Managing global financial crisis

The present global financial crisis has been attributed to the subprime mortgages which
originated in the US housing mortgage sector few years back. During the booming
housing market, when low interest rates were prevailing and the housing prices were
continuously increasing, offering financial assistance to subprime borrowers was
considered a lucrative proposition by some banks/financial institutions ignoring the
inherent risk involved in such activities.
The situation got complicated when some investment banks innovated some complex
financial instruments based on the underlying subprime mortgages and marketed these
instruments to investors across the globe. However the situation changed dramatically
when the property prices started falling sharply leading to significant rise in default in
mortgage loans and foreclosures.
One of the latest international surveys reveals that the top three reasons for this financial
crisis are inadequate risk management practices at banks, increased complexity of
financial instruments and speculation of financial market.
However, in my opinion there are four systemic issues involved behind this crisis. (i) The
entire financial risk analysis was mainly based on an unrealistic assumption that property
prices will not fall drastically, rather it would continue to rise. (ii) Too much greed and
unrealistic expectations of higher return from mortgage-based loan.
This encouraged many banks to increase their risk exposure disproportionately in single
line of business ignoring the underlying risk involved. (iii) The underestimation of
underlying risk by the various intermediaries involved in the process of development of
complex financial instruments. Considering the subprime borrower profile with lack of
stable income, many of these mortgages were already at high risk. Yet these mortgages
were packaged with some credit enhancement mechanism by some banks and financial
institutions in such a way that these obtained high rating.
However, in reality, the original risky loan remained risky even with this credit
enhancement as the underlying cash flows from the borrower remained uncertain. (iv)
Over-reliance on quantitative analysis on risk modelling without giving much importance
to underlying assumptions. Risk models (such as estimation of value at risk) that were
based on a short history of abnormal loss data and unrealistic assumptions, one of being
continuous liquidity, did not prepare them for crisis conditions. Reliance on these models
led to a myopic focus within institutions that ignored the risk of a significant disruption to
the financial system if everyone reacted to a large shock in the same way.

Thus the current crisis is not only the fallout of a faulty risk management strategy, but
also factors like failure of business strategy; asymmetric information system of the
intermediaries involved in the complex financial product; and rating agencies that had
assigned rating based on mainly secondary source of information about the borrowers and
bank's profile and probable impact of market dynamics of such products under adverse
business conditions. All these led to systemic failure in the banking and financial sector.
The important lessons to be learnt from this experience is that we should be adequately
prepared to reduce the probability as well as impact of such events, if they recur in future.
Against this background, the importance of risk management has increased as well as its
role and responsibilities has broadened further. Risk managers have to adopt much more
pragmatic and forward-looking approach towards managing its risk in the banks to
protect them from any such adverse events.
Banks should set the risk exposure limit based on their risk appetite and risk absorption
capacity. While setting these limits, banks should keep in mind that this must be aligned
with the organisation's business objectives, lest the limit acts as a hindrance for
organisation's growth.
The banks that failed in the recent financial crisis tended to have higher leverage ratios
and thus less flexibility. While successful diversification reduces risk by reducing positive
correlation, the risk managers in a bank must know the areas where risks are correlated
and to what extent diversification of risk assets will be safe for the banks.
To estimate ideal risk capital, banks need to develop a model considering various adverse
economic scenarios which might affect financial system like higher inflation, poor
economic growth, scarce liquidity, high unemployment scenario, etc. Banks need to
capture robust historical data with different frequencies and severity under each of the
probable risk events in different area of activities. It has been observed that banks did
their best based on available data within sample periods which mainly captures normal
risk events.