The Global Financial Crisis 2007/2008 and Financial Risk Management

Introduction

After the global financial crisis of 2007/2008, it was elaborated what were the real issues involved at that time specifically considering Financial Risk Management. Some related work to this elaboration is presented below.

Amadeo (2018) reported that generally the financial crisis was primarily caused by deregulation in the financial industry. That permitted banks to engage in hedge fund trading with derivatives. Banks then demanded more mortgages to support the profitable sale of these derivatives. They created interest-only loans that became affordable to subprime borrowers. In 2004, the Federal Reserve raised the fed funds rate just as the interest rates on these new mortgages reset. Housing prices started falling as supply outpaced demand. That trapped homeowners who couldn't afford the payments but couldn't sell their house. When the values of the derivatives crumbled, banks stopped lending to each other. That created the financial crisis that led to the Great Recession.

Ashby (2010) focused specifically on Risk Management in order to investigate the underlying causes of the crisis. For this purpose, a series of interviews were conducted with a range of senior risk management professionals (including chief risk officers and board directors where possible) from across the financial services sector (retail and investment banks, a clearing house, building societies, life and general insurers and consultants). In total 20 interviews were conducted. Interviewees were asked both what caused the crisis and the lessons that they believed needed to be learned for the future. Reassuringly there was a considerable degree of consistency in the responses provided by these interviewees and a number of common themes emerged:

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  There were failures of implementation in relation to both risk management and corporate governance. Notably some financial institutions did not implement risk management and corporate governance frameworks that were aligned with accepted good practice (e.g. they failed to implement adequate stress and scenario testing and risk reporting processes). Moreover, some institutions placed excessive reliance on certain tools (e.g. quantitative models for risk assessment) at the expense of others (e.g. good management judgement).

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  Human/cultural weaknesses such as: ego, greed and ‘disaster myopia’ have a role to play in explaining the risk management decisions of financial institutions. However, some financial institutions were much better than others at controlling these basic human instincts, suggesting that differences in their corporate culture had a major role to play in explaining their lower exposure to the effects of the crisis. Notably the most badly affected institutions were characterised by sales cultures that promoted market dominance and rapid growth over traditional banking values like prudence, financial security and taking the long-term view.

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  In addition to certain basic human/cultural failings there were complementary weaknesses in risk reporting and management competency in some financial institutions, at both the board and senior management levels. However, there were also weaknesses in relation to the competency of risk management staff – which were not always able to communicate effectively to senior management/directors or provide the kind of support that they needed (e.g. support for strategic decision making).

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  It is not necessarily fair to apportion all of the blame for the financial crisis on the weaknesses of individual financial institutions or those of their management. Specifically, many financial institutions found it difficult to stay out of some of the riskier activities that characterised the last boom (sub-prime lending, etc.) due to competitive pressures. That said, certain institutions did take steps to protect themselves from the developing crisis and in so doing have been much better able to weather its effects.

Many interviewees felt that there had been significant regulatory failures – both in terms of the design of regulatory regimes (e.g. Basel II and its focus on capital modelling) and their implementation (in relation to the quality of supervisors and their ability to make effective judgements). Failures that may have even helped to both cause the crisis and deepen its effects.