The study illustrates the poor risk management by financial institutions which have resulted in the global financial meltdown. The reality of practical risk management is much complex involving issues from regulations to innovations. There are a number of issues which are interconnected and financial innovations have tied everything together in such a way that it has created a huge systemic risk for the whole financial system. The evaluation of the failed risk management which was practiced in reality is the focus of this dissertation. The dissertation begins with the established risk management theories and different types of risks that can be identified. The models that are critiqued in the study are widely used by present financial institutions. The issue of subprime crisis which eventually led to the global financial meltdown is something not found directly in risk management theories. Further insight is provided with two case studies. Solution to the issue is deliberately not suggested as it would be another temporary solution before the next crisis. It is risk managers and top management who has to take rational decisions and carefully analyze their investment decisions.
Table of Contents
Chapter 1 Introduction
Methodology
Chapter 2 Established Theories
2.1 Risk & risk management
2.2 Different forms of risks
2.2(i) Market Risk
2.2(ii) Credit Risk
2.2(iii) Liquidity Risk
2.2(iv) Interest Rate Risk
2.2(v) Off-Balance Sheet Risks
2.2(vi) Foreign Exchange Risks
2.2(vii) Systemic risk
Chapter 3 Models
3.1 Value at risk (VaR)
3.1(i) Limitations of VaR
3.2 KMV Portfolio Model
3.2(i) Limitations of KMV portfolio model
3.3 Conclusion
Chapter 4 The Crisis
4.1 Overview of the recent crisis
4.2 Different toxic risk management instruments of the new era
4.2(i) Hedge Funds
4.2(ii) Collateralized Debt Obligation
4.2(iii) Structured Investment Vehicle
4.2(iv) Credit Default Swaps
4.3 Seemed to be a Brilliant Strategy
Chapter 5 The Reality Of Practical Risk Management
5.1 Inadequate Risk Evaluation
5.2 Serious Issues
5.2(i) Credit Rating Agencies
5.2(ii) Hedge Funds
5.2(iii) Mortgage Broking
5.2(iv) Liquidity
5.2(v) Capital Adequacy
5.2(vi) Transparency
5.3 Creating Problems Worldwide
5.4 MainCulprits
Chapter 6 Lehman Brothers
6.1 Background
6.2 Post Mortem
Chapter 7 AIG
7.1 Background
7.2 Post Mortem
Chapter 8 Conclusion
Objectives & Core Themes
This dissertation examines the failure of risk management practices within financial institutions that contributed to the global financial meltdown. It analyzes how financial innovations and complex instruments were inadequately managed, leading to systemic risk, and explores the specific failures of major institutions like Lehman Brothers and AIG.
- Evaluation of established risk management theories and their limitations.
- Critique of widely used risk models such as Value at Risk (VaR) and the KMV Portfolio Model.
- Analysis of toxic financial instruments (CDOs, CDS, SIVs) and their role in the crisis.
- Investigation into the specific failures of Lehman Brothers and AIG during the market collapse.
- Assessment of the systemic impact of poor risk evaluation and regulatory gaps.
Excerpt from the Book
4.3 Seemed to be a brilliant strategy
Everyone assumes that the financial markets are able to calculate the optimum risk involved in their activities and can handle the risk. Earlier a bad or a risky loan stayed in the books of the financial institution until it was paid or written off as bad. The other players did not bother about it either as they were not linked directly. Morris (2008) In the 1990s a new financial innovation allowed the banks to package all kinds of loans together in bundles and sell those off to a third party, and thus loans could be wiped off their books.
This third party (generally the investment banks) who bought this bundle of huge broke down the total loan into small units of issuable bonds to investors. This line of securities was divided into different levels of risks called tranches. Investors could buy their tranche depending on their ability to bear risk. Moreover these securities were tradable in the stock market and some institution like the hedge funds were always there to buy the riskiest tranche. So it was easy to sell off all the loans to different grades of investors and distribute the risk.
Summary of Chapters
Chapter 1 Introduction: Provides an overview of the relationship between risk management and profit, highlighting how human sentiments and greed fueled a housing bubble and subsequent financial turmoil.
Chapter 2 Established Theories: Reviews fundamental concepts of risk, including market, credit, liquidity, interest rate, and systemic risks, as defined by established financial theories.
Chapter 3 Models: Evaluates the limitations of widely used risk assessment models like Value at Risk (VaR) and the KMV Portfolio Model in the context of modern complex financial environments.
Chapter 4 The Crisis: Details the evolution of the subprime crisis, focusing on the role of toxic instruments like Hedge Funds, CDOs, SIVs, and CDSs in facilitating the meltdown.
Chapter 5 The Reality Of Practical Risk Management: Investigates the practical failures in risk evaluation, transparency, and capital adequacy that allowed the crisis to spread globally.
Chapter 6 Lehman Brothers: Analyzes the collapse of Lehman Brothers, attributing its downfall to excessive leverage, short-term debt dependence, and failure to manage risk properly.
Chapter 7 AIG: Examines how AIG's extensive involvement in the Credit Default Swap market and poor model validation led to its near-collapse and need for a federal bailout.
Chapter 8 Conclusion: Summarizes the dissertation, concluding that the meltdown was a systemic failure of risk management processes blinded by financial innovation and greed.
Keywords
Risk Management, Financial Meltdown, Subprime Crisis, Value at Risk, KMV Portfolio Model, Collateralized Debt Obligation, Credit Default Swaps, Lehman Brothers, AIG, Securitization, Systemic Risk, Capital Adequacy, Leverage, Financial Innovation, Credit Rating Agencies
Frequently Asked Questions
What is the core subject of this dissertation?
The dissertation explores the inadequacy of risk management practices within financial institutions and how these failures contributed to the global financial meltdown.
What are the central thematic fields?
Key themes include the critique of established risk theories, the role of toxic financial instruments, regulatory shortcomings, and the mismanagement of systemic risks.
What is the primary research objective?
The primary goal is to illustrate how financial institutions failed to evaluate risks involved in their activities and how these actions sparked a global economic crisis.
Which scientific methods are applied?
The study utilizes a review of established risk theories and models, combined with a comparative analysis of institutional failures through specific case studies of Lehman Brothers and AIG.
What is covered in the main section of the work?
The main section covers the analysis of risk management theories, a critique of specific models (VaR, KMV), the mechanics of the subprime crisis, and detailed case studies of institutional failure.
Which keywords characterize this work?
Core keywords include Financial Meltdown, Risk Management, Subprime Crisis, CDO, CDS, Systemic Risk, and Leverage.
How did financial engineering contribute to the collapse of Lehman Brothers?
Lehman Brothers utilized high leverage (a 30:1 asset-to-equity ratio) and financed long-term assets with short-term liabilities, a strategy that failed when market volatility increased and liquidity dried up.
Why does the author consider AIG a primary example of failure?
AIG's failure highlights how an insurance giant used faulty computer models and relied on AAA ratings to sell massive amounts of Credit Default Swaps, leaving it unable to meet collateral demands when the underlying assets devalued.
- Quote paper
- Kaushik Nandan (Author), 2009, Risk management in the light of current global financial meltdown, Munich, GRIN Verlag, https://www.grin.com/document/295299
