Role of Financial Engineering in Organisations, Link between Operational, Credit, and Systemic Risks - Essay Example

Running Header: Risk Management Your name: Course name: Professors’ name: Date Introduction In the recent past, the Global Financial Crisis (GFC) has escalated and most significant sectors have been adversely impacted. Risk management systems are established to deal with cases of GFC in brand organisations. The events that lead to GFC have been qualified as a series of bad investment decisions made by brand organisations. The bad investments lead to sub-prime mortgages that caused liquidity crisis in the US. Poor decision making drained confidence in investment ventures and the federal Band of US channelled a large amount of capital into the financial markets. Consumer confidence went down the drain and the stock markets across the globe declined leading to global credit crisis. The cycle of events that triggered the global financial crisis were propelled by poor risk management models. The ISO31000:2009 risk management model was established to standardise approach to risks allowing companies to attain resilience. Risk management is an integral element of an organisation and should comply with the recommended global standards. Role of financial engineering in brand organisations For organisation brands such as Lehman Brothers, Bear Stearns and Meryl Lunch did not survive the global crisis (Steinberg, 2011). AIG was nationalised to rescue it from going under the rocks. The organisations had effective risk management systems but, failed to maintain their operations because of the credit crunch that struck major companies across the globe (Crotty, 2009). Financial engineering played a vital role in the risk management of the companies in terms of collateralised debt products. Contracts of difference and other derivative types considered essential to salvage the companies were employed during the crisis. The derivates types were used before the global standard risk management was established. These elements include contract of difference and collateralised debt products that organisations employ to deal with financial risks. The contract of difference risk management strategy works to settle financial risks through cash payments as opposed to securities or physical goods. For the Lehman Brothers, Bear Stearns and Meryl Lunch organisations, the plan failed to work and the companies were rendered bankrupt. They fell out of business because of the credit crunch that their plan had created (Crotty, 2009). The organisations managed to pay their investors their accrued liabilities in terms of risks. The global credit crunch promoted their downfall since the financial markets had declined. Since the value of the organisations had dropped investors pulled out and the organisations succumbed to the global financial crisis. The liquidity of the organisations could not hold leading to their dissolution. Collateralised debt products such as loans, mortgages and bonds of an organisation were used by Lehman Brothers, Bear Stearns and Meryl Lunch organisations during the GFB. The organisations pulled together all their cash-flow generating assets to offset their financial responsibilities (Steinberg, 2011). The debts were overwritten to settle their investors who lost money through shares. The credit crunch prompted the move and the organisations were obligated to respond to the financial situation that had befallen them. The AIG Company was crippled financially for using collateralised debt products as guarantees. The housing market fell and the company was bankrupt. The company became nationalised by the US government to salvage its financial problem and keep at float during the GFB (Pupke, 2008). 1. Initially derivative products were a risk management device, so what happened? Derivative products were considered risk management industries before the global financial crisis. The derivatives differ from one industry to another. Derivatives are essentially variables that rely on cash-flow generating assets to settle credits. The traditional perception of derivatives is that they allow a company to hedge against instability in cash flow and profits made. The concept is factual and has been used for a long timeframe to manage risks in most industries (Pupke, 2008). However, the derivatives are being wiped out because of their potency for generating further risks for a company. To understand the disadvantages of using derivates as risk management tools the derivates are explored one by one. One is foreign exchange rate; the banking industry is the main foreign exchange avenue. Using the exchange rates for risk management poses a risk to customers since the currencies fluctuate (Crotty, 2009). There are two risks that arise from this derivative. The transactional risk involves is transferred to the customer during transactions. Translational risks arise from the translation of assets held by the bank. The risks are promoted by assets or liabilities own by a bank in foreign currencies. Since stability of foreign currencies is unpredictable, the earnings and capital of are risked in case of global financial problems. During a financial crisis where the currency drops in value, the bank is unable to retain its assets or settle its liabilities (Stulz, 2003). The move promotes the institution to declare bankruptcy. Therefore, exchange rates are not advisable tools for risk management. Secondly, another reason for sidelining derivatives as risk management tools is the issue of interest rate. Interest rates are prone to fluctuations and influence from both internal and external factors of a bank (Crotty, 2009). The changes lead to loss which weighs heavily on the profitability and market value of equity. In cases of financial risk the bank is unable to insulate itself against bankruptcy. The third reason for discarding the derivative risk management approach is explored in the light of security lending. Security lending is a situation where investors give out their bonds and stocks to other market participants. Most of the investors are institutional investors that include mutual fund, pension funds and, exchange-trade funds. The derivative is discouraged for risk management because borrowers may fail to meet margin calls for the borrowed securities (Stulz, 2003). The borrower in this situation is unable to repay the security. Institutional investors lose their securities that valued in monetary terms. The lending process is not centralised thus; transparency of the deal is uncertain. Such opaque arrangements prompt fraud that leads to financial risk for the investors. Lastly, derivatives were outfaced because of the price derivative in the market. Most prices are set within the different financial markets (Stulz, 2003). There is no global standardization of the prices exposing vulnerable companies to the surge in market. The derivative is not appropriate to be as an instrument in risk management. Businesses that are commencing operation in the industry are struggled in their infant stages by the prices of commodities that demand high costs of production (Crotty, 2009). During the global financial crisis the companies are unable to retain their relevance in the market thus; they collapse such as in the case of Lehman Brothers, Bear Stearns and, Meryl Lunch organisations. The price risk derivative affects companies or industries that not well established or with a small market coverage. When the global financial crisis hit the world such companies had no place to fall back to financially hence; they were pushed out of the system. Financial risks cannot be tackled from a price risk point of view since there are different companies in a given industry: Established and upcoming companies 2. The interconnectivity between operational risk, credit risk and systemic risk An organisation experiences different risks depending on the industry they operate in as a business. The AIG faced three major risks that brought it to its knees before the US government stepped in to save the situation. The three risks are interconnected in several ways. The risks include system, credit and, operational risks. Focus is given to the risks because they contributed to the liquidity of major industries. AIG had to be nationalised to keep it running after the global financial crisis of 2007-2008. The connection between the three risks helps financial risk managers to establish a standard approach of dealing with the risks. The standard risk management procedures recommended for all organisations are stipulated in ISO31000:2009 risk model (Steinberg, 2011). Identifying each risk individually allows an individual to understand the interconnectivity of the risks. The connection between operational, credit and systematic risk is part of the risk management system in which the risks are analysed Systematic risk is described as a risk fostered by external factors of an institution. The factors are usually beyond an organisations control. The risk is macro and influences all organisations under the same umbrella. In the case of AIG, the insurance companies were all affected. Systematic risk may follow a sequence where the risk recurs after a regular period hence; the name systematic (Steinberg, 2011). Under systematic risk there are several minor risks among them, credit or financial risk. The risk is triggered by change in capital outlook of an organisation. The capital may be structured in three different ways. Owned, borrowed or retained earnings. Credit risks entail exchange rate, recovery rate, and credit event, non-directional and, settlement risks in an organisation. The final risk is categorised under unsystematic risks that are triggered by factors within an organisation (Steinberg, 2011). The factors are micro and can be controlled from within the company. The risk is referred to as operational risk and it is described as human error risks that are likely to cause the downfall of an organisation. The risk is not consistent in the industry and varies from one organisation to another. It is propelled by breakdown of internal factors such as people, policies, systems and internal procedures. The risk is explored under four sub-titles that include model, people, legal and, political risks. The interconnectivity of the three risks can be evaluated on the basis of internal and external factors of an organisation. Considering internal factors, the risks are linked through factors such as model and people. The model aspect of connectivity is where the risks are designed to influence the operations of a company (Steinberg, 2011). Regardless of being macro or micro, the risks are intertwined since the adversely impact on an organisation and the industry at large. People interconnect the three risks such that the operational mistake done in one organisation affected the industry. Failure to adhere to procedures of risk management stipulated in recommended guides leads to negative repercussions in the industry. The risks are interconnected where the credit risk is under the umbrella of systematic risk. Credit risks become macro risks since they are under a macro risk. The macro risks are propelled by micro risks that include operational risks. In cases where human error overlooks or exaggerates an event, the systematic and credit risks are affected (Stulz, 2003). The connection of the three risks is centred on the operational risks since they are internal factors of the organisation. What happens to the organisation from an internal point of view is transferred to the industry. The internal procedures and systems of a company influence the overall outlook of the industry. The three aspects owned fund, borrowed fund and, retained earnings of systematic risk affect the credit event and legal risk of credit and operational risks respectively. What happens in the microenvironment affects the macroenvironment and vice versa. 3. The role of Governance and non-regulatory compliance in risk models The new global standard risk management system advocates for compliance from all organisations to create an environment that is immune to bad investment decisions. Risk models are dived into several sub-titles to simplify the detailed system of risk management. Governance and non-regulatory compliance models are among other risk models to be considered. The two models are globally recognised under the ISO31000:2009 risk management principles and guidelines (Ghosh, 2012). Governance is predominantly used in operating model of an organisation. The model views governance as a tool that an organisation uses to locate loopholes that could cause risks for the organisation. The mechanism and interface between boards and management of allows the organisation to improve its governance incentives. Non-regulatory compliance in risk models entails concentration on internal approaches to manage risks (Stulz, 2003). The concept requires that selected members of the organisation are fed the knowledge on current affair regarding risk management in the organisation. The ideology differs from governance since governance allows knowledge of the issues within the organisation to be shared among heads of departments an organisation. Governance risk models are mandated with the role of organising key aspects of an organisation. These aspects are financial, risk management, operational and, sufficient flow of information. The governance of a company complies with strategies and plan of risk management in order to bridge the ridge between governance plans and operational realities of an organisation (Ghosh, 2012). The governance compliance model of risk management also functions as an informer of the organisation’s board. The model provides defined decisions and action plans of dealing with risks. The decisions and actions implemented are confirmed by the board before they are executed. The regular flow of information from governance to management allows the organisation to identify likelihood of risks and act before the organisation is affected. The model allows the organisation to meet its compliance objectives in risk management (Stulz, 2003). The plan helps the clients and other relevant persons gain cushioning against potential financial risks such as the 2007-2008 financial crisis. The consistency and effectiveness of an organisation’s response to challenges is enhanced via the model. Non-regulatory compliance risk model is not bound by existing external laws. The organisation solely defines their risk management framework and implementation. The model is not influenced by what happens in the industry that the organisation operates. Following the global financial crisis, revoking the model is being deliberated upon since most organisations were failed by the model (Ghosh, 2012). The role of the model is to ensure that the organisation maintains control over their risk management system. The management of an organisation is able to make decisions without consulting external persons. The model also plays an integral function in maintaining an elaborate system that governs internal procedures. Risks such as unprofessionalism under the operational docket are handled under this model. 4. What role will ISO31000:2009 play, if any, as the new global standard for risk management, in creating an environment of resilience in the global economy The global financial crisis that hit the world in 2007 through to 2008 promoted innovation in risk management to ensure that major economic boosters are insulated. The economic performance, professionalism and environmental impacts of the GFB are still felt to date. The new global standard risk management helps to create a resilient global economy that is not susceptible to economic veer (Friedman & Kraus, 2011). Managing risks on a standard scale eliminates possibility of financial damage in case the economy fails. The main purpose of the new standard of risk management is to expand, execute and regularly enhance the risk management outlook. The global standard approach to risk management has several advantages that organisations across the world stand to enjoy. The risks are identified based on impact of ambiguity on objectives of an organisation. The new approach makes the principles of risk management explicit to encourage transparency. The risk management outlook is flexible and can be adjusted to suit the current affairs of risk approach in organisations. Since the management outfit is standard, all organisations under the ISO31000:2009 description is allowed to integrate their management skills with the global risk management outline. The ISO31000:2009 as a new risk management framework has several roles that are explained in a systematic manner considering the detailed procedures of risk management. One of the roles that the new management observes is mandate and commitment. Through this framework, the new risk management allows organisations to develop a program that focuses on identifying, alleviating and eradicating a risk within the business (Stulz, 2003). The segment gives persons in charge an understanding of the support of senior management since it approves the set guidelines for risk management. The next segment is designing a framework for handling risks. The role is vital for the organisations since they are legally bound to uphold the framework stipulated. The internal and external risks of an organisation are considered (Friedman & Kraus, 2011). The system develops a policy that determines a risk management function. Resources required to implement the recommended risk management plan are brought together. The designed framework creates an internal and external feedback channel that allows prominent people in the organisation to have knowledge of the results obtained. Another role of the ISO31000:2009 standard risk management is implementation of the risk management framework. The program is used to benchmark a risk management set-up against its standard provisions. The new global risk management program is a fundamental for all organisations to evaluate the implementation potency of the risk management programs in line with the recommended approach (Friedman & Kraus, 2011). The new risk management plan monitors and reviews frameworks of an organisation in terms of risk management. The plan focuses on essentials such as macro and micro audits of the organisation’s risk management program. The audits are used to evaluate and justify the risk management plan for an organisation. The new approach to risk management considers all aspects of effective and logical risk management. The reviews eliminate cases of operational risk in an organisation. Continued enhancement of the framework is also the role of the new global standard risk management approach (Ghosh, 2012). The ISO31000:2009 allows changes on risk management approach to be implemented to cater for the different industries across the globe. The flexible aspect of the system is vital for the current economic environment that is uncertain. Conclusion In summary, risk management in organisations is an integral factor that should be looked into as part of management of the organisation. Global financial crisis is attributed to poor handling of investments that is probably caused by lack of effective risk management plans. Derivative type products are sidelined as risk management tools because they tend to give uncertain methods of dealing with financial risks. The interconnectivity of systematic, credit and, operational risks affect an organisation and the industry in which it operates. The risks entail macro and micro contracts that influence the framework of an organisation. Global financial crisis was influenced by the three risks to cause a credit crunch that lead to liquidity risk. The models of risk management depend on the preference of an organisation. Governance and non-regulatory models are prominently used in most organisations to combat risks. The new global standard risk management framework; ISO31000:2009 seeks to enhance transparency and efficiency in risk management globally. The approach is flexible and can be integrated in all organisations around the world. References Crotty, J. (2009). Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture’. Cambridge Journal of Economics. 33(4).pp.563-580 Friedman, J., & Kraus, W. (2011). Engineering the financial crisis: Systemic risk and the failure of regulation. Philadelphia: University of Pennsylvania Press. Ghosh, A. (2012). Managing risks in commercial and retail banking. Singapore: John Wiley & Sons. Irwin N. (2014). Financial crisis. Journal of Economics and Sustainable Development. 5(8).pp.12-13 Stulz, R. M. (2003). Risk management & derivatives. Mason, Ohio: South-Western/Thomson. Steinberg, R. (2011). Governance, risk management, and compliance: It can't happen to us— avoiding corporate disaster while driving success. Hoboken, N.J: Wiley. Pupke, D. (2008). Compliance and corporate performance; the impact of compliance coordination on corporate performance. Norderstedt: Books on Demand GmbH. Read More