Introduction
‘We tend to think of the task of managing as one defined by carefully considered, long-term thinking. If the global financial crisis taught us anything, it is that more often than not organizations operate with very short horizons, reacting to an ever-changing environment.’
In this literature review essay, I will explore the different management practices that have been employed in dealing with the recent global financial crises. The strategies employed ensured the survival of some firms better than others. The 2008 global financial crisis that started in the US was caused by problems of liquidity in the banking sector, translating to the plummeting of the real estate business, increased unemployment rates and collapse of business (Judge & Stahl 2004).
The crisis was so severe that it not only affected the US, but also spread across borders to other countries. Investors pulled out funds from the US market, leading to a huge loss in securities in the stock markets (Higgins 2005). Inflation was high at all times, businesses closed down and people lost their homes due to increased mortgage rates that led to foreclosures.
Loss of investor input destabilized the global financial market, leading to the decline in the value of the US dollar. Forums were created to look into the causes of the stress.
Managers and experts from the United States, Germany, England, Japan, France, Canada and Switzerland set out to evaluate how managerial weaknesses in different firms and internal controls contributed to the growth of the financial meltdown. This paper will look at the management strategies that were undertaken to deal with the issues of funding and liquidity risk management (Noble 2009)
The crisis displayed the vulnerability of firms that mainly modeled their structures around financing long-term illiquid assets. This model made it difficult for firms to shoulder stresses in the absence of monetary deposits. Financial institutions had been set out to satisfy their customers, while ruining their own financial stability.
Banks afforded short term loans for assets that required long term financing (Herner 1989). Management strategies of different firms projected the extent to which they were affected by the crisis. Firms that exercised restrain in prioritizing short-term funding, were least affected.
This brought to question the management styles of the managers that headed the most affected firms. However, some of the firms, due to their size in monetary value, were able to cushion themselves by drawing support from their reservoirs that consisted of deposits, bonds and other sources which included maximizing on the central bank lending facilities (Heracleous 2000)
The collapse of Lehman Brothers International also emphasized on the risk of depending largely on the customer securities as source of funding. Rehypothecation of customer securities provided a crucial support to the Lehman Brothers, but with the onset of the crises, the customers withdrew their support, being afraid of huge loses as they would not have been able to recover their uninsured funds (Homburg & Krohmer 2004).
The firm in turn declared bankruptcy and its subsidiaries consequently suffered from its misfortunes. The overreliance on securities and money market funds posed serious demands on the liquidity of firm’s reserves. This reduced the firms’ capacities to invest (Noble 2006).
The crisis also had an impact that transcended from capitalist nations to socialist economies. The Russian economy had suffered a 50% decline in its stock exchange markets and the central bank was forced to float a huge sum to prevent a further decline against the dollar and the Euro (Nilsson & Rapp 2000).
The developing nations were not as adversely affected by these events as the developed nations. This is attributed to the use of traditional financial systems.
The borrowers in the developing nations need to have a clean record of financial security in order to access funds. This measure, however, reduces the financial risks in the long run. In general, whether in a developing or developed nation, a financial meltdown cuts off the flow of funds, and institutions have to fall back to other alternative means or rely on the bailout facility (Robert 2007).
Evaluation of Managerial Practices
After the crisis, firms have done as effort to revisit their managerial structures to find out where they went wrong, and in order to avoid future breakdowns. The lessons drawn from the exercise reaffirmed the need for firms to redirect their modes of doing business from a practice that heavily relied on trading of illiquid assets to a more refined model that allowed the flow of funds. This will enable the firms to come up with contingency plans that will mitigate future liquidity risks.
Firms also learnt a valuable lesson that they needed to put in place measures that would cushion a lengthy stress period. Before the crisis, many firms relied on a short-term contractual cover which did not adequately shielded them from the long-term effects of the recession.
Studies have also shown that complex organizational structures have an impact on how a corporation is able to formulate an alternative funding. Complex structures imposed constraints on the flow and access to funds within the firm, as there are networks of legal huddles that need to be satisfied. Managers therefore need to come up with simple governance strategies that reduce the strain.
Firms acknowledged that their management information systems were not equipped to provide on-time analytical reports that were essential to manage liquidity and funding during financial distress. The reports that the existing infrastructures produced did not accurately capture the risk factors.
For instance, borrowings were corresponding with their asset liquidity and there was lack of transparency in the off-balance-sheet funding, hence increasing the loop hole for risks. Firms were therefore forced to reassess the informational mechanisms, to ensure constant supply of accurate reporting.
The metric system that was used to capture elements of financial stress was not effective. The ‘months of coverage’ was found to be insufficient in dealing with long-term liquidity issues.
Firms therefore resorted to accumulating sufficient cushion that would counter loss of unsecured funding. The crisis also emphasized the importance of diversifying sources of funds and reducing approval channels and clearances to get access to funds. Another strategy put in place was limited lending. This measure was put in place to improve the firms’ liquidity capacity.
Firms and market stresses
The crisis came as a surprise to those firms that had heavily depended on the supply of secured funding. The turnaround of events during the 2008 period left the financial market in disarray.
Firms were unwilling to finance the high risk assets. Creditors held back their funds from firms that they considered to be weak, increased asset fair value and reduced credit extensions. The secured lenders also took advantage of the situation by choosing which collateral they would lend against. Bear Stearns’ near collapse situation brought to light several aspects of the financial crisis:
- The firm’s overreliance on short-term secured funding.
- Lack of effective contingency plans, when firms were unable to secure funding.
- When firms lose investor confidence, they also lose control over their assets and Prime brokers withdraw their free credit balances leading to increased absence of the investors from the firm.
Interbank lending was almost at 2% as most investors and lenders became more concerned about the security of their funds. Another common feature of financial firms was the triparty repo transactions. Firms showed tendency towards dependency on repos, which provided lending services on lower quality assets of short-term arrangements. This mode of transaction created a false confidence on the firms’ liquidity capacity.
The repo business grew at the expense of collapsed financial markets, offering financial brokerage to firms. However, the repos had no stable access to funds and often offered unsecured lending. Their legal structures however were different in the United States and Europe. The short loan-borrowing maturity extensions became a source of frustration for the borrowers who needed long-term loaning facilities. Since the repos deal with illiquid assets, selling them would cause an undesired downward pull on the already strained financial market.
The capacity of clearing banks to liquidate collateral is often hampered by hostile market conditions during crisis and they resort to credit withdrawals. Borrowers are therefore left with the alternative of doing risky business with the short-term repo utilities. Investors tend to characterize their deposit trends according to the strengths of the firms.
Weak financial institutions experienced overwhelming outflows, some banks almost faced oblivion in the week following the collapse of Lehman Brothers bankruptcy. The financial crash has different effects on strong firms. These banks received an inflow of uninsured deposits. Interbank transaction was limited as strong banks were reluctant to lend to weaker ones. The net effect of these actions translated into huge deposits in the central bank.
The weak banks were beaten but not out of competition. Promotional campaigns and strategic pricing provided incentives to activate deposit inflows, investors appreciated low investment rates. However, this offer did not last for a long time as the 18 month period was not enough to make a comeback for some of the firms and they soon went out of existence.
Credit crunches left the financial market in a polarized state that was a minimal business transact. Interbank transactions only took place amongst strong institutions that had the capacity to ride the crisis tide. Issuance of debt obligations was only available to selected firms but in a limited scale. Managers, who had accumulated funds from the previous year were not as worried as their counterparts. Even though they were spending more on the rates, it was a good effort to keep them afloat for the 12 months that succeeded the crisis.
The international money markets suffered the same fate as the local markets. Japanese and European firms that had issued credit to collapsed firms were left hanging in a balance.
European firms that had translated most of their assets into dollars had no access to their monies; this situation led the firms to convert the dollars back to their home currencies. This mismatched exchange and thus, led to loss of assets due to the depreciating value of the dollar. This was a non-profitable move but nonetheless essential for survival in the volatile environment.
Internal Management controls
Contingency funding plans
Complex institutional structures constrained the efforts to come up with effective contingency packages. Individual firms have therefore styled the structures to provide cushions from within (Homburg & Krohmer 2004)
The rehypothecation of customer securities had to be reformed. Detailed documentation and contractual agreements have been drawn to limit over utilization of the hedge funds. Customers were secured from loss of funds as witnessed in previous cases. Better measures were also put in place to prevent bankruptcy and boost investor confidence.
Before the crisis, firms had the ability to draw down credit balance. However, after the Lehman’s bankruptcy, the firms could not cope with increased outflows of cash balances; as a result reporting and transfer pricing had to be modeled to suit the ensuing financial conditions. Prime brokerage pricing also went up reducing the returns accrued to hedge fund credit balances. These adjustments were aimed at tightening the control on the brokerage system and prevent the firm’s vulnerability to liquidity issues.
Prior to the crisis, managers had to maximize profits from reinvesting the customers’ high risk assets in low-rate interest business deals. However, the crisis rendered most of these securities illiquid; the alternative means of countering the effect was to increase cash flows. The net effect of these actions was an increase in the liquidity ratios that translated to a 20-30 % increase, compared to previous 8-10% before the crisis. Borrowing and lending trends took a dive for the worst, as neither the lenders nor the borrowers were willing to incur huge loses in the recession.
The money market mutual fund crisis created the need to reconstruct the practices used in investment management for assets that held a stable net asset value. Transparency was of priority as investor confidence needed to be regained. Therefore, it was important to ensure that the investors had the right information as pertains the composition of portfolio holdings.
Liquidity buffers were also raised to 25 %, up from 10 percent to cope with the hostile money market. The United States is amending rules governing money markets funds aimed at withstanding short term market crisis and to cushion the investors against losses of their funds.
Improved managerial practices
These practices have been incorporated into the management strategies to improve risk management and prevent future distresses.
Management oversight
Since the crisis started, managers have been on the receiving end to clean up their leadership flaws. Some of them have been working to align their firms with accepted standards of managerial practices. Increased oversight structures have been put in place to strengthen the authority of the risk management and governance. The role of the board and senior management has been structured to include engagement in the risk management protocols (Hrebiniak 2006).
Information flow has also become multidirectional, reaching all staff from the juniors to the seniors. Firms which had poor crisis-detection mechanisms have enhanced more effective measures, by including the office of the chief crisis analysis officer into various committees. The office has been given more powers, as it is in a direct contact with the prevailing situation. The close monitoring is essential for swift action in case of a potential crisis.
Compensation practices
This has been proposed as a long-term strategy that can be used for future occurrences. Previous practices were aimed at retaining staff but they were not classified under the firm’s internal control. Managers had reviewed the compensation packages and it was established that they did not give a clear depiction of the firm’s earning power and business capital.
Compensations to retain staff had a negative effect and perhaps contributed to the unstable conditions of mismanagement. Compensation needed to be restructured and integrated into the firm’s control framework.
Restructuring the information technology
Firms need to implement sufficient information technology support with the capability of channeling accurate reports during crisis. This is an important strategy in monitoring activities across the board. Firms have in the past not been able to process large volumes of data and transactions, during crisis situations. Modernization of information platforms and retaining staff to utilize the restructured infrastructure has become a key agenda of the proactive firms (Kim & Mauborgne 2007)
Stress testing
There is no better way of preparing for a crisis than performing an internal evaluation, to test the firm’s capacity to withstand stress. There is a tremendous improvement in the ways that firms are preparing for disasters. Senior managements have embarked on an extreme stress testing regiment.
Various risk scenarios have been incorporated in the programs to enable the firm’s structures to fight back. Some firms still depend on historic events when conducting their tests. Therefore, there is need to conduct regular exercises that are flexible to the situation in the ground (Lehner 2004).
Operational and Market structures
There is a considerable improvement in the standardization of practices, which have in turn improved the techniques employed by the managers. It is no secret that some of the staff in the front-office and risk management staff lacked the skills to operate financial utilities.
Firms are making efforts to create awareness for both their junior and managerial staff to reduce a backlog of over-the-counter derivatives. The structures are aimed at streamlining the business processes to a more unified platform, to ensure speedy transactions across firms (Matthews 2000).
Liquidity risk management
Lessons from the crisis dictate that there is need to improve liquidity risk measures and general funding to the expectations of the industry standards.
There is noticeable improvement in the firm-wide governance of the liquidity utility. During the crisis firms showed that they were unable to absorb the pressures of the crisis, as they had no customized contingency plans to the situation. Funds transfer pricing, collateral management procedures, need to be prioritized in order for them to become fully integrated into the system (Ellis 2007).
Conclusion
Some of the managerial risk strategies employed by firms are short-term and achievable, such as restructuring of the firms’ organizational models to incorporate risk and financial management in their principle committees. The 21st century requires a managerial practice that has an oversight body and stress testing kits. The essay shows that both long-term and short-term strategies are essential to the survival of the firms during the financial crises. Short-term goals are a key component in a firm’s daily activities. However, some of these practices are only adapted to short-term changes in the business environment. The managements should have contingency plans that address long-term financial stresses. In the period following the crisis, the managers had displayed a reluctance to transform their institutions in a way that would accommodate potential market distresses. The September 2008 events can only serve as a warning lesson for the future managements.
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