Hafiz
13-10-08, 09:49 PM
I was reading a thread/ post someone had a quesiton regarding credit crunch how it arised etc. Cant seem to find the post to reply to have searched. So im going to put a few details here.
Root causes of the credit crunch
Key factors
ACCA believes that excessive short-termism, coupled with a lack of accountability both within financial institutions and between management and shareholders, is at the heart of the problem. This has meant: failure of institutions to appreciate and manage the inter-connection between the risks inherent in their business activities and management and remuneration incentives, remuneration structures/bonuses of banks being characterised by excessive short-termism. This neither supports prudent risk management nor works in owners’ long-term interests risk management departments in banks which did not have sufficient influence, status or power and weaknesses in reporting on risk and financial transactions.
Secondary factors
Further contributory factors were: over-complexity of financial products and lack of management understanding of the associated risks – including the fact that, currently, there is no genuine market for certain asset-backed securities, over-dependence on debt and an assumption of a continuing low cost of capital environment, scale of issuance of securities and the interconnectedness of financial institutions, especially between retail and investment banking, human weaknesses: a failure to appreciate the influence of cultural and motivational factors such as rigidity of thinking, lack of desire to change. An attitude of ‘it is not my problem’, inappropriate vision/drivers and, perhaps most importantly, human greed, lack of training to enable management to understand underlying business models, leading to poor managerial supervision, lack of rigorous challenge by non-executive directors possibly caused by poor understanding of the complexities of the business and bad habits and complacency after a prolonged bull market.
Corporate governance
ACCA believes that underlying much of the credit crunch has been a fundamental failure in corporate governance.
While the financial institutions involved may have been in compliance with local requirements and codes, they have ignored the key point – good corporate governance is about boards directing and controlling the organizations so they operate in their shareholders’ interests. Boards should be answerable to company owners, to account properly for their stewardship and to ensure both sound internal control and the ethical health of the organisations.
The use of overly-complex financial products, which thwarted effective supervisory control, and the unethical advancement, at the point of sale, of loans to people with little realistic hope of repaying them shows a lack of basic corporate governance.
A fundamental role of the board is to provide oversight, direction and control but also to challenge where necessary. This does not appear to have happened in many of the banks. No doubt this is partly owing to a lack of understanding of the complexities of the business, but more training is probably only part of the solution. Further research is needed to understand what inhibited boards and managers from asking the right questions and understanding the risks that were being run on their watch.
Remuneration and incentives
ACCA believes that executive remuneration arrangements should promote organisational performance. Existing incentive and career structures of banks meant enormous rewards but have reinforced short term thinking, which hasbeen one of the major causes of the credit crunch.
If not addressed, remuneration issues will continue to frustrate other attempts for reform. This is a human behaviour challenge. Risk management and remuneration and incentive systems must be linked. Executive payments should be deferred (eg held in an escrow account) until profits have been realised, cash received and accounting transactions cannot be reversed. Instead of paying out on paper profits, there must be a much stronger link to genuine operational cashflows. These measures would make the risk management function more important in organisations - risk managers should be regarded as having a status equal to those in the ‘front office’ and should be remunerated accordingly.
We question whether the relative share of bank income paid as remuneration compared with dividends has been in the best interests of long-term shareholders. Investors and shareholders have limited ability to influence companies they own. Not all shareholders invest for the long-term and not all of them have an interest in holding boards to account for their stewardship. This is a fundamental governance challenge in capital markets where shares are widely held, and is not confined to the banking sector. The emergence of new strategies (e.g using derivatives) for participating in corporate profitability and new types of shareholder, such as sovereign wealth funds, compounds the challenge.
One way to help address both challenges is to ensure that boards and shareholders receive appropriate, clear, timely and reliable information on risk and financial results.
Risk identification and management
Banks have highly sophisticated risk management functions yet recent events have tested them and found many wanting. A report from UBS in April 2008 to its shareholders explaining the reasons for its write-downs provides a very clear example of risk management failings, with a clear disconnect between incentives to senior staff and risk management. In early 2007, few senior managers thought they were betting on the viability of their banks. It appears they did not understand the risks and were using risk assessment with tools which were inappropriate. Boards may not have expended the necessary time and energy, and/or lacked the expertise to ask the right questions.
There seems to have been widespread misunderstanding about credit ratings. Some investors may have believed that an AAA-rating meant ‘safe’. Others were allowed by their employers to buy AAA-rated instruments with little or no further diligence or consideration of risk. As referred to above, the risks of such an activity were not matched to the incentive system. This meant that traders were able to buy large volumes of mortgage backed security and receive a bonus based on the difference between the yield on the security and the bank’s internally charged cost of funds. There was no downside risk for them individually.
The inherent risk to the bank from such a trade was enormous yet was either ignored or not recognised.
Such activity generated a huge demand for AAA-rated securities. Selling derivatives of securities became akin to selling betting slips. Products were created, packaged and marketed which were a ‘bet’ on the performance of the reference assets. Collateralized debt obligations (CDOs) were created, in part, because there was an insufficient volume of underlying mortgage-backed security (MBS) origination to meet investor demand. These products relied for their existence on credit grades as there was no claim on the underlying assets in difficult circumstances as there was in an MBS.
:SLEEP:
Root causes of the credit crunch
Key factors
ACCA believes that excessive short-termism, coupled with a lack of accountability both within financial institutions and between management and shareholders, is at the heart of the problem. This has meant: failure of institutions to appreciate and manage the inter-connection between the risks inherent in their business activities and management and remuneration incentives, remuneration structures/bonuses of banks being characterised by excessive short-termism. This neither supports prudent risk management nor works in owners’ long-term interests risk management departments in banks which did not have sufficient influence, status or power and weaknesses in reporting on risk and financial transactions.
Secondary factors
Further contributory factors were: over-complexity of financial products and lack of management understanding of the associated risks – including the fact that, currently, there is no genuine market for certain asset-backed securities, over-dependence on debt and an assumption of a continuing low cost of capital environment, scale of issuance of securities and the interconnectedness of financial institutions, especially between retail and investment banking, human weaknesses: a failure to appreciate the influence of cultural and motivational factors such as rigidity of thinking, lack of desire to change. An attitude of ‘it is not my problem’, inappropriate vision/drivers and, perhaps most importantly, human greed, lack of training to enable management to understand underlying business models, leading to poor managerial supervision, lack of rigorous challenge by non-executive directors possibly caused by poor understanding of the complexities of the business and bad habits and complacency after a prolonged bull market.
Corporate governance
ACCA believes that underlying much of the credit crunch has been a fundamental failure in corporate governance.
While the financial institutions involved may have been in compliance with local requirements and codes, they have ignored the key point – good corporate governance is about boards directing and controlling the organizations so they operate in their shareholders’ interests. Boards should be answerable to company owners, to account properly for their stewardship and to ensure both sound internal control and the ethical health of the organisations.
The use of overly-complex financial products, which thwarted effective supervisory control, and the unethical advancement, at the point of sale, of loans to people with little realistic hope of repaying them shows a lack of basic corporate governance.
A fundamental role of the board is to provide oversight, direction and control but also to challenge where necessary. This does not appear to have happened in many of the banks. No doubt this is partly owing to a lack of understanding of the complexities of the business, but more training is probably only part of the solution. Further research is needed to understand what inhibited boards and managers from asking the right questions and understanding the risks that were being run on their watch.
Remuneration and incentives
ACCA believes that executive remuneration arrangements should promote organisational performance. Existing incentive and career structures of banks meant enormous rewards but have reinforced short term thinking, which hasbeen one of the major causes of the credit crunch.
If not addressed, remuneration issues will continue to frustrate other attempts for reform. This is a human behaviour challenge. Risk management and remuneration and incentive systems must be linked. Executive payments should be deferred (eg held in an escrow account) until profits have been realised, cash received and accounting transactions cannot be reversed. Instead of paying out on paper profits, there must be a much stronger link to genuine operational cashflows. These measures would make the risk management function more important in organisations - risk managers should be regarded as having a status equal to those in the ‘front office’ and should be remunerated accordingly.
We question whether the relative share of bank income paid as remuneration compared with dividends has been in the best interests of long-term shareholders. Investors and shareholders have limited ability to influence companies they own. Not all shareholders invest for the long-term and not all of them have an interest in holding boards to account for their stewardship. This is a fundamental governance challenge in capital markets where shares are widely held, and is not confined to the banking sector. The emergence of new strategies (e.g using derivatives) for participating in corporate profitability and new types of shareholder, such as sovereign wealth funds, compounds the challenge.
One way to help address both challenges is to ensure that boards and shareholders receive appropriate, clear, timely and reliable information on risk and financial results.
Risk identification and management
Banks have highly sophisticated risk management functions yet recent events have tested them and found many wanting. A report from UBS in April 2008 to its shareholders explaining the reasons for its write-downs provides a very clear example of risk management failings, with a clear disconnect between incentives to senior staff and risk management. In early 2007, few senior managers thought they were betting on the viability of their banks. It appears they did not understand the risks and were using risk assessment with tools which were inappropriate. Boards may not have expended the necessary time and energy, and/or lacked the expertise to ask the right questions.
There seems to have been widespread misunderstanding about credit ratings. Some investors may have believed that an AAA-rating meant ‘safe’. Others were allowed by their employers to buy AAA-rated instruments with little or no further diligence or consideration of risk. As referred to above, the risks of such an activity were not matched to the incentive system. This meant that traders were able to buy large volumes of mortgage backed security and receive a bonus based on the difference between the yield on the security and the bank’s internally charged cost of funds. There was no downside risk for them individually.
The inherent risk to the bank from such a trade was enormous yet was either ignored or not recognised.
Such activity generated a huge demand for AAA-rated securities. Selling derivatives of securities became akin to selling betting slips. Products were created, packaged and marketed which were a ‘bet’ on the performance of the reference assets. Collateralized debt obligations (CDOs) were created, in part, because there was an insufficient volume of underlying mortgage-backed security (MBS) origination to meet investor demand. These products relied for their existence on credit grades as there was no claim on the underlying assets in difficult circumstances as there was in an MBS.
:SLEEP: