LPHI Risks and Disaster Myopia - Assignment Example

LPHI risks and disaster myopia BY [Name of the organization] [Author’s name] [Date of fulfillment] Acknowledgments Abstract The central theme of this paper is related to the multi-dimensional problem of Northern Rock. The paper tries to speculate the complex set of inter-related problems of this financial institution and thereby analysing all kinds of solution that can be derived from it. The focus is on the persuasion of liquidity management and the analysis of subject to more rigorous stress tests in reference to the banking context. In this particular paper the understanding of crisis has been sorted out by a comprehensive analysis of the problems faced by Northern Rock. The attempt is to derive certain solution for futuristic application. Table of Contents Acknowledgments Abstract Table of Contents The List of Tables Executive Summary introduction Conclusion References Bibliography The List of Tables Fig. 1 Spreads of international three-month interbank rates to three-month expected policy rates Fig. 2 An integral conceptual model Executive Summary The target of this paper is to lay emphasis over the comment "LPHI risks tend to induce disaster myopia so that such risks are discounted altogether and the probability is assumed to be zero." I am trying to check this particular comment in reference to the Northern Rock. The context has been sorted out from David T. Llewellyn, ‘The Northern Rock crisis: a multi-dimensional problem waiting to happen’, as published in Journal of Financial Regulation and Compliance, in the year 2008. This paper is the understanding of the scenario as taken place in Northern Rock and the derivative solutions related to it. The purpose of the paper is to elaborate the need of greater transparency in financial instruments and the application of regard to banks’ risk exposures including their off-balance-sheet vehicles introduction The incident related to the Northern rock is an absolute condition that needs to be studied for the purpose of risk management. It is in its own way one of the major incidences related to bank crises. The purpose of this paper is to make the assessment of multi-dimensional nature of the whole episode. The perception that holds is that NR always opted for a significant business model (Schwartz, Barry; 1990). The structure was all led through originate-and-distribute methodologies. Unlike many banks NR never scrutinise its assets at the margin. The securitisation is always relied on short-term market funding. The basic ingredient that made this bank one of those particular financial institution is its strategic outcome related to the low-probability-high-impact (LPHI) risk. As a consequence the bank was totally dependent over the short-term funding. On the contrary the liquidity in the markets was unpredictable. There were chances that it gets evaporated suddenly on a large-scale. This is what is considered as the nature of LPHI risk and this paper is making an evaluation of this nature and its impact over the financial set up. Northern Rock incident has demonstrated that a liquidity crisis even hit a bank that funds itself through long-term funds. That brings home the point that static liquidity measures such as gap analysis and analysis of average maturities are not sufficient in modern banking. The average life of Northern Rock’s mortgage assets was only three years and one month because borrowers refinance their mortgages much earlier than their stated maturities. Must laws change Given this scenario it becomes essential to assess the risk of insolvency of financial institutions. Domestic insolvency laws or regulatiions may be immediately challenged when a large part or most of the domestic financial sector appears to be under a insolvency threat. Consequentlt there must be a proper framework or law in place that deals wuth such insolvencies and enables the institutiions to handle a major financial crisis. Definitely law msut change. Insolvencu legislatiion has recently undergone a number of changes in EU and countries like Japan, India, Switzerland, Thailand and United Kingdom Further revisions are needed. Weakness in liquidity insolvency crisis management Employing crisis management may be contrary to the popular belief that problems will be solved at a single stroke or or in a jiffy by a last-ditch effort. This is partly matter-of-the-fact and partly due to the fact the there are, more often than not, inherent ses in crisis management itself. Analysts believe that crisis management is itself a three-dimensional problem, which needs to simultaneously address issues as: • strategic and operating problems; • the political problem that arise from implementing deicisions among often conflicting yet interested parties; • the organizational structure necessary to overcome the crisis. HM Treasury (2007), states that there is no denial to the fact that the business model was successful for a small span of duration. The LPHI risk emerged in global financial turbulence. Its chief focus was on SPM lending in the USA. NR had no part in it and thus claimed that it is the victim of this turbulence without any reason. According to McGregor D. (1960), the applied strategy of the bank landed it up with the risk initiated by LPHI. This is the risk that is very much associated with a state of drying-up of liquidity (Goodhart, C.A.E. 2007). This was very much an unbalanced part of the London financial markets and several fault-lines came up on the part of NR. Healey, J. (2001), discovers that the process of implementation of securitisation by NR with over-reliance on short-term market instruments was not validated well. Subsequently the management of LPHI risks in banks were handled and the effect was directly proportionate to the deposit protection regime in the UK. All kinds of money market operations of the Bank of England and the local institutional financial regulation and supervision structure were all scrutinised (Korsgaard, C. 1996). There were rapid dominance of the rapid corporate governance arrangements and the role of the government turned up to be crucial in reference to the response to financial market distress. (Goodpaster, Kenneth E; 1991, pp. 54-73) declared that the actual hurdle as has been faced by NR was a business model that exposed itself to the consequences related to LPHI risk. As a result to this consequence the supervisors of the bank never considered this feature of the bank’s strategy with enough severity (Berg, Per Ol). There is however instances that the Financial Services Authority (FSA, 2007) and the Bank of England came up with general warnings about the liquidity risk. Liquidity of the Crisis DeGeorge, Richard T. (1990), discussed exclusively about the crisis faced by Northern Rock and declared that it is not a solvency issue it is rather liquid in character. The analysis been discovered as per the British Bankers Association (2007). The suggestions are that if someone has comparatively a bigger amount of money in one of its accounts then it’s recommended to check whether he can have a better rate in some other bank. Northern Rock discloses that it "cannot gaze into a crystal ball" on what the prospect may get, and that the Bank of England's solution is a short-term appraisal. Lenders such as Paragon, Alliance & Leicester and the Bradford & Bingley have all denied that they have any trouble with this particular liquid condition of the bank (Ferrell, O.C., & John Fraedrich, 1991). However it is very improbable that there will be a full-blown banking crisis - the FSA, the Bank of England and the Government will do everything in their powers to prevent such a catastrophic occasion from ever getting phenomenon. These are basically labelled as "action-based" and "agent-based" approaches. In such cases the former tends to highlight on moral rules that can be normally functional to indentured situations (e.g. Kantianism and utilitarianism). On the other hand, virtue ethics concerns the aspirations of the agent, and thereby the agent's ability to exercise the moral 'virtues'(MacIntyre, 1988, p. 137). Thus rather than being some peripheral adjunct or constriction on a substance-based consistency perception, this come within reach of places morality of a business strategy. Fig. 1 Spreads of international three-month interbank rates to three-month expected policy rates The effect is bigger than ever expected. The implications of the critical situation of credit of Northern Rock's problems are being felt across the mortgage market too. The costs of new mortgages and personal loans are likely to continue to rise. This is where we see the conflict between the theory of Adam Smith and Keynesian Ethical theories. In a way even those people will get affected who doesn’t have an account in Northern Rock (Milbank, D. 1996). As it has been seen that several lenders, including Abbey and Halifax, raised rates on their new variable-rate of mortgages; it is clearly affecting all the people who ever thought that they will not be facing any problem for the Northern Rock crisis. The affect is also on the property-buyers and those who were about to remortgage their capital. Risk matrix: LPHI risks In the words of Lacziniak, Gene R. (1983), risk analysis gets the saturation through the consequences related to probability of an event that keeps on occurring and consequently the impact takes place. LPHI risks are very hard to manage, and when it gets into the banking crises it occurs at a very high proportion. The gets into the periphery of it and continues to function in the area of the matrix. The LPHI risks are more characteristically structured to induce disaster myopia. It is the instance where low-probability risks get discounted. As a matter of fact the whole behaviour is absolutely under the presupposition of the probability that turns up to be zero. These are difficult risks have no realistic price for them. The consequences were such that suppliers got disinclined to provide a product if it is not known if and when payment will be received. The involvement of Corporate Social Responsibility (CSR) in the new-fangled economy has come to be recognized as one of the major components of business growth and protractability. The disputes necessitate business and their managers to think afar conventional way of looking for short-term goals. It needs business and the people within these behemoths to grip a much broader standpoint that is also comprehensive of stakeholders. It should remain in the public domain for a longer time, for better functionality at the business end. The matter of concern is that the crisis of Northern Rock needs to be sorted as fast as possible and that the issue should go international. Though it seems that these types of crisis are rare, yet from business ethical point of view they should be a matter of much concern. Fig. 2 An integral conceptual model As the functionality gets into the process of pricing a risk of the bank to ultimate destruction the only realistic option that remains is to limit the bank’s exposure to such risks. The contributions led by FSA (2007) with full proof methodology in its risk-based approach get initiated for the supervision of the subject in assessment to same disaster myopia that consequently leads to LPHI risks. Goodhart, C.A.E., Hartmann, P., Llewellyn, D., Rojas-Suarez, L. and Leisured, S. (1999), made the assessment related to the detection of LPHI risk in the bank’s ground and behaviour. It has come up with no obvious problem in the initial proceedings. As in case of NR’s highly business strategy; it is very much high and unusual depended on securitisation and short-term wholesale market (David T. Llewellyn, 1988 pp. 35 - 58) the purpose gets the funding that is very much exposed to the affects related to the dynamic LPHI risk. Oosterloo, S. and de Haan, J. (2003), are of the idea that the most strategicdownfall comes in with the drying up of liquidity. This is something that happens in relation to the relevant London and international financial markets (Carmichael, J., Fleming, A. and Llewellyn, D.T. 2004). As such risks get preceded the financial scenario turns into low-probability event. The impact of LPHI risks is always severe and there is no coming out of it. the consequence gets initiated when the generalised warnings about liquidity risks made by the financial bureaucrats are ignored and the supervisors of the financial institution did not take precaution or action against it (Llewellyn, D.T. 2004). This is something that exactly was the scene with NR. As a result the derivations from NR suggest that there is every possibility of having the consequence of disaster myopia. Conclusion Eventually the derivations are very predominant and the consequences show that the UK’s crisis management arrangements are under the pressure of getting the ultimate refinement. These reforms must be done with a prolific attention over the issue related to the insolvency arrangements of banks. The consequences are well faced by NR and that is the best example to be analysed for the same. As for the deposit protection arrangements needed there is the need of severe credibility and that makes FSA and Bank of England more responsible. All kinds of situation that is related to LPHI risks need to be scrutinised more and considered and managed more professionally with all kinds of upgradations. O'Brien, D. (2001), Sveiby, K.E. (2001) states that the responsibility needs to be shared with an absolute participation made by the Bank of England. As its money market operations gets re-visited and all kinds of implications are needed for individual financial institutions (Bagehot, W. 1873). Pricing of risk in the sequence of Governance arrangements within the periphery of banks must have the explicit speculation related to the board in the act of monitoring the risk models. Northern Rock used an aggressive business model and proverbially pushed it to the wall, waited with a baited breath, and just joped that liquidity would always be there. The danger that was lurking couldn’t be spoted by FSA, and that was lesson one i.e. what meets the eye is necessarily not what would meet the truth.. The Bank of England failed to reassure its depositors when everything seemed well under control but reassured them too much when control was lost. That was lesson two i.e., never shy away from the reality but if you have stay composed and take proper damage-control measures. References Bagehot, W. (1873), Lombard Street: A Description of the Money Market, Henry S King, London. Bank of England (2007a), “Turmoil in financial markets: what can central banks do?”, Evidence to House of Commons Treasury Committee, Bank of England, London. Bank of England (2007b) Financial Stability Report, Bank of England, London. Berg, Per Ol of Magic in Action: Strategic management in a New Economy. British Bankers Association (2007), The Credit Crunch: Implications and Changes Required, British Bankers Association, London. Carmichael, J., Fleming, A. and Llewellyn, D.T. (2004), Aligning Financial Supervisory Structures with Country Needs, World Bank Institute, Washington, DC. David T. Llewellyn, The Northern Rock crisis: a multi-dimensional problem waiting to happen, Journal of Financial Regulation and Compliance, 2008, 16: 1 pp. 35 - 58, ISSN: 1358-1988 DeGeorge, Richard T.; 1990, Business Ethics 3d ed. (Macmillan, New York). Ferrell, O.C., & John Fraedrich, (1991). Business Ethics: Ethical Decision Making and Cases (Boston, MA). FSA (2007), Evidence on Northern Rock to the House of Commons Treasury Committee, Financial Services Authority, London. Goodhart, C.A.E. (2007), “Liquidity risk management”, Financial Markets Group, London School of Economics, London. Goodhart, C.A.E., Hartmann, P., Llewellyn, D., Rojas-Suarez, L. and Leisured, S. (1999), Financial Regulation: Why, How and Where Now?, Routledge, London. Goodpaster, Kenneth E; 1991 "Business Ethics and Stakeholder Analysis" Business Ethics Quarterly 1:54-73 Healey, J. (2001), “Financial stability and the central bank: international evidence”, in Brealey, R. (Ed.), Financial Stability and Central Banks, Routledge, London. HM Treasury (2007), Banking Reform-Protecting Depositors: A Discussion Paper, HM Treasury, London. Kant, I. 1994: The metaphysics of moral; The metaphysical principles of virtue (1797). In I. Kant Ethical Philosophy 2nd edn, Trans. by James W. Ellington. Indianapolis/Cambridge, MA: Hackett Publishing Company. Korsgaard, C. 1996: Creating the Kingdom of Ends. New York: Cambridge University Press. Lacziniak, Gene R. (1983). "Framework for Analyzing Marketing Ethics." Journal of Macromarketing, 1, 7-18. Llewellyn, D.T. (2004), “Institutional structure of financial regulation ad supervision: the basic issues”, in Carmichael, J., Fleming, A. and Llewellyn, D. (Eds), Aligning Financial Supervisory Structures with Country Needs, Chapter 2, World Bank Institute, Washington, DC. MacIntyre, Alasdair 1988, Whose Justice? Which Rationality? University of Notre Dame Press, Notre Dame McGregor D. 1960: The Human Side of Enterprise. New York: McGraw Hill Book Company. Milbank, D. 1996: Hiring welfare people, hotel chain finds, is tough but rewarding. The Wall Street Journal. October 31. O'Brien, D. (2001), Sveiby, K.E. (2001) Integrating Corporate Social Responsibility with Competitive Strategy. 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