Why it is Important for Banks to Manage Financial Risk
The Northern Rock case is a perfect case that explains the importance of managing financial risk by banks. For three days in august 2007, the northern rock –a medium seized bank experienced problems due to lack of proper management of its risks in the UK. Around £3 billion which were withdrawn from the bank led to the subsequent problems that it experienced. It is apparent that the bank had remained legally solvent some months earlier and even reported profits. The quality of its assets was also not in question and its loan record was good. In short, it was a key performer in the financial market. It is vital to note the above key strengths of this bank just to acknowledge how fast a bank may incur risks if it not careful in risk management (BOE, 2007, p.69).
First it is important to manage financial risk so as to maintain the confidence of an asset associated with a particular bank. Lack of confidence with mortgages was one of the problematic issues. Second, banks need to manage financial risk in order to keep a good perspective of the viability of their business model. When referring to our case study which is Northern Rock, it is revealed that doubts about the viability of its business models emerged as a result of the crisis that was experienced. Thirdly, banks need to have a strong management of its risks to avoid funding problems that result from the same. Some banks including the Northern Rock bank which depended heavily on securitization programmes encountered serious funding problems because of uncertainties on their position in a weakening market (BOE, 2007, p.69).
This is maintaining a strong liquidity in the inter-bank markets. Lastly banks require a strong risk management to avoid or reduce influence of their performance status by external factors such as poor economy. Declining in house prices together with increased interest rate in the US was some of the key factors that led to a risky crisis that need to be managed.
The Centre for Economic Policy Research [CEPR], finds a necessity to address the effect of regulation on financial stability. It does an analysis on several policy proposals on how the G20 process and the London Summit might find working and implementable solutions that can restore confidence that did disappear when the collapse of Lehman Brothers occurred in September 2008. It pursues economic recovery. The creation of an international Financial Stability Fund that can take equity positions in the financial institutions of the participating countries and monitoring their activities was also considered. This proves how the impact of regulation is great in relation to financial stability. When key differences in the regulation of the three financial sector namely; banking, securities and insurance sectors are present, then financial stability might decrease. The supervision and regulation of the sectors is specific, as revealed by the independent development of the core principles and standards of each of these sectors.
Whensuch principles fail to specifically take into consideration the systemic risk of each of the sectors, then financial stability is not likely to be realized. In addition, when some differences exist in the view of the relative importance that is attached to market regulation across the three sectors by supervisors, then it implies that regulation will result in a decrease of financial stability. Despite the three sectors becoming more closely related in terms of activities, a sector -specific approach is crucial to ensure financial stability. Failure to adopt such an approach in the current market results into financial instability. In addition, failure to updating and making more consistent principles that are related to market conduct and consumer protection acts as another channel of decreasing financial stability. G-20 made a recommendation that all international bodies should take account of financial stability as a supplement to their main mandate. This was reported in March 2009 on a mission of enhancing sound regulation and transparency. The team does agree that general maintenance of financial stability and reduction of systemic risk is a cross-sectoral standard of financial regulation. The lack of a successful international framework for least capital adequacy in each sector is also another factor that might lead to a decrease in financial stability. International working frameworks for a minimum capital adequacy ought to be put in place in each sector so as to reduce regulatory arbitrage between countries. They also serve to maintain and facilitate the supervision of cross-border groups.
The Different Functions of Investments The word investment has diverse definitions in finance and economics. In finance it means putting money into something with the expectation of gain. What is invested proves to have a relatively high degree of security of both principle and return within a particular duration of time. In Keynesian economics, financial investment serves to transfer rights or title from one person to the other. The rights are transferred from the owner of the stocks, shares debentures and bonds to the investor. It is an investment on one side and a disinvestment on the other side. It should be noted that financial investment does not actually add to the nation’s total stock of capital (Bagehot 1893, p 56). This is because the value transaction mutually cancels. However it serves to create new capital assets or makes an addition to the already existing market stock in terms of productive assets from an economy’s point of view. According to private investors, investment, profit making is a strong motive and it forms the basis of their investment. The Private entrepreneurs only consider quick yielding projects worth investing. The gestation period of the investment must be short. This was Keynes point of view about the function of investment by private investors.
The other function of investment is depicted by the public investors who include central, local and state government. The function is to build up infrastructure of the public utilities, economy and social goods. The goal is on social net gain and welfare but not profit gain. In addition, investment serves a channel of disposing excess exports of a country. This serves to benefit both the importing country and the exporter. The other function of making an investment is to meet increased demand in a community. As the income rises nationally, then the aggregate demand and the level of consumption of a community also rise. In order to meet the excess demand, investment has to be improved in terms of capital goods which ultimately lead to an increase in the consumption goods’ production. The motive of investment in this case is both increasing income and profit –making (Bagehot, 1893, p 56)
Question 2 A
Dimensions of efficiency
The financial sector is slowly changing in response to the deep-seated changes in regulation and technology present in the market. They response by an attempt to improve their efficiency and searching for new customers, increasing products’ range that they offer and their geographical reach that they serve. The efficiency improvement of a financial sector is gauged by performing a review on the effect of M&As. Efficiency refers to a broad concept which is applicable to various dimensions of the activities of a firm. (BOE, 2007, p. 69)
A narrow technical definition states that a firm is cost-efficient if it is able to minimize costs for a specific quantity of output. Financial institutions achieve cost-efficiency by ensuring that they control their cost and make more revenues which increase profits hence ensuring cost-effectiveness.
A firm proves to be profit-efficient when it does a maximization of profits for a certain combination of inputs and outputs.
Technological efficiency does a consideration of scale and scope of economies. A technologically efficient firm is revealed as one that reaches the optimal size for its industry (scale) and produces an optimal mix of products given the prices of their production factors (scope).
Evidence that markets in the U.K are efficient
According to several studies that have been performed on market efficiency, the market s in the U.K has proved to be efficient. One such study was performed on the insurance industry in the OECD countries. It revealed that an increase in productivity was observed in insurance companies in all the countries were due to technical progress. Despite this view, efficiency scores do vary widely by country, with the UK firms being, the most efficient on average. Efficiency seems to be positively correlated with the reinsurance rate but negatively correlated with the share of life insurance; this can best be explained by the national characteristics of life insurance market, which impedes foreign entry and hence decreases competition, thereby allowing domestic firms to have a growth complacently (Bagehot, 1893, p 56)
The UK non-life insurance institutions operate at an efficiency level that ranges from 80% of the best practice assessed for the medium-sized companies to 90% for the large ones, it depicts that competition deters them from becoming too inefficient and improvements from M&As are likely only for the firms in bad conditions. The inefficiency level in the life segment of the insurance industry is averagely higher, ranging between 35 and 50. The evidence that is available for other countries points towards having a larger gap between the best practice firms and the other industries with the average efficiency level being around 50% for France and Belgium about 50% .The level seems to be growing higher in Germany and a little higher in the British life insurance industries. Given that the efficiency seems to be higher in the countries with a lower regulatory burden, deregulation would be a solution in closing the efficiency gap through introduction of more competition.The insurance industry is still fragmented due to regulation and the specificity of some of its products (Bagehot, 1893, p 56)
The dispersion of efficiency levels that emerge from these barriers to entry would probably be reduced if the proper management of firms would take over the weaker ones. However the lacks of evidence for the past and the rapid changes the future holds make it hard to assess the potential efficiency gains from M&As.
Question 2 B
Financial markets risks and returns
Investments in financial institutions are highly affected by the risk factors. For example, following the 2008 mortgage risk, investors developed risk adverse attitude and indeed, investments in high return but risky investment became subject to high reassessed before a decision is made. Although traditional financial theories such as Fama (1970) which argued that investors are rational and they would use logic to plan for their investments the moment they receive information, some modern theories propose differently. As such, “even if assets deviate from a reasonable valuation, through arbitrage they return to reasonable price” (Jordan and Kass, 2002, p. 63). Different risk preferences have seen the financial institutions design products with varied risk character to suit their needs. The traditional theories assume that the investors ordinarily make rational decisions while investing in the financial market, and that they would always try to maximize their wealth. As such, investors who are risk takers have preference for more risky but high return investments. On the other hand, investors who are not risk takers have preference for low return but less risky investments. Financial institutions usually targets both long term investors and short term investors..
Question 2 C
Risk adverse investors
In every business or investment there must be risks involved. The risk adverse investors tend to shy away once they are aware of the risks involved, consequently, they lose their future chances of profitable long-term investment and choose less risky investments, which are short term and have low profits. Study shows that psychological emotions play a very huge role in influencing investors in decision-making. Investors think more of the losses they can incur rather than the gains in the investments and thus in most cases have sleepless nights and eventually they tend to involve in less risky investments……………………………………………………………………………..