. Thus, the article aims to recall and draw lessons from an unprecedented crisis that broke out in the USA financial market and rapidly spread throughout the global financial system. After this brief introduction, the document details many developments of the financial crisis, and thus, in addition to presenting its origins and revealing the main risks accumulated over several years in the American financial market, the main consequences of this crisis are also identified, in particular, the occurrence of bankruptcies and redemptions of several banks. In september 2008, Lehman Brothers bankruptcy was a bank "too big to fail". A chronology of the main events of the financial crisis is made up of three different phases of the crisis and different regions of the world in order to materialize the effects of contagion of the United States (US) financial system with the rest of the world, as well as the effects of the systemic risk in the real economy. In order to complement this article, and because the financial crisis has largely resulted in an inadequate risk management policy for banks, this issue is addressed, identifying in detail the financial risks of banks (credit, market and liquidity risk), as well as non-financial risks (operational, reputational, business, etc.) and other risks that characterize banking activity. Finally, we present some emblematic cases of bank failures that result from failures in the management of financial risks such as credit, market and liquidity risk. 1. The Financial Crisis: Origins and Consequences The crisis that is intended to be contextualized refers to the first financial crisis of the 21st century, which began at the heart of the US financial system as a result of macroeconomic imbalances, failures in coordination and financial regulation, and inadequate risk management policies. At this point, a brief analysis is made of the origin and consequences of the global financial crisis of 2007-2008, as well as widespread financial crisis. Abreu et al. (2007) perceive as a financial crisis a strong disturbance in one or several financial markets, characterized by a sharp fall in the value of assets and often leading to the bankruptcy of numerous financial and non-financial companies. Banking Risks: Lessons from the First Financial Crisis of the 21st Century *Corresponding Author: Marco Amaral 1 www.aijbm.com 51 | Page 1.1 Origins In mid-2007, the financial world witnessed the bursting of the speculative bubble in the residential mortgage credit segment of the United States of America - the subprime1. In fact, the exuberant American growth was largely based on real estate and related activities. Between 2003 and 2007, more than half of US GDP – Gross Domestic Product growth was based on real estate (home sales, construction jobs, consumer stimulus, and rising indebtedness), resulting in the so-called "new real estate economy". However, by the end of 2006, a decline in house prices in the US triggered a housing bubble - a real estate crash (Graph 1) and many Americans saw their principal real estate devalue. Graph 1 - Evolution of US housing prices - "real estate bubble" Source: Own elaboration based on the Standard & Poor's Dow Jones Indices data for the evolution of the S & P / Case-Shiller price index (composed of 10 cities) in the period from june 2000 to december 2010. The events that triggered the financial crisis began well before 2007. In 2001, with the economy in recession (aggravated by the september 11ͭ ͪ terrorist attacks), the Federal Reserve System (FED2), seeking to stimulate consumption and economic production through credit, began to reduce interest rates, thereby creating favorable conditions to real estate investment. For Zaki (2009), while the Fed's primary mission is to maintain price stability and the financial system, Alan Greenspan's policy has made the latter chronically unstable, favoring predatory practices in the credit industry and high-risk investment strategies, based on the use of financial leverage3. In the same view, Amaral (2009) points out that Greenspan's laxists monetary policies at the FED helped the speculative bubbles that contributed to the crisis. In fact, what happened was that, with low interest rates, demand for real estate grew, attracting buyers and inducing the demand for loans by many high-risk clients, with low-income, jobless or un-patronized customers, and sometimes with history of non-compliance with the financial system (the subprime customers). With the expansion of real estate, banks began to develop frantically new financial techniques (financial innovation), namely securitization of mortgage loans or securitization of assets that served as a form of financing. As Bessis (2010) points out, securitization was the main source of financing for banks, and not just a way of saving capital. In practice, the model consisted of the creation of credits that were later securitized (model originate and distribute). 1 Mortgage or subprime mortgage. Brasseul (2014), in a comparison of the financial crisis of world economic history, states that the recent financial crises have a new character, are more contagious (due to globalization) and more brutal. For example, the Asian crisis that broke out in Thailand in 1997 and extended to Russia led to a 20 percent fall in the GDP of the countries targeted and the subprime crisis that began in the United States in 2007, a global recession. 2 US Federal Reserve (Central Bank) chaired by economist Alan Greenspan in the period from 1987 to 2006. 3 For Neves et al. (2010), the financial leverage can generally be defined as the change in the return on equity caused by indebtedness. 100 125 150 175 200 225 250 S&P/Case-Shiller 10-City Composite Home Price Index Banking Risks: Lessons from the First Financial Crisis of the 21st Century *Corresponding Author: Marco Amaral 1 www.aijbm.com 54 | Page Table 1 - Chronology of major events Region Year Event B e fo r e C r is is USA 2001 Economy in recession compounded by the september 11ͭ ͪ. 2002 Stimulating the economy through the reduction of interest rates by the FED. 2003 Beginning of the real estate "boom" through the construction and purchase of houses. 2004 Investors, cheap and easy credit, securitization of credit and mortgages. 2005 Higher demand than real estate offers a sharp increase in prices. D u r in g t h e C r is is USA 2006 Rising interest rates by the FED creates a "bubble" real estate. USA / Europe 2007 In august, the subprime crisis erupted - default increased, liquidity declined and financial markets became suspicious of the global financial crisis; banks are redeemed. World 2008 The bankruptcy of Lehman Brothers comes to a close in september, followed by other entities that provoke the contagion effect - globalization of the economy. A ft e r C ri si s World 2009 Country governments bail out several banks and insurers. 2010 The financial crisis passes to the real economy - the sovereign crisis arises. 2011 Some countries need the external assistance provided by the IMF. 2012 Following the sovereign (economic) crisis comes a social crisis (people). Source: Own elaboration. For Loser (2009, apud Probohudono et al., 2013), the financial crisis of 2007 to 2009 represents the most serious slowdown that the world economy has experienced since the Great Depression. For the IMF (IMF, 2009), mid-2006 did trigger the beginning of the crisis, however, 2007 is considered the real year of the global financial crisis and 2008 is undoubtedly the worst year of the crisis. The year of 2009 is marked as the beginning year of recovery from the crisis (Graph 3). Graph 3 - Growth of the Gross Domestic Product (in percent, quarter to quarter changes, annualized). Source: IMF - International Monetary Fund, staff estimates, january 26, 2010. Banking Risks: Lessons from the First Financial Crisis of the 21st Century *Corresponding Author: Marco Amaral 1 www.aijbm.com 55 | Page II. BANKING RISKS Risk is an element that exists in all activities of our life. Solomon et al. (2000), encompass all risk types (financial and non-financial) faced by firms and consider that risk can be understood as uncertainty as to the amount of results associated with both earning potential and exposure to loss. The banking activity, by its specific nature, implies the exposure of the institution to several types of risks. For Peleias et al. (2007) taking risks is at the heart of the activities of a financial institution. In the banking context, risk is considered to be the probability of loss (Alcarva, 2011), that is, risk may be anything that impacts on the institution's capital value, which may arise from expected events or not. Thus, there are several types of risks that confront the banking business, as shown in Table 2. Table 2 - Types of risks in banking Types of Risks Subcategory Description F in a n ci a l R is k Credit Default Risk of an asset or loan becoming all or part irrecoverable in the event of default. Concentration Collateral Market Interest rate Risk associated with financial instruments transacted in own markets and/or for transactions in markets with low liquidity. Exchange rate Commodities Trading Real estate Liquidity Mismatches Lack of liquidity to meet commitments. Concentration N o n F in a n c ia l R is k Operational Fraud/Errors/Processes Risk associated with inadequate processes, people and information systems failures. Information technologies Safety/Environment Strategy Decisions/Business Changes in the market. Reputation Public image Negative image perception. Compliance Rules/Legal Breach of regulations. Country Political upheavals Risk of default of a state. Pension Fund Devaluation of the fund Contributions not foreseen. O th er R is k s Solvency Capital Inability to cover business losses. Contagion Asset Contamination of financial sector agents. Systemic Financial shock Propagate the entire financial sector. Source: Own elaboration. The various types of financial, non-financial and other risks inherent in banking activity are the main obstacles in the management of financial institutions, and their identification, control and mitigation are essential tasks for the continuity and growth of the banking business. Thus, financial institutions must carry out an efficient and balanced management of the risks associated with their activity. The type of bank risks can be distinguished according to their nature as follows: Financial risk: when the risk is directly related to the monetary assets and liabilities of the institution; Non-financial risk: when the risk arises from external circumstances (social, political or economic phenomena) or internal (human resources, technologies, procedures and others) to the institution; Banking Risks: Lessons from the First Financial Crisis of the 21st Century *Corresponding Author: Marco Amaral 1 www.aijbm.com 56 | Page Other risks: specific risk whose negative impact results in a strong imbalance for the entire financial system, whether at a country or worldwhile. As noted above, banks are subject to many risks that go beyond financial risk. However, the focus of this paper is on the approach to financial risks of banks, which was largely stimulated by industry regulators who defined the basic principles and rules to be applied to financial institutions. In this article particular importance is given to the financial, credit, market and liquidity risks. a. Credit Risk Pinho et al. (2011) point out that loans are one of the oldest financial activities, with the credit risk associated with the loss due to non-payment (or breach of contract) by the counterparty. The definition used by the author is consistent with the definition provided by Alcarva (2011), which corresponds to the risk that the counterparty in the financing will default on its obligation at a specific date. Still in the same line of thought, but taking into account the credit risk assessment, Caiado (1998) states that borrowers may not pay credit and interest rates, and it is therefore imperative to evaluate, with much prior to the granting of the loan, the conditions which must be laid down, including the provision of real or personal guarantees, and the sending of information on their situation and activity. For Bessis (2010) credit risk is the most important risk in the banking sector, and it meets the definitions of the previous authors, defining as the counterparty's risk of defaulting on the payment of its obligation. It also states that credit risk is divided into several risk components, of which the following are the most significant: Default risk5: is the risk of the borrower not complying with the debt service of a loan resulting from a default event, over a certain period of time. The author cites as examples, the delay in payment; the restructuring of an operation and the bankruptcy or liquidation of the debtor, which may result in a total or partial loss of the amount lent to the counterparty; Concentration risk: possibility of losses due to the concentration of large loans to a small number of borrowers and / or risk groups, or in few sectors of activity; Collateral impairment risk: it does not result in an immediate loss, but rather in the probability of a default event occurring due to the decrease in the quality of the collateral offered, caused by a devaluation of the collateral in the market, or by the disappearance of the assets by the borrower. The concepts used by these authors confirm the definitions disseminated by the international entities of banking regulation and accounting standardization. In this context, the Basel Committee on Banking Supervision - CSBB views credit risk as the possibility that the bank or counterparty borrower may not meet its obligations in accordance with the agreed terms (CSBB, 2000). The International Financial Reporting Standard - IFRS 7 - Financial Instruments: Disclosure of Information (IFRS 7, 2005) defines the risk that a participant of a financial instrument will not fulfill an obligation, thereby loss to the other participant. Credit risk is considered the main risk underlying banking activity, and its management consists in the execution of strategies to maximize results against the exposure of the risks assumed in the credit operations granted, always respecting the regulatory requirements of supervisors. b. Market Risk There is a diversity of market risk concepts by various authors. For Caiado et al. (2008) in the development of their activity, institutions are subject to market risks, both in the balance sheet and in off- balance sheet positions. For this author, market risk consists of the possibility of losses arising from adverse market conditions, such as changes in interest rates, exchange rates, stock market prices and commodities. Ameer (2009) and Othman and Ameer (2009) (apud Alves et al., 2013) identify market risk as the risk of loss resulting from adverse changes in market rates and prices, such as interest rates, exchange rates, commodity prices, or stock quotes. In this way, it can be said that market risk derives from potential losses on trading book or investments, due to changes in the economic and financial conditions of the market. In the approach to investment portfolios, Neves and Quelhas (2013) state that in the composition of a portfolio, this risk can not be completely eliminated through diversification, since market risk affects behavior of all the securities and, as well, of all the portfolios. 5 Each financial institution adopts its own concept of default event, and is usually related to the delay in payment of the obligation for periods of up to 90 days. Banking Risks: Lessons from the First Financial Crisis of the 21st Century *Corresponding Author: Marco Amaral 1 www.aijbm.com 59 | Page L iq u id it y R is k Cyprus (CY) 2013 Laiki Bank - Settlement of the country's second largest bank, with more than 100 years of history, as a result of the inability to reimburse state expenses in international markets. This generated a behavior of the customers through the run to the bank runs, aggravating its liquidity. The bank eventually had to be rescued by the Eurogroup, the International Monetary Fund (IMF), the European Central Bank (ECB) and the European Commission (EC). Source: Own elaboration. IV. CONCLUSION The recent global financial crisis has uncovered the huge regulatory and supervisory failures of the banking sector, inadequate risk management policies pursued by some financial institutions. As described throughout this article, the origin and development of the crisis resulted from multiple factors that must be understood, among which we highlight: i) the low interest rates that provided favorable credit situations (cheap and easy credit); ii) the excess liquidity in the market has had an effect on the real estate market, raising the prices of residential houses (real estate speculation); iii) the taking of risks by the banks in the classification of credits granted (the subprime clients); iv) the innovations of the financial markets that served as a form of bank financing (securitization of mortgage credits or securitization of assets); v) the sharp rise in interest rates in a short period of time led to credit default and the widespread fall in real estate prices; and vi) the stagnation of the US economy. As a consequence of the combination of these factors, the financial crisis broke out in mid- 2007 within the US financial system, implying the rescue of the first entities dedicated to the granting of high- risk mortgage credit. In september 2008, the bankruptcy of Lehman Brothers (Too Big To Fail) followed and other entities causing global contagion (globalization of the economy). Regulators and supervisors are launching an extensive package of measures to improve and enhance market transparency and financial system risks, as well as financial aid from the world's economies to avoid further weakening of the financial system. However, there is an enormous turbulence in the financial markets caused by the loss of confidence in the mechanisms of the financial system, and the world economy enters the period of deep recession (sovereign crisis), which has materialized in the world's biggest financial crisis since the Great Depression (1929). 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