How Mismanagement of Financial Risks by Banks Contributed to Subprime Mortgage Crisis - Research Paper Example

Running Header: Global Financial Crisis Student’s Name: Instructor’s Name: Course Code & Name: Date of Submission: Contents 2 Contents 2 Abstract 3 1.0 Introduction 4 2.0 Background 5 2.1 Global Financial Crisis 5 2.2 Financial Instruments 5 2.3 Basel Capital Accord 5 3.0 Discussions 5 3.1 Mismanagement of Financial Instruments and Global financial Crisis 5 3.11 Deterioration of credit standards 6 3.12 Derivatives and Credit –default swaps 7 3.13 Securitization funding 8 3.2 Risks that could have been prevented 9 3.21 Credit risk 9 3.3 Role of Basel Accord in contributing towards the subprime crisis 9 3.31. Capital requirements 10 3.32 Fair value accounting 10 3.33Credit Rating 11 4.0 Recommendations 11 5.0 Conclusions 12 References 13 Abstract Scholars and practitioners are interested in understanding the role of banks in subprime mortgage crisis and subsequent financial crisis. Interest in these studies developed after the global financial crisis of 2007/2008. That is why study of the role of banking institutions in global financial is of great importance. This report tries to understand and analyze how mismanagement of financial risks by banks contributed to subprime mortgage crisis. Firstly, the report reveals that the banks deteriorated their credit standards in order to make more profits. Additionally, loan securitization and lack of adequate rules in the derivative market made the banks to increase their credit risk. Moreover, the report notes that the banks could have controlled the credit risk. Finally, the report finds out that inadequate capital, use of fair value accounting and poor credit rating by Basel Accord contributed to the onset of the subprime crisis. 1.0 Introduction The growth in risky speculations and financial innovations as well as the increase in prices of assets and loans have been attributed to play an important role in global financial crises. Credit expansion by banks encourages firms to accumulate debt hence this makes them to increase their investment based on optimistic assessments of future profits. However, during economic recession occurrence, firms experience negative cash flows that result to incurrence of losses. Hence, they find it difficult to pay their debts leading to financial crisis (Fratiani and Marchionne 3). Andries emphasizes that the recent global financial crisis can be attributed to financial innovations by the banks as well as inability of institutions to pay their debts (151). Additionally, banks facilitate efficient transfer of financial crisis because of the fact that they act as financial intermediaries. Therefore, it is evident that banks contribute significantly towards global financial crisis. Therefore, the studies relating the role of banking institutions in global financial crises have gained increased attention. The purpose of this report is to explore the extent to which mismanagement of financial risks by banks contributed to global financial crisis. Moreover, the report will identify the aspects of risk management that the banks could have improved so as to prevent the crisis. Finally, the report will evaluate how the Basel Capital Accord contributed to the sub-prime crisis. 2.0 Background 2.1 Global Financial Crisis According Nato, global financial crisis involves widespread business contractions, decrease in government revenues and increase in unemployment. This in turn causes financial institutions to collapse and businesses to experience losses due to reduction in customer purchases. 2.2 Financial Instruments Financial instruments refer to any contracts that give rise to financial assets of one firm and financial liabilities or equity instruments of another firm (Subramani 2). They include; bank loans, bank overdrafts, investment in securities and various forms of derivatives. 2.3 Basel Capital Accord The Basel Capital Accord aims at strengthening financial institutions prudential framework by providing recommendations relating to capital requirements, regulation and supervision, liquidity management and risk management (Cornford 9). 3.0 Discussions 3.1 Mismanagement of Financial Instruments and Global financial Crisis 3.11 Deterioration of credit standards Poole states that the main cause of the submarine mortgage crisis was due to mismanagement of credit risk by banks (1). The growth in submarine mortgage volume made the banks to deteriorate their credit standards with an aim of earning more profits. Annual Growth of household debt and mortgages Source: (Fratiani & Marchionne 28) In 2001 to 2006, household debts increased tremendously due to increase in prices of morgages. People were anticipating that the prices of houses would increase. However, with the decline in prices of houses between 2007/2008 people failed to pay their mortgages loans leading to global financial crisis. Banks allowed homebuyers who had poor debt servicing record, inadequate income to service and inadequate assets to acquire submarine mortgages and this contributed to an increase in credit risk (Andries 151). The high lending rate contributed to excess home inventories however, the economic recession that began in 2007 made it difficult for individuals to service their loans. Fratianni and Marchionne state that the declining lending standards were accompanied by large default rates which in turn led to crisis in submarine mortgages (43). A majority of subprime borrowers were speculating increase in house prices in order to refinance their mortgage however, with the fall in price made them to delay or default their loan repayments. This in turn made many banks to collapse hence causing global financial crisis. 3.12 Derivatives and Credit –default swaps Moran notes that the derivative market operated in secrecy with no legal and public disclosure requirements (42). On the other hand, credit default swaps were allowed to grow with. According to Fratianni and Machionne, the banks relied heavily on credit rating of securities that was made by firms which were selling the swaps (17). This made them to use derivatives as a tool for taking excessive risks. Ciro states that the banks took large positions in credit derivatives without putting the appropriate hedges in place (77). Therefore, individuals failed to repay their loans and the banks were left with insufficient capital to provide them with security against the large credit risks that they had taken. Additionally, the subprime mortgage crisis was caused by the opaqueness and lack of regulation that existed in the derivative and credit swaps market (Moran 40). Lack of transparency in these markets made it difficult for regulators to assess the amount of risk as well as to determine whether valuations had been conducted effectively. Mortgage related securities and credit default swaps were valued using financial models that could not predict risks in the financial systems hence they underestimated the risks that were involved. Moreover, the banks packaged and repackaged the derivatives such that it became difficult to determine the real value of these securities (Vonea & Anton 140). However, due to bad loans banks that were exposed to securities backed by mortgage or by credit derivatives were forced to lower their values and this contributed to subprime mortgage crisis. 3.13 Securitization funding Moran states that banks innovations enabled them to sell mortgage payments and the credit risk involved to investors through secularization (32). This motivated the banks to expand their loans hence increase their lending rates. Additionally, securitization investors are able to transfer the risk that originated from mortgage lenders by selling the loans to banking institutions. According to Andries, the ability to securitize loans made the investors to increase their demand for submarine mortgage loans in order to generate mortgages that were backed by securities.(154) However, the banks were unable to sell all the mortgages that were backed by securities. This meant that they were left holding them in their books. Therefore, the original owners began to default their loans and the values of the mortgages began to decline leading to the banks to fall. 3.2 Risks that could have been prevented 3.21 Credit risk According to Fratiani and Machionne, the credit boom motivated banks to lower their lending standards (5). This means that the banks could have avoided the credit risk by maintaining their lending standards. Voinea and Anton state that banks extended their loans to customers who had poor credit rating or who had insufficient assets (142). Therefore, there was a possibility that majority of debtors could not repay their mortgage instalments as well as their interest rates. The banks could have avoided the credit risk by adhering to the set standards. By improving their credit standards the banks could have minimized the possibility of borrowers failing to repay their loans. 3.3 Role of Basel Accord in contributing towards the subprime crisis 3.31. Capital requirements Nanto state that the capital that banks are required to maintain by the Basel Accord is inadequate (3). Basel Accord requires banks to maintain capital which is equal to 8% of assets which is risk weighted. Under the accord, risk weighting should be calculated on external basis ratings which are to be produced by independent agencies involved in credit rating. Grossman notes that the accord allows banks with sufficient amount of resources to develop their own models for credit risk rating (287). However, the fact that rating agencies are subject to conflict of interest because they are paid to make the ratings meant that they allowed the banks to maintain inadequate capital by giving them a high rating. The low capital made the banks to collapse easily after the failure of the borrowers to pay their loans hence this led to the subprime crisis. Additionally, risk weights were generated by the banks and this meant that they could easily manipulate them. This in turn enabled them to operate with inadequate capital. 3.32 Fair value accounting Basel Accord requires banks to use fair value accounting and this made them to increase their risks (Nanto 3). Fair value accounting requires financial institutions to calculate unrealized gains or losses in relation to their trading securities and this is due to the fact that these items affect the capital of banks. Fratianni and Marchionne notes that the banks were able to move assets that belonged to the trading securities category into held to maturity (12). This made the banks to appear as if they had adequate capital. Moreover, using fair value accounting it is difficult to ascertain the accurate value in relation to the assets held by a firm due to lack of information. Therefore, the banks were able to use the method in order to overvalue their assets and this made them to appear financially stable. However, the banks were unable to cope with the high loans default rate because they had insufficient resources and this made them to collapse hence causing global financial crisis. 3.33Credit Rating Nanto note the Basel model requires the banks to use non-banking institutions in order to assess credit risk (3). Non-banking institutions played a dominant role in determining credit worthiness of institutions. The agencies placed a high rating on securitized investments and this was particularly influenced by conflict of interest (Cornford 12). Therefore, the banks were forced to extend credit to institutions which could not service their loans due to misleading ratings. Moreover, they were forced to buy overvalued securitized investments. This in turn contributed significantly towards the subprime financial crisis. 4.0 Recommendations The onset of subprime mortgage crisis and subsequent global crisis can be greatly attributed to poor banking regulatory and supervision policies. Therefore, there is essential to come up with strict rules to govern banking institutions in order to prevent reoccurrence of similar crises. Banks should be adversely monitored in order to ensure that they do not lower their credit standards. Moreover, the Basel accord should be reformed so as to manage the risk associated with credit rating and capital requirements. Finally, more regulations should be implemented in order to control the derivative market and ensure that it becomes more transparent. This will assist in ensuring that assets and liabilities are valued accurately. 5.0 Conclusions In conclusion, deterioration in credit standards made the banks to extend their loans to individuals who had poor debt records. However, with the reduction in value of houses, the individuals delayed or failed to repay their loans and this made the banks to incur huge losses making them to collapse. Banks could have avoided this risk by observing the required standards while offering loans. Additionally, loan securitization and inadequate regulations in the derivative market are other factors that have been attributed to cause the subprime mortgage crisis. Finally, the Basel Accord contributed to the subprime crisis through its inadequate capital requirements, poor credit ratings techniques and use of fair value accounting. References Andries, Alin. Role of Banks in Financial Crisis. Journal of Finance, 7.1(2008): 150-158. Ciro, T. Global Financial Crisis. London: Ashgate Publishing, 2012. Cornford, Andrew. Basel: The Impact of the Financial Crisis Implications. United Nations, 59.1(2010): 1-20. Moran, Eamonn. Wall Street Meets Main Street: Understanding the Financial Crisis. Banking and Finance, 3.1 (2011): 66-90. Frantianni, Michele & Marchionne, Francesco. The Role of Banks in Subprime Financial Crisis. Money & Finance, 23.1(2009): 1-38. Nanto, D. The Global Financial Crisis: Analytical and Policy Implications. Congressional Research Service, 7.1(2009): 1-30. Poole, William. Fundamentals of the Financial Crisis: Mismanaging Risk. Risk and Finance, 1.1(2008): 1-12. Prager, Jones. The Financial Crisis of 2007/20098: Bank Mismanagement. Finance and Economics Studies, 1.1(2011): 1-44. Sabramani, Venkata. Accounting for Investments. Hoboken: John Wiley & Sons, 2011. Voinea, Gheorghe & Anton, Sorin. Lessons from the Current Financial Crisis: A Risk Management Approach. Risk and Management, 5.1( 2009): 140-146. Read More