EU Financial Crisis: Risk Management Failures Report

Executive Summary

The European continent and the world at large are nursing the effects of one of the worst financial downturns in recent history. In efforts to avert such scenarios in the future, European nations are in need of a risk management framework that should not overly depend on the results of external assessments and risk models from rating agencies. Europe has learnt the hard way that risks are interrelated and the correlation may result in an effect that had not been detected earlier.

Consequently, the EU members have adopted frameworks of managing organisational risks that are firm- wide and which addresses the different forms of potential risks that firms may encounter. Central banks have a very essential role to play in risk management during such crises. However, they have to operate in a way such that they are able to strike a balance between their policy making duties and still maintain credibility and independence from other arms of the government or other agencies.

The EU has learnt that risks do not become obsolete with time. Most of the risks that financial institutions ignored or had “forgotten” about were the same as those that crashed financial systems. Nonetheless, the crisis has reminded nations and institutions to focus more on how to effectively manage risks from an internal perspective that is informed by expert judgement.

Introduction

Most of the firms which were severely hit by the effects of the credit crisis in Europe had put in place various systems of risk management. However, it is important to note that huge losses are not incurred as a result of failed risk management systems only. The amount of losses incurred by corporations and organisations in the western nations has left a mark that will not be forgotten easily in the history of finance and economics.

There are many theories which have been put forth to explain or put into perspective the European credit crisis. Some of them include the various inconsistencies both in the governments and in the private sectors.

However, one of the most obvious causes of the crisis is the inadequate risk management measures in the various organisations. With the crisis is out of the scene- at least momentarily- it is essential to find out what can be learnt from the horrific financial and economic experience and determine how risk management systems can be used to avert future downturns (Higdon & Busch 2010).

In this report, the author makes an attempt to outline the failures in risk management initiatives just before and during the crisis. This is in addition to a critical analysis of the efforts made by the European Union (herein referred to as EU) to reinforce proper management of risks in the future.

Causes and Dynamics of the Crisis

Economists have written and published several papers and books touching on the dynamics and causes of the global financial and economic crisis that began in 2007. Today, most of the reasons why Europe and the United States found themselves in the economic depression seem to be very much obvious. However, that was not the case before the crisis struck. It is very clear that the way many institutions and governments view trade- offs between returns and risks has changed a great deal since 2008 (Higdon & Busch 2010).

Zaharia, Zaharia, Tudorescu & Zaharia (2011) point out the main reason why public authorities, participants in the markets and academics have devoted more resources to the identification and assessment of issues that are related to risks is not because of the challenges and uncertainties facing the financial and economic systems.

They add that it is not even because of the fact that the crisis was one of the most devastating in recent history. On the contrary, the focus on risk has been necessitated by the fact that everything that is related to the crisis- roots, trunks and branches- are correlated to governance aspects and risk management.

In the light of this reality, there are several convincing explanations that have been provided to address the dynamics and causes of the economic and financial crisis. It is clear that risk managers may find these explanations to be very useful because they may hold some truth.

Of most importance is that no single argument can sufficiently explain or account for what happened from late 2007. However, it is equally essential to remain objective in order to distinguish between ideologies and facts. This is as scholars assess the pieces of work, some of which are best- selling (Jourdan, Meier, Pacitto & Soparnot 2012).

Various commentators have made several suggestions in efforts to explain the credit crisis. Some of them include:

1. The financial and private sectors borrowed heavily and incurred large debts because of the low rates of loans just before the crisis.
2. the building up of disequilibria in the financial sector and the bubble in asset prices.
3. the biased offering of incentives which encouraged investors to take excessive financial risks.
4. the strategic drift that disabled regulators and prevented them from adapting to the evolving financial system.
5. the conflicts between agents who were needed in secularization.
6. failures in the markets that were mainly caused by lack of accountability and transparency concerning product characteristics, risks and information asymmetry.
7. Most of the investors over- relied on economic models and information that was unable to correct project some very important risks and as such they did not conduct themselves with the expected due diligence (Jourdan et al. 2012).

Many scholars agree that after the burst of the United States’ housing bubble, many people defaulted on their loans, which led to widespread underperformance in the mortgage sector. The resulting financial inadequacies were the spark that ignited the global economic crisis.

In early 2008, many high profile investors decided to unwind their positions so that they can take care of margin calls. As a result of this, the liquidity in fixed- income markets began to dry up rather fast. Losses that were related to the risk in liquidity began to pile up and real estate risks started to manifest in a manner that had not been witnessed before since the end of the 1930s’ great depression (Polak, Robertson & Lind 2011).

One of the most important lessons that Europe and the world has learnt is that downturns are more frequent than previously thought. The EU is thus bracing itself for new slumps in the future, economic slumps that may be very different from what happened during the recent crisis. Regardless of the cause of such a crisis- whether high prices of food and oil, asset bubbles or geo- political tensions- nations and organisations around the world should have the capacity to react and weather the effects of such shocks.

The lack of asset liquidity and the fact that most of the main players in the financial markets were going through some of the most difficult times- reconciling losses and trying to consolidate and deleverage them- rendered most of the risk management models obsolete.

Over- reliance led to a false increase in the scope of risks that the models were supposed to cover and address. This led to a great deal of uncertainties regarding the real value of the assets that were in the custody of financial institutions. Institutions and governments began to discover the “forgotten risks” in addition to credit and tail market risks.

Nonetheless, such traits were still not enough to wake them to the fact that the decisions of global investors were misplaced. However, the increased defaulting rates and collapse of large banks both in Europe and in the United States made the concerned parties realise that they had to begin focusing on counterparty risks. These risks were of immense importance to the governments in Europe (Higdon & Busch 2010).

International integration and financial globalisation- which highly determine the prosperity of nations- became shock transmission channels that relayed the effects of the crisis throughout the global economy. With time, systemic risks set in because of the links between global financial systems and the difficulty of isolating problems in the financial institutions and in sectors where the crisis had begun to encroach (Higdon & Busch 2010).

Risk Management and the Crisis

The parties concerned in the crisis abandoned some of the most basic practices of risk management. This is for example the practice of identifying one’s counterparties, investing only in services and products you comprehend, not outsourcing risk management by over- relying on external assessments of credit, and not exclusively relying on quantitative risk management models, regardless of their sophistication (Jourdan et al 2012).

Throughout Europe, there was evident overdependence on some aspects that made the situation even worse. This is for example over- dependence on:

1. the capability of managers to create returns.
2. the merits of financial innovation in efficiently spreading returns and risks in the market,
3. the sufficiency of data and models used for risk estimation in the market,
4. Assumed market efficiency, and
5. the willingness and ability of authorities in the financial sector to alleviate the effects of slumps in the asset prices (Polak et al 2011)

According to Polak et al (2011), this over- dependence denied capital markets the opportunity to reflect on the price in the culminating risks.

Regardless of how one looks at it, there are many lessons that nations and institutions can learn from the financial crisis regarding the importance of strategic management of risks.

This is the reason why financial markets all over the world are characterised by buzzwords such as sovereign debt, animal- spirits, black- swan, and stress- testing. The experience has made risk managers realise and appreciate the need for the right risk management models at the right time. It has also made portfolio managers realise how risks really manifest themselves.

The market participants are now aware of the compound impacts of risks, crises dynamics, and systemic risk effects that arise from shocks in global economics, courtesy of the recent economic meltdown. The participants are also aware of the various hidden imbalances and contagion effects of such a crisis.

Courtesy of the crisis, practitioners and academics are now able to analyse failure in markets with more emphasis placed on institutional and behavioural aspects. Moreover, investors and their companies have become quite sceptical as they have discovered the need to diversify their operations. They are also aware of the fact that their assets may not be risk free after all (Higdon & Busch 2010).

It is noted that as a result of the recent economic and financial crisis, risk management has emerged as a popular strategy among stakeholders in this industry. For example, the participants’ reaction to rumours regarding the financial stability of institutions has changed drastically.

Kirkpatrick (2012) notes that generally, the financial industry’s capital position has been watered down. In addition to this, some institutions have been forced to go back to processes such as risk downsizing and deleveraging. However, such processes can bring the European capital markets down again if there are no proper check mechanisms. It is thus adversely affecting the way risks are viewed all over the world (Higdon & Busch 2010).

There are two major explanations for the negative feedback that is brought about by financial crisis. One of them is the fundamental point of view where the risks all over the world increased while loss absorption capacity decreased. Another one is the behavioural perspective where confidence waned as the crisis pushed the world towards unchartered territories, far away from presumed comfort.

Higdon (2012) points out that the approach adopted in the management of risks in the financial sectors (by bankers and risk managers) may not be explained by the understanding of the recent risk. On the contrary, it is a reflection of the drastic rise in measures to avert risks.

He adds that such a phenomenon is not fully justifiable on the basis of the “learning process.” In this regard, it is always important to take into consideration the fact that behavioural factors provide the momentum that drives markets when making decisions and formulating models that support such processes (Jourdan et al 2012).

However, it is advisable to remain optimistic given that individuals, institutions and nations have learned important lessons. It is noted that when reforms are implemented when necessary, the confidence of the financial system is restored. Nonetheless, one major question still persists.

This is the question of whether the European countries have adequately learnt from the effects of the crisis or whether they are simply living in the crisis mode and will forget the lessons as soon as the downturn is in the books of financial history (Higdon & Busch 2010).

Risk Management in the New Environment

In this section, the report will address some of the reactions to these new developments in the global arena. It is noted that nations in Europe have begun to embrace risk management strategies to cope in the developments in the market. Public authorities in the United Kingdom have started to put into practice the lessons learnt from the crisis. Kirkpatrick (2012) is of the view that the EU has adopted various regulatory initiatives in order to protect the region from similar crises. These include:

1. The promotion of sound practices of risk management and the integration of risk management into the process of making regional financial and economic decisions.
2. Addressing challenges that are posed by institutions that were previously regarded as too-big-to-fail and the associated moral hazards.
3. Enhancing the financial infrastructure of the region to make it more tolerant to risks. This is through the promotion of initiatives and instruments to alleviate counterparty risks and limitation of contagion channels of sector or firm- specific shocks.
4. Making sure that financial statements are standardised, valued fairly, and transparent.
5. Redesigning capital requirements and regulatory policies to prevent pro- cyclical impacts. This is for example through the introduction of provisioning mechanisms and funding as well as liquidity requirements.

The Basel III Agreement provides guidelines for the changes that should be implemented in the regulatory standards of the banking industry. The effects of the new regulations will be mitigated as countries in Europe begin to slowly adjust to the proposed regulatory framework, taking into consideration their feeble economic and financial position.

In the long run, as these nations transit from the crisis to a framework that is meant to enhance organisational risk management and the capital position of institutions in the financial sector, the public’s confidence in credibility of financial systems will be restored (Jourdan et al 2012).

There is need for more intervention measures from the government. This is the reason why the European Central Bank- in association with other key partners in the market- has made the decision to disclose ‘loan by loan level information’ and data in the European ABS market.

This will definitely go a long way in revitalising the markets and in mitigating the risks related to such products (Higdon & Busch 2010). However, the effectiveness of the ECB initiative will be determined by the diligence of participants in the market. Public institutions will be expected to provide high standards of governance.

The problems faced by financial institutions and governments in the recent past are not solely as a result of measures taken to address risks such as value-at-risks or as a result of adoption of models such as Gaussian copula model or the opinions of credit ratings. On the contrary, the problems have been brought about to a large extent by the failure to elucidate on the limitations of such models and measures (Higdon & Busch 2010).

The EU is currently encouraging financial risk managers not to be too comfortable with established standards and historical risk management regularities. All departments in financial institutions are supposed to make contributions to the organisational function of risk management and come up with effective communication strategies to address this issue.

Europe has gone through economic uncertainties that no institution or person in contemporary society would have predicted. However, although the idea of managing risks has much to do with uncertainty than making forecasts, the placid financial risk management models coupled with myopic inputs could not capture the hazards that plagued the financial systems in the continent and elsewhere in the world (Zaharia et al. 2011).

This notwithstanding, economists continue to wonder how governments and banks could have fallen blindly for the predictions given by the models that were using data collected over a period of ten years. The data was used to erroneously predict that global financial systems were not likely to face a crisis in a period of 100 years.

However, in addition to the economic downturn that materialised from 2008, the world has experienced two global wars over the last one century. This is in addition to the Great Depression of the 1930s and several financial and economic crises that have crippled many sectors of the society and affected virtually all countries in the world. One does not need to be an expert in statistics to realise that governments and financial institutions misused the models that were in place at that time.

The most disturbing question is whether Europe and the world at large can withstand such crises in the future if there is failure to assimilate experiences of the past. Some analysts have pointed out that the standard models of risk management did not have the capacity to effectively capture and address what they are referring to as a black- swan event (Higdon 2012).

This is the reason why stress- testing is regarded as one of the most essential components of a contemporary risk management model. Designing plausible but forward- looking (as well as demanding) stress- tests at the firm- level and at the business level significantly improves the comprehension of causes and effects of risks encountered by financial institutions and such other organisations.

One of the most important lessons that European governments have learnt from the economic crisis is the fact that the various kinds of risks are interrelated. At times, the correlation results in a compounding effect that had not been detected by the tools of risk management used by the organisation.

Therefore, the frameworks used in managing organisational risks and which have been adopted by institutions in the EU are firm- wide and collectively address the various risks encountered by the firms. This explains the current emphasis on both inter- risk and intra- risk interrelations which are aimed at building a diversified portfolio on the two dimensions while at the same time matching the needs of the market and risk- return preferences (Higdon & Busch 2010).

In order to successfully weather such a crisis, it is important to understand the fact that economics and finance are quite different from natural sciences. While such disciplines are based on the discovery of fundamental laws, finance is based on modelling and relating the interactions between people and systems. Such an understanding will be a vital asset for bankers and risk managers operating in the industry (Jourdan et al. 2012).

Controversies Surrounding the Crisis

According to Jourdan et al. (2012), one of the major controversies surrounding this crisis is the bailout plan adopted by several governments in the region. Analysts who are against such measures are of the view that at the end of the day, all they will achieve is shifting the exposure from the financial institutions in the region to the public.

The banks are the ones that stand to benefit from such measures at the expense of the taxpayer. This is given that the managers and directors are likely to walk home with bonuses and other benefits, courtesy of the European taxpayer (Higdon 2012).

It is noted that financial institutions from German have benefited from the bailout plans rolled out by the governments in the region. According to Jourdan et al. (2012), these financial institutions have received a disproportionately huge chunk of the bailout money that has been given to countries such as Greece which are already reeling from the effects of the crisis.

Such developments will hamper efforts to come up with risk management strategies to address such situations in the past. For example, the banks may encourage or fuel such crisis in the future given that they are likely to benefit from the measures that will be put in place by the governments to address it.

Stakeholders Fuelling the Financial and Economic Crisis and Risk Management

Credit Rating Agencies

These are some of the stakeholders that, according to Jourdan et al. (2012), led to the onset of the crisis in the first place. The risk management strategies in these agencies were very poor or non-existent in some cases. Analysts cite organisations such as Moody’s and Fitch (Higdon 2012), which have been blamed for the crisis that took place in the US and whose effects persist today.

It is noted that such bodies have continued to provide misleading ratings mainly as a result of conflicts of interests among the management (Jourdan et al. 2012). Such ratings negatively affect the efforts of risk managers in the market.

The Media

As usual, the media has been blamed for the crisis that is taking place in the region. This is especially so in the case of English language media houses. The media is believed to have created tension among members of the public by blowing the situation out of proportion.

This sentiment was captured in the statement released by Papandreou, the Prime Minister of Greece (Jourdan et al. 2012), one of the countries that have been largely affected by the crisis. The leader was of the view that his country will not withdraw from the European Union. He opined that the crisis was a political and financial propaganda propagated by media.

Risk managers may at times make use of information that is availed by the media in making decisions touching on the financial status of their organisation. As such, misleading media statements may lead to erroneous decisions on the part of the risk manager.

Challenges for European Central Banks

The job description of a risk manager is directly related to what happens in a conventional central bank. A central bank is constantly exposed to crisis situations and has to come up with solutions using limited resources at its disposal. The ECB has played a major role in assisting European companies deal with the diverse phases of the downturn.

In order for central banks to effectively undertake such risk management roles, there needs to be an understanding of systemic risks that the economy is exposed to. Risk materialisation may to some extent impact on the financial position of the central bank. In such a context, they are risk takers as well as investment and monetary policy makers (Higdon & Busch 2010).

Central banks are different from other players in the economy. As such, their reaction to a crisis and their operations in such a situation are very different from those adopted by other stakeholders. This is mainly because they have the additional responsibility of managing public funds. That is why they are regarded as conservative investors in the economy.

Such a perception is fairly accurate in defining the risk appetite of a central bank but not in defining its policy making role. They take on risks that the investment banks would not have the capacity to handle. Additionally, in times of economic downturns, they follow the inertial principle because of the nature of their policy making responsibilities. The inertial principle posits that the organisation should not take risk management actions that may deepen the financial markets’ pro- cyclical behaviour (Higdon & Busch 2010).

As the markets served by the main financial institutions in Europe were reeling from the effects of lack of money, central banks in the continent had to take unconventional measures to supply the economy with credit. This is in order to sustain the process of implementing the various monetary policies in the most dangerous financial environment ever.

All risk managers understand that resorting to such measures means exposing themselves more to such risks. Long- term operations, asset purchases, full- allotment tendering and collateral framework relaxation have one thing in common. This is in times of such crises. However, central banks had to take that responsibility, albeit in a calm and disciplined manner (Higdon 2012).

During crises, the level of risk for central banks always increases. According to Higdon (2012), what makes the situation even worse is that they have to maintain their credibility and independence as they implement the monetary policy.

In light of such a reality, central banks are supposed to constantly monitor and evaluate their frameworks for risk management so that in times of crises, they can easily adapt to the situation at hand and remain credible and independent. This is so that after the downturn, they can continue pursuing their organisational objectives (Higdon & Busch 2010).

Conclusion

The recent global economic crisis has been a wakeup call to the entire world and as such, there are many lessons for all participants in the global market. One of the most disturbing lessons that may not be forgotten any time soon is that there are no risks that become obsolete with time.

The risks that many banks and governments in Europe had forgotten about and which no one could include in a presentation are the same that got revitalised and took the world by storm. One of the few positive effects of the crisis is that, for institutions and persons who are charged with the duty of designing and implementing public policies, there is an increased awareness of the need to have strong internal practices for risk management.

Another important lesson is that, even when risk management initiatives are implemented flawlessly, there is no guarantee that losses will not be made. On the contrary, the organisation may even incur huge losses in such a case. Losses can be caused by other diverse factors such as bad luck or poor business operations.

However, the crisis highlighted some of the most serious flaws in the risk management models adopted by global financial institutions. Some European firms went down courtesy of known unknowns like liquidity risk and model risks.

However, many of the firms were failing in 2008 courtesy of unknown unknowns such as contagion risks and structural as well as regulatory changes in regional and global capital markets. Admittedly, some of such risks could not be formally measured. Nonetheless, there are various effective risk management models that can be used to protect the EU from the effects of a similar crisis in the future. These include stress- tests and scenario analysis.

References

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Jourdan, P Meier, O Pacitto, J & Soparnot, R 2012, ‘How to emerge from the crisis and from crisis: lessons learned from a European survey’, International Business Research, vol. 5 no. 6, pp. 105-11.

Kirkpatrick, G 2012, ‘Corporate governance lessons from the financial crisis’, OECD Journal, vol. 1, pp. 61-87.

Polak, P Robertson, D & Lind, M 2011, ‘The new role of the corporate treasurer: emerging trends in response to the financial crisis’, International Research Journal of Finance & Economics, vol. 78, pp. 48-69.

Zaharia, C Zaharia, I Tudorescu, N & Zaharia, G 2011, ‘Effects of the financial crisis on the real economy’, Economics, Management & Financial Markets, vol. 6 no. 2, pp. 164-169.