Risk can be defined as the uncertainty about the future occurrences (Bénéplanc and Rochet 5). Risk management therefore may be defined as the process of identifying, measuring, prioritizing and setting up ways of minimizing the risks in an organization (Bénéplanc and Rochet 6). Risk management is a major goal in every organization. This is because good risk management will help an organization to increase probability of success in its mission by minimizing chances of failure. Therefore, risk management should be a continuous process and it should aim at managing probable risks that may arise at any levels of the organization.
Risk management should cover all areas of the organization from decision making, planning, implementation, monitoring and evaluation of projects (Bénéplanc and Rochet 7). Risks facing the objectives of an organization can be either internal or external. Hence, risk management process should be dynamic as some risks that occur may be unexpected. It helps an organization by creating a controlled framework of activities, improved decision making and planning, efficient allocation of resources, strengthening organization’s management body and providing optimal efficiency in operations.
Risk identification requires a person to have full knowledge of the organization goals, operations and external environment surrounding it such as political, social, cultural and legal factors (Bénéplanc and Rochet 8). It should be structured in such a way that all levels of the organization are included and their probable risks identified. Risk measurement can be quantitative or qualitative depending on the probability of occurrence and possible consequence. The results of measurements can either be positive or negative. These results are compiled and prioritizing is done. After prioritization, risk treatment is taken which may involve avoiding, reducing, transferring or acceptance of risk.
Using the 2007 credit crunch crisis that affected the entire global economies as our base, we can learn some of the problems faced by financial institutions as they tried to manage risks (Tarantino and Cernauskas 5). Vulnerable firms faced sustained outflows of cash deposited while the strong one faced increased deposits (Tarantino and Cernauskas 5). Banks that appeared to be vulnerable experienced sharp withdrawals during crisis such as commercial banks. These funds were transferred to other banks that were thought to be stronger leading to an increase in their deposits. The funds were further transferred to central banks by the banks as they did not trust credit worthiness of their counterparts such that they could lend to those requiring funding. So, some of those vulnerable firms collapsed as they had no funds to maintain them in business.
Unsecured funding from banks, interbank deposits and foreign exchange decreased in the markets (Tarantino and Cernauskas 13). Many banks that offer financial assistance to smaller banks reduced their funding to conserve their liquidity as they did not trust the repayment abilities of their debtors. Central banks remained as the only hope to the market by trying to offer financial support to the institutions and save them from collapsing. The lending period also reduced to short term credits only with high interest rates thus reducing the borrowing capacity of smaller firms and individuals. According to Tarantino and Cernauskas (15), the collapse of Lehman Brothers International in Europe led to the decrease of US dollar in the market, causing a rise in the exchange rate to the dollar in the world as many commercial banks could not offer it. Central banks again remained as the only hope for exchange of the dollar in the market.
Some firms and institutions experienced decreasing liquidity or market value loss since some of the debtors defaulted to pay their debts (Tarantino and Cernauskas 27). Some of the collateral used to borrow loans decreased in value or froze. Besides, many people shunned away from loans. The reinvestment firms such as those that sell shares in capital markets were adversely affected as people shunned away from this business too. They were forced to find other sources of funds to enable them remain in business as the business went down.
In times of financial crisis, there is a quick change of the economic situation of a country (Tarantino and Cernauskas 42). Inflation is likely to rise at very high rates such that people cannot afford to buy goods and services due to the high prices. This causes businesses to collapse as their liquidity decreases. On the other hand, banks raise interest rates with a directive from central banks in order to try and control the inflation rate from rising. This reduces the borrowing rate as people shun away from loans due to high interest rates charged. The banks also shift to short term loans so as to reduce cases of defaults in loan repayment. These two contributes to increased unemployment in the country as employers lack money to recruit new employees. Sometimes it may lead to lay-offs of some workers so as to reduce unnecessary expenses in their firms.
Business may close off temporarily or hold on to cash which they have as a way of controlling their liquidity. Some that are worst hit in the crisis may collapse or move into receivership. This leads to reduced goods and services in the market and thus escalating prices.
The bankruptcy of the Lehman Brothers international in Europe brought about clearly the risk of relying on the client security as a source of funding (Tarantino and Cernauskas 59). This company was the most adversely affected by the global crisis such that it collapsed when clients’ investment decreased. The security lending cash for reinvestment also reduced their lending to any vulnerable institution. This led to devaluation of stocks on loan causing owners of capital to withdraw their cash from investments experiencing losses. The free credit balance institutions were also affected. For example, in the US when one of the broker dealers with Bear Stearns a prime brokerage firm withdrew all his cash from the institution, it had to seek for funds from other sources in order to finance the other customers’ balances.
From the above analysis, it is true that risk management has become even harder in times of crisis. This is because risk management entails the avoidance of risk and management of continuing risks. During financial crisis periods, the possibility of even the non-risky customers becoming high risk customers remains very high which makes risk management during crisis very difficult (Arboleda-Florez and Bessis 66). Besides this Arboleda-Florez and Bessis (66) further asserts that there is no stability of major currencies during risk management which makes it even harder to manage risks during crisis.
Recommendations to banks
Banks are expected to come up with long term cushions (Tarantino and Cernauskas 202). These cushions must last long such that they can withstand losses for one year without unsecured funding. They should also come up with alternative sources of funding and maintaining required limits of funds. Banks should come up with better management information systems as the prevailing ones did not capture many important parts during the financial crisis. This involves increasing expenditure on infrastructure, data quality improvement and strengthening timelines and quality of risk reporting. This may also include increasing the frequency of reporting during crisis to be on daily basis and even in between the day. The management information system may also be widened in terms of coverage such that they will be more detailed and cover other areas previously not covered.
Banks should go beyond the traditional way of managing liquidity stress to modern methods that involve testing on credit quality deterioration and looking more on rising hypothetical situations that are more systematic naturally and have long duration. Another important aspect of the stress is improvement on reporting and better coordination between their business lines. Frequency of stress testing should be paramount as it will help identify problems at an earlier stage.
Proper funds transfer pricing mechanisms should be put in place for the financial institutions (Tarantino and Cernauskas 234). This will allow transfer of money from funding institutions to increase liquidity of smaller illiquid firms. Funds transfer pricing activities should be retained for liquidity risk management structure. This will ensure that established costs and incentives attain the required goals thus avoiding arbitrage opportunities.
Every bank should pay a specified amount for coverage during crisis. This insurance should help institutions during financial crisis periods by funding them to increase liquidity. Banks can embrace valuation practices and loss recognition as it plays an important role in corporate control. They should be independent, allow sufficient sizes and farm influence. For example, if a difference occurs between business control and personnel over valuation and there is no clearly defined market based price, then growth processes must be clarified and control function be made to prevail. Risk managers may also undertake the task of reviewing and explaining the results of profit and loss to senior managers. This will help in early loss recognition in the firm.
Training of risk management officers should be paramount as it will equip banks with the necessary skills in risk management as highlighted by Tarantino and Cernauskas (288). This should be done to new managers in order to increase the number of risk managers and continued workshops for the old ones. It will also help in identification of risks at an earlier stage and controlling it as early as possible. Another method is streamlining goals of the business and implementing uniform technology platforms and enhancing proper collateral management.
Banks should be well equipped to counter risks increasing the flexibility in terms of operations and organization. This will help in countering unexpected risk and monitoring it to reduce the shocks that come with it. Banks should also aim at integrating stress testing to help in measuring of risk. This may also be enhanced through additional risk analysis and increasing the sensitivity of credit valuation adjustment.
Besides the above recommended steps for banks to undertake, risk management steps can also be helpful in minimizing risk during crisis times. This involves risk identification whereby the risk management department of an institution should identify the risks involved in every section of the institution (Bénéplanc and Rochet 38). The external and internal risks are identified. The external risks are risks due to the location of the institution which include, social environment comprising of the behavior and social status of people living around the institution, cultural environment which looks at the culture and beliefs of the people, economic environment which considers the economic statuses economic activity of the people, political environment which looks at the political organization or affiliation of the people to political parties.
The next step is measuring the risk either through qualitative or quantitative method depending on the type of risk. This will help in determining the probability of occurrence and resultant consequences of the risk. The consequences may be in form of threats or opportunities to the firm while probability will be categorized as high or low. Once the risks have been measured, they should be analyzed and listed in an ascending or descending order depending on the strength of occurrence or consequences. This listing helps in prioritizing so that one which requires urgent attendance is attended first.
Lastly, risks treatment process is done which involves attending to the risks in the order of their prioritization. Various methods are used in risk treatment as the consequence of risks varies. The method used in treatment should be carefully selected to ensure that the most appropriate and effective method is settled on. It should also be cost effective whereby it should not be expensive for the firm to implement. Risk treatment should be aimed at either eliminating the risk or minimizing it so that it does not have adverse effects to the firm.
Arboleda-Florez, Julio & Bessis, Joël. Risk Management in Banking. New York: John Wiley & Sons. 2011. Print.
Bénéplanc, Gilles & Rochet, Jean-Charles. Risk Management in Turbulent Times. Oxford: Oxford University Press. 2011. Print.
Tarantino, Anthony & Cernauskas, Deborah. Risk Management in Finance: Six Sigma and Other Next-Generation Techniques. New York: John Wiley & Sons. 2009. Print.