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“As a financial markets strategist in a large investment bank, you are required to produce a briefing document explaining why existing risk management techniques might not be fit for purpose when examined in the context of overall financial stability.”

“As a financial markets strategist in a large investment bank, you are required to produce a briefing document explaining why existing risk management techniques might not be fit for purpose when examined in the context of overall financial stability.”

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An essay for the 2011 Undergraduate Awards Competition by Stephen Kearns. Originally submitted for Financial Economics at University College Cork, with lecturer Mr. Don Walshe in the category of Business & Economics
An essay for the 2011 Undergraduate Awards Competition by Stephen Kearns. Originally submitted for Financial Economics at University College Cork, with lecturer Mr. Don Walshe in the category of Business & Economics

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Published by: Undergraduate Awards on Aug 29, 2012
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05/13/2014

 
“As a financial markets strategist in a large investment bank, you are requiredto produce a briefing document explaining why existing risk managementtechniques might not be fit for purpose when examined in the context of overallfinancial stability.”
Til Schulman once proclaimed that “when models turn on, brains turn off.”
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It isglaringly evident from the events of the previous international financial crisis, that itis time the fundamental risk management techniques we practice should bescrutinized and reconsidered. Not since the 1930’s Great Depression have we seensuch worldwide financial instability. It is with this disaster in mind that I am producing this briefing document highlighting where, and why, existing risk management techniques are no longer fit for purpose. First and foremost, I will befocusing on how investment banking utilised the originate-and-distribute (O&D) banking model, how current risk management techniques manipulate, slice and sellrisk as derivative products such as collatorized debt obligations (CDO) and creditdefault swaps (CDS), amongst other securitization products. I will investigate howinvestment banks, by establishing subsidiary companies and taking advantage of accounting loopholes, are able to hide toxic debt from regulators and other investment banks. Finally, I will touch on how investment banking regulation and credit ratingorganisations (CRO) have failed in their attempt to keep investment banks and their  balance sheets in order.The introduction of the O&D banking model in the banking industry significantlycontributed to the previous financial crisis, primarily fuelled by the US housing andlending boom. As Brunnermeier (2009) highlights “instead of holding loans on banks’ balance sheets, banks repackaged loans and passed them on to various other financialinvestors, thereby off-loading risk.”
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This model allowed banks to take advantage of loopholes in banking regulation, such as the Basel II accord. Brunnermeier (2009)explains that Basel II “implemented capital charges based on asset ratings, but bankswere able to reduce their capital charges by pooling loans in off-balance sheetvehicles”
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, through structured investment vehicles (SIV), or conduits. Thus, theutilisation of the O&D banking model by major financial institutions has resulted inthe growth and development of “shadow” banking. This is the banking strategy of investing in long-term assets and borrowing with short-term paper. However, this risk 
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management technique leads to funding liquidity risk, whereby investors mightsuddenly stop buying asset-backed commercial paper, preventing SIVs from rollingover their short-term debt. It is now evident that this existing risk managementtechnique is not fit for purpose when examined in the context of overall financialstability as it in essence hides debt from a bank’s balance sheet and doesn’t show thetrue leverage of the bank when inspected by regulators. As witnessed in 2007 and2008, reductions in funding liquidity led to significant stress of the financial system,which in turn led to catastrophic events. Also, this existing risk managementtechnique is not fit for purpose as it doesn’t apply banking regulation stringentlywhich as we have seen, has been one of the contributory reasons for the recentfinancial crisis.Some of the derivative products used by risk management in the housing and liquidity boom led to multi-trillion dollar securitization markets, which ultimately were basedon the improbable assumption that housing prices would continue growing whichmore worryingly, were not transparent on banks’ balance sheets. Progressively andinterconnected, major banking institutions created a US housing bubble, in which theyduly obliged to generate serious “artificial” profit. I use the word ‘artificial’ asinvestment banks’ risk management seemed to be obliviously ignorant to the fact thatthis growth trend in housing prices was not sustainable in the long-run, i.e. that theywere in the heart of a property bubble, and that inevitably they would reap therepercussions of actively inflating house prices, providing toxic liquidity in thesecuritization markets, while all the time intensifying worldwide financial instability.As Brunnermeier correctly stated, “just because a substantial part of the risk was borne by other financial institutions, banks essentially faced only the “pipeline risk”of holding a loan for some months until the risks were passed on, so they had littleincentive to take particular care in approving loan applications and monitoringloans.”
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Thus, ethically, the idea of sub-prime mortgages (i.e. approving mortgages tolower income clients who couldn’t realistically sustain monthly mortgagerepayments) was simply irresponsible, negligent and a naked moral hazard by banks’risk managements. Caprio, Demirguc-Kunt & Kane (2008) support my point bystating that “the gain from securitization was that it reduced the cost of mortgages andmade home ownership more affordable for a range of marginally less-credit-worthyindividuals.”
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Dell’Arriccia, Igan and Laeven (2008) show that “standards weakened
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the most for borrowers whose risks were highest.”
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However, we now know fromhindsight that this theory was only feasible in the short-run. Even though, financialinstitutions proceeded making substantial “artificial” profit throughout this bubble period through CDOs, in which banks offloaded risks by creating products/bundlingtogether a diversified portfolio of various types of loans, i.e. sub-prime mortgages,corporate bonds, and then slicing these portfolios into different tranches. UsingMoody’s rating definitions, “AAA are judged to be of the highest quality, withminimal credit risk” with “C being the lowest rated class and typically in default, withlittle prospect for recovery of principal or interest”.
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However, this property bubblewas incomprehensively burst as the US sub-prime crisis hit in 2007. As Reinhart andRogoff (2008) put it, “unfortunately that innovation (securitization) also made theresulting instruments extremely non-transparent and illiquid in the face of fallinghouse prices.”
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Some of the resulting instruments Reinhart and Rogoff speak about used by banksthroughout the property bubble included CDSs and Repurchase Agreements (Repos).CDS are a credit structured product which act as insurance to the buyers in case of thetrance defaulting, i.e. the risk of default is transferred from the holder of the fixedincome security to the seller of the swap. Brunnermeier (2009) clarifies, “the buyer of these contracts pays a periodic fixed fee in exchange for a contingent payment in theevent of credit default.”
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This was a very risky investment on the behalf on the seller as we saw in the downfall of Lehman Brothers and AIG, when these institutionsdidn’t have the required capital requirement (adequate leverage) on their balancesheets to deal with the liquidity spiral. These downfalls resulted from the amount of defaulting toxic liquidity held on their CDS books, which triggering large payments tothose who had bought these swaps. As a result “the prices paid for CDS that offered protection against defaults of the remaining banks soared, as each bank tried to protectitself against counterparty credit risk.”
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We have witnessed that this was a secondmajor contributory factor to the previous financial crisis. What's more, we can nowsee that this existing risk management technique is not fit for purpose, as the seller of CDS must have a highly leveraged balance sheet so as to be able to pay out in the caseof wide-scale default and also, the nature of the CDO technique is that “outsourcingthe funding side of an originator’ balance sheet undermines its incentive to monitor 
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