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Financial regulations, risk management and value creation in financial institutions: evidence from Europe and USA


par Agborya-Echi Agbor-Ndakaw
University of Sussex - Master of Science 2010
Dans la categorie: Economie et Finance
   
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Dissertation

Programme: MSc. In Financial Mathematics Minor: Banking and Finance

Name: Agborya-Echi Agbor-Ndakaw

Candidate Number: 59990

Title: Financial Regulations, Risk Management and Value Creation in Financial Institutions: Evidence from Europe and USA.

Supervisor: Dr Michael Barrow

Date: 02/09/2010 Number of Words: 18,651.

ABSTRACT

The present global financial crises resulted in a near collapse of the world banking system. Some financial institutions and financial markets could continue operations only upon reception of public rescue packages. It also brought to light the inadequacies of the financial model both at the national and international levels. This study brings out the need for revising these financial regulations hence. This study also revealed how behavioural finance greatly contributed to the out break of the present crisis and therefore suggests the licensing and supervision of financial institutions at all times.

The principal aim of this study is to investigate how the relationship between financial regulations, risk management and value creation alongside other behavioural factors influence the process of investment decision-making by investors. Some of the behavioural factors revealed by this study include overconfidence, gambler's fallacy and availability bias. In addition to these, this study also revealed that some assets (CDOs and CDSs) within the financial industry also influence the investment decision-making process.

This study focuses on the role of risk management within financial institutions thereby establishing a framework for efficient and effective risk management. The goal of such an activity is that of achieving the highest value added from the risk management procedure being undertaken thereby restoring the trust and confidence that has been lost in financial institutions and banks as a result of the present crisis.

KEYWORDS: RISK, RETURN, RISK MANAGEMENT, FINANCIAL REGULATIONS, VALUE CREATION, INVESTMENT DECISION-MAKING, COLLATERIZED DEBT OBLIGATIONS (CDOs), CREDIT DEFAULT SWAPS (CDSs), BANKS, GLOBAL FINANCIAL CRISIS AND BEHAVIOURAL FINANCE

ACKNOWLEDGEMENT

The completion of this study would not have been possible without the help and support of some people. Firstly, I will like to express my gratitude to my supervisor, Dr Michael Barrow for his professional guidance and advice. His suggestions and critical remarks to the realisation of this study have been inspiring.

I will equally wish to acknowledge the support of the rest of the program instructional team, the entire staff of the University of Sussex in general and the School of Mathematical and Physical Sciences in particular for making my stay here memorable. I will also like to thank my classmates for their help and support.

My sincere gratitude also goes to my family and friends for their abundant love, support and encouragement throughout the study period. Success is better when it is a result of teamwork.

Finally and most importantly, I thank God for making it possible for me to be here.

Contents

ABSTRACT .1

ACKNOWLEDGEMENT 2

CONTENTS 3

CONTENTS .4

List of Figures 5

List of Tables 5

CHAPTER ONE 6

INTRODUCTION 6

1.1 Background 6

1.2 Rationale of Study and Gaps in Existing Research .13

1.3 Research Questions 15

1.4 Aims and Objectives 16

1.5 Hypotheses 17

1.6 Summary of Methodology 18

1.7 Summary of Chapters 18

1.8 Summary of Chapter One .19

CHAPTER TWO ..20

LITERATURE REVIEW ..20

2.1 Introduction 20

2.2 Definition and Meaning of Risk ..20

2.3 Definition and Meaning of Return ...23

2.4 Relationship between Risk and Return .24

2.5 Types of Risks within Financial Institutions 25

2.6 Definition and Meaning of Risk Management ..28

2.7 Reasons for Risk-taking in Financial Institutions 32

2.8 Definition and Meaning of Financial Regulations 33

2.9 Definition and Meaning of Value Creation 38

2.10 The Decision-Making Process 41

2.11 Behavioural Factors Influencing Investment Decision-Making 43

2.12 Assets Influencing Investment Decision-Making 46

2.13 Conclusion 60

CHAPTER THREE ..61

METHODOLOGY 61

3.1 Introduction

61

3.2 Research Philosophy

61

3.3 Research Approach

.62

3.4 Choice of Method

63

CHAPTER FOUR

.64

PRESENTATION AND DISCUSSION OF FINDINGS

.64

4.1 Purpose of Chapter

64

4.2 Description of Findings

64

4.3 Discussion of Findings

...67

4.4 Conclusion

71

CHAPTER FIVE

72

CONCLUSIONS AND RECOMMENDATIONS

.72

5.1 Introduction

72

5.2 Overall Assessment of Aims and Objectives Attainment

...72

5.3 Conclusion

73

5.4 Recommendations

...75

REFERENCES 77

List of Figures

Figure 1: Capital Market Line 7

Figure 2: Security Market Line 7

Figure 3: The UK Bank Rescue Package 11

Figure 4: Risk Management Procedure 31

Figure 5: Estimated Global CDO Market Size 37

Figure 6: Global CDO Market Data for 2006-2007 48

Figure 7: A Summary on How CDS Works 53

Figure 8: Increase in CDS Markets 57

Figure 9: Factors Influencing Investment Decision-Making 65

Figure 10: Summary 72

List of Tables

Table 1: Estimated Size of the Global CDO Market by the End of 2006 37

Table 2: Global CDO Market for 2006-2007 47

Table 3: The ISDA Market Survey for CDSs 56

CHAPTER ONE INTRODUCTION

1.1 Background

The relationship between financial regulations, risk management and value creation is the brain behind the investment decision-making process especially within financial institutions. This relationship is such that forms the general idea on the understanding of how financial institutions work with regards to investments and the investment decision-making process. To successfully establish this relationship between financial regulations, risk management and value creation, it will be ideal to pinpoint the fact that financial institutions can stand a better place in creating value and restoring the trust and confidence that has been lost in financial institutions and banks as a result of the outbreak of the 2007-2009 financial crises.

Economists have proven that there exist a number of classical financial theories which support the opinion that risk and return trade-off play an important role in arriving at investment-making decisions. Some of these theories include the CAPM, Modern Portfolio Theory (MPT) and the Efficient Market Hypothesis (EMP). This can be proven using the Capital and Security Market Lines whereby both portray a positively sloping curve implying that the higher the risk the higher the expected return.

Figure 1: Capital Market Line. Figure 2: Security Market Line

Looking at the above graphs (indicating that the higher the risk taken the higher the expected return), and according to Haslem, 2003, investors should be compensated for taking very high risk in the hope of expecting higher returns. Never the less, investors are adviced to create a market portfolio(a portfolio consisting of all securities / assets whereby the proportion invested in each security corresponds to its market value) which is located on the efficient frontier (describes the relationship between the return that can be expected from a portfolio and the riskiness of the portfolio). The fact that risk and return form the foundation in classical finance especially when investment decision-making is concerned has led to the birth of many schools of thought and authors amongst which we have Angelico et al (2000) and McMenamin (1999) . They are all bring out the point that risk and return lay the foundation for very important and rational investment decisions to be taken. There are number of assumptions associated with these classical financial views. Some of these include:

· The fact that risk is an objective measure which is quantitative in nature hence can be calculated using historical as well as statistical data (Beta and Standard Deviation) (Levy and Sarnat, 1972).

· The opinion that investors are generally rational in their decision-making and are generally risk-averse in their attitude as far as risk is concern (Pratt and Grabowski, 2008).

· The point that higher risk will always be rewarded with higher return also known as the risk-return trade-off.

Owing to these assumptions, it is evident that investors when faced with investment decision and considering risk and return remaining constant, all investors will definitely choose the investment that will result to a less risky alternative though at the same level of the expected return (Friedman and Sevage, 1948). Critically looking at the assumptions of the classical

finance, it is evident that all investors and everybody in the financial market think in the same direction. This goes to confirm the point that whether they are expert professionals, institutions or indidvaidual investors, there is actually no difference in investors' behaviour.

Contrary to the above, the behavioural finance school of thought differs from the classical school of thought. This is to say, within the behavioural financial content, they try in explaining investors' behaviour in decision making process. They do so by looking at the socio-psychological factors point of view that influence investors when making their decisions. Some behavioural finance economists including Statman (1995, 1999), Tversky and Kahneman (1974), Thaler (1994) stress on the fact that based on these sociopsychological factors, there exist sufficient evidence in support of the repeated patterns of irrationality and inconsistence when investment decision-making is concern especially when there is a choice of choosing from a situation of uncertainty. Behavioural finance school of thought views risk as being a subjective measure hence investors are bound not to only exhibit a risk-averse attitude towards risk but they can as well be risk-seeking or risk-neutral. This therefore implies investors will not only seek the risk's highest level of return but will like to as well maximise the risk's expected return hence wanting to maximise the satisfying strategy (Sortino, 2001).

According to Frankfurter et al (2002), «Behavioural finance has looked at risk in greater depth and found that attitudes towards risk are not logical.... Real individuals usually have to address risk in situations that they have never encountered before and will never encounter again, for which statistical techniques are largely irrelevant.... There is clearly much more to risk than finance has begun to consider, and much of it involves how people form images of the events of which they are expected to assess the risk»(p. 456).

The human decision-making process as claimed by the researchers of behavioural finance, is subject to a number of cognitive illusions which can be grouped into heuristic decision processes (overconfidence, anchoring, gambler's fallacy and availabilty bias) and the prospect theory (loss aversion and regret).

Regarding the arguments surrounding how risk and return greatly influence investment decision, it therefore calls for concern to find out the extent to which the relationship that exists between risk and return help in influencing the investment decision-making process.

In the last three years or so, the cry of the day has been that of the global financial crisis. Most writers and businessmen say this is the greatest global financial crisis since the Great Depression in the 1930s which could be traced as a failure in financial regulations to keep pace with an out of control financial system (Krugman,2008). The causes of today's financial crisis such as inefficient risk management, inadequacies of the global model of banking regulations, are not different from the causes of the Great Depression in the 1930s, no doubt Krugman describes it as the return of the Depression.

The root cause of the most recent global financial crisis can be traced back as a result of the failure of the US Treasury allowing Lehman Brothers- a major Wall Street investment bank, to default sometime around September 2008. This resulted to a lot of panic with so much consequences felt in the financial sector as the prices of most financial assets had a massive turndown. As if that was not enough, there was also the freezing of most inter-banks' loans thereby resulting to `insecurity' and doubts in the banks shares as well as the banks' balance sheets. This was a clear evident that the crisis has brought to light so much focus on the inadequacies in the present regulations in financial institutions, no doubt, there was the need of restructuring these financial regulations specifically within financial institutions. This is because the initial phase of the present financial crisis almost led to the near collapse of

Northern Rock, a UK medium size mortgage provider. Moreover, the high and incontrollable risk-taking of some big hedge funds and the building role they played in this crisis has resulted in it being the centre of discussion as far as global finance regulations are concerned.

This was done with the US, the UK together with some EU countries putting together pieces of bank rescue packages together. These rescue packages were centred on bank recapitalization where by the states had to purchase most of the bank shares in a bid to reestablish that investors' confidence in financial institutions. These rescue packages introduced were to an extent temporary no doubt there was some part-nationalisation of some banks whereas, in some cases there were out right purchase of these bad loan assets by the state. For instance, the US at one point in time had to grant state guarantees of some bank assets so as to stabilise the inter-bank connections and businesses. The above mentioned points are enough evident for the need for financial regulations to be implemented for the sake of these financial institutions to be operated orderly as well as avoiding the outbreak of any other financial crisis in the nearest future. The diagram below summarises the UK bank rescue package.

Figure 3: The UK Bank Rescue Package

Source: HM Treasury 2008-9 Near-Cash Projections

The above UK rescue package is aimed at putting the British banking system on a better footing. This is because it is hoped that the deal will get money moving again thereby assuring the future of the banking system once more. Looking at the diagram above, it is seen that £250billion from the Treasury and the Bank of England is being injected into the economy through commercial banks. By implication, there is up to £250billion in the form of loan guarantees to be available at commercial rates so as to encourage banks to lend to each other as well as to individuals and small businesses. From here, banks can easily lend money to other banks, individuals and small businesses whereby these individuals and small

businesses will repay the borrowed money plus interest to the banks and the banks to the Bank of England (UK Central Bank). But bear in mind that, in order to participate in the scheme; banks will need to sign an agreement on executive pay and dividends.

In order to put into effect these rescue packages, some banks especially commercial and investment banks began utilizing the prevailing atmosphere made up of excessive liquidity and financial innovation in acquiring huge exposures in the global credit markets. With the use of these of alternative investment schemes, massive amounts of assets and liabilities were moved off the balance sheet resulting to the so called shadow-banking (banking system referring to any unregulated activities carried out by regulated financial institutions). Although the risks associated with these positions were unpredictable, yet there were some financial institutions which enjoyed some reasonable amount of government guarantee and ended up adopting very casual attitude towards risk controls. To an extent, it is evident that one of the root causes of the present global crisis is as a result of this attitude towards risk hence resulting to most rescue packages being directed to universal banks especially in EU and Switzerland.

Some international investment funds such as the hedge funds were of the highly leveraged institutions and as such, they were to a larger extent of regulatory oversight. Thanks to their active participation in the global credit market, they were constantly increasing in size and number. As such, some economists have argued that one of the causes of the present global financial crisis was the unregulated nature of the practice of shadow-banking. As if that is not enough, the nature in which the shadow-banking sector was operated coupled with the absence of the global regulation framework especially for international investment funds, greatly contributed to outbreak of the present global crisis thereby bringing the global financial system into a near collapse.

1.2 Rationale of Study and Gaps in Existing Research

Although there are numerous conceptual evidence on the validity of classical financial theories such as the CAPM, MPT and EMH, in trying to provide insights and explanations to the general idea of the investment decision-making process, there is a need for reviewing the existing literature revealing that very little attention is being given to the behavioural aspects influencing the entire process. The classical finance school of thought seeks in portraying investment decision-making processes as processes which can be studied and applied properly in real life. With investors bearing this in mind, they will be allowed to be able to predict as well as beat the market hence the issue of human error and irrationality will not arise.

On the other hand, behavioural finance has proven to have very strong implications especially when seeking to provide cover for the lacuna done by the classical finance school of thought when trying to stress on the investment decision-making process. Behavioural finance researchers try in providing detailed explanations for the existence of irrationality and human errors as far as investment decision-making are concerned so as to reduce risk if it cannot be avoided. It is evident that the behavioural finance scholars always try to stress on the fact that in order not to avoid any investment mistakes caused by human beings, then the practitioners (financial) should always try to understand the factors of finance brought out by the behavioural finance scholars. This is because these scholars try to provide an adequate understanding of the application of socio-psychological factors in the investment decision-making processes. This can successfully be done by looking at the way individual investors are influenced by certain cognitive illusions especially as they try to arrive at a decision. As these behavioural finance scholars struggle to provide an adequate understanding into the investment decision-making processes, they have as well failed to look at the proposed sociopsychological factors in details alongside with the classical finance scholars thereby resulting in a gap in the entire investment decision-making processes which therefore calls for concern.

Nevertheless, it has been argued that the theories of classical finance such as CAPM are based on many assumptions some of which are obviously unrealistic?.... «The true test of a model lies not just in the reasonableness of its underlying assumptions but also in the validity and usefulness of the model?s prescription. Tolerance of CAPM?s assumptions, however fanciful, allows the derivation of a concrete, though idealized, model of the manner in which financial markets measure risk and transform it into expected return.» (Mullins, 1982).

This then implies that such important classical finance theories should never be underestimated or disregarded when trying to provide explanations for other factors influencing investment decision-making process.

Judging from the above mentioned points, it can be concluded that the main reason of this research is filling that gap left by the financial researchers by way of critically analysing the process of investment decision-making. That is finding out if the different financial scholars' factors have been assimilated by other different scholars influencing the decision-making process. This therefore leaves us with the question of determining the extent to which the behavioural as well as the classical factors influence the investment decision-making processes thereby giving room to actually understand the domain of finance and investment and how the investment process works as a whole.

1.3 Research Questions

From a general point of view, there always exist some research questions to help in achieving the aims and objectives of any research. This therefore implies that it is not only important but very imperative in identifying some key questions for which the answers will be sought through out the research. It is assumed that when questions are well defined and precise, it is easier and helps the researcher in determining the scope of the study thereby remaining focus on this scope (Porter, 2003). It is evident that these research questions help the researcher in

writing the literature review, tailoring the study framework as well as setting up what techniques to apply and their analysis. In this regard, this research aims at answering the following questions:

Question 1: What types of risks affect financial performance of financial institutions?

Question 2: What financial regulations methods can be used and how will they be implemented?

Question 3: How financial institutions manage risks and create value?

Question 4: What are the key factors affecting preferences for managing risks, financial regulations and value creation?

Question 5: What is the perception of managers regarding risk management, financial regulations and value creation approaches used?

Question 6: What value creation strategies are to be used in financial institutions that will fully incorporate risks management and financial regulations and how successful will these strategies be?

1.4 Aims and Objectives

Specifically, this research aims at critically analysing how financial institutions deal with financial regulations, risk management and value creation, hence the research aims at achieving the following objectives:

. Explaining the meanings of financial regulations, risk management and value creation.

. Reasons for financial regulations, risk management and value creation.

. Methods of financial regulations, risk management and value creation.

? Identifying and determining risks that affect financial performance of financial institutions.

? Examining financial regulations, managing risks and value creation approaches of financial institutions.

? Identifying key factors hindering financial regulations, risk management and value creation strategies

? Examining the perception behind managers behaviour towards financial regulations, risk management and value creation approaches

. Recommendation of the importance of financial regulations, risk management and value creation in financial institutions.

1.5 Hypotheses

According to Lind et al, 2005, a hypothesis could be defined as a statement made with reference to a population parameter which is developed for testing purposes. Although, Zikmund, 2003, looks at hypothesis from a different point of view where he sees hypothesis as an unproven proposition that explains certain facts tentatively and these facts can be tested empirically. Hypotheses are usually expressed in two forms: the null and the alternative forms (the exact opposite of the null hypotheses),whereby the null hypothesis is usually a more naturally conservative and dogmatic statement about the status quo which is tested using statistical evidence and helps in rejecting any contrary propositions not tied to it. The null hypothesis is usually denoted by (Ho) with the alternative denoted by (H1).

Therefore for the purpose of this research, the hypotheses shall be stated as follows:

Ho: Financial Regulations, Risk Management and Value Creation are the main factors influencing investment decisions in financial institutions.

H1: Financial Regulations, Risk Management and Value Creation, are not the main Behavioural Factors influencing investment decisions in financial institutions.

Researches in behavioural finance show that the process of decision-making is subject to a number of cognitive illusions which are grouped into heuristic (overconfidence, gambler's fallacy as well as availability bias) decision processes and the prospect theory (regret and loss aversion). These behavioural factors equally play an important role when the investment decision-making process is concern.

1.6 Summary of Methodology

The research methods to be used will be the secondary and tertiary methods. This will entail the reading of textbooks and financial websites and journals. With the information collected from these methods, the researcher will be able to know the extent to which the notion of financial regulations, risk management and value creation influence investment decisions in financial institutions and whether there exists other factors that influence these investment decision-making process and how these factors act up with financial regulation, risks management and value creation as far as investment decision-making is concern in financial institutions.

1.7 Summary of Chapters

This research will be made up of five chapters with chapter one being based on providing
justifications for the study and bringing out the general idea about the entire research, stating

the objectives and the hypotheses of the study ,as well as the rationale of the study and its implications though from different perspectives.

Chapter two brings out the theoretical as well as the empirical literature on financial regulations, risk management and value creation and the role they play in investment decision-making. In this chapter, all the key terms will be defined as well as looking into the relationship existing between the key terms. The last part of this chapter is dedicated to the investment decision-making process and how behavioural factors as well as some financial assets influence the investment decision-making process within the financial sector.

For the purpose of our research, chapter three will be based on providing arguments on the methods used in carrying out the research as well bringing out the short comings of the methodology.

Chapter four will be responsible for the analysis and discussion of the findings.

Chapter five will be dedicated to the conclusion and proposition of a frame work (recommendations) which can be of help for future research work.

1.8 Summary of Chapter One

The back bone of this chapter is the provision of a general background and a justification for the research. This chapter contains the research questions, hypotheses, aims and objectives of the study. It has as well as provided a summary of the methodology to be used through out the research.

CHAPTER TWO
LITERATURE REVIEW

2.1 Introduction

This chapter centres around the existing literature on aspects relating to financial regulations, risk management and value creation with regards to investment decision. There exist different scholars with different theories and arguments in relation to this study. This chapter aims at examining secondary as well as tertiary data collected from textbooks, journals, magazines and internet websites/sources.

2.2 Definition and Meaning of Risk

It is evident that everything done in our normal day to day activity involves some aspect of risk-taking. This is to say from getting out of bed to going to sleep, driving a car to merely crossing a road or making an investment decision, all centre on an aspect of risk-taking. Fortunately, the whole idea on risk is very interesting because while some risks might be out of control others are not.

Many schools of thought claim that the word risk is thought to have originated from either the Arabic word `risq? or the Latin word `riscum?, with `risq? signifying something given by God from which a profit can be drawn thus having either a fortuitous or favourable outcome (Merna and Al-Thani, 2008).

Economists claim that the Latin word `riscum? refers to barrier challenges presented to a soldier. Although it has a fortuitous connotation, it is more likely linked to unfavourable events. This word was first ever used in English around the mid-seventeen century with it featuring in insurance transactions in the eighteen century although it has also been used in

both French and Greek with both resulting to positive and negative connotation. Amazingly, throughout the years, the common usage of the word in English has changed though statistics has proven that every aspect of our daily life involves some degree of risk-taking. Hence as a result of this, in today modern day English, there is literally no generally accepted definition for the term risk.

There is a wide range of descriptions that have developed over time as different schools of thought and authors including Slovic (1964), Payne (1973) and Webber (1988) came up with different meanings and descriptions. It has been revealed that just within the field of accounting and behavioural finance, there exist more than 150 unique accounting, financial and investment measurement still under investigation and these have up to date remain as potential risk indicators, (Ricciardi, 2004).

Owing to the above mentioned points, it is clear that the definition of risk can be looked at from different perspectives with every particular discipline coming up with its own definition and meaning of risk. According to Lane and Quack (1999), risk can be defined as follows:«...a state in which the number of possible future events exceeds the number of actually occurring events and some measure of probability are unknown can be attached to them. Risk is thus seen to differ from uncertainty where the probabilities are unknown. Such a definition is beholden to mathematically inspired decision theory and the rational actor? model, and does not sufficiently consider the complexity of risk in business.»( p.989).

Owing to the point that the definition of risk is being looked at from different perspectives, Brehmer, (1987) brought to light the fact that the different definitions of risk differ significantly regarding the specific activity, situation and circumstances. This opinion was further supported by Rohrmann and Renn, 2000 where it was explained that with regards to disciplines such as engineering, physics and toxicology, a definition of risk may be based on

the probability as well as the physical measurements of the negative outcomes. In the social sciences, risk is looked differently again with attention being paid to the qualitative aspects of risk which are seen as crucial facets of the concept.

Reading from Kaplan and Garrick (1981) risk is looked upon as a combination of Uncertainty and Damage. As if that is not enough, Frank Knight (1921) tries to provide a meaning to the word risk explaining the notion of risk differentiating it from uncertainty.«... Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated. The term «risk,» as loosely used in everyday speech and in economic discussion, really covers two things which, functionally at least, in their causal relations to the phenomena of economic organisation, are categorically different... The essential fact is that «risk» means in some cases a quantity susceptible of measurement, while at the other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the two is really present and operating.... It will appear that a measurable uncertainty, or «risk» proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all. We ... accordingly restrict the term «uncertainty» to cases of the non-quantitative type». (Damodaran, 2008).

According to Knight (1921) risk/certainty can be separated with reference to two different points of view (a) knowing the future outcome and (b) knowing the probability that a future outcome will occur is known. Looking at the various definitions of risk, it can be concluded that the definition and meaning of risk can be summarised as the potential recognition of an undesirable consequence that is to happen to anybody. Therefore there exists a relationship between danger and opportunity whereby there is a need to strike a balance as to when to expect higher returns/rewards which comes with the opportunity as well as the risk involved that has to be born as a consequence of the danger. No doubt, Haslem (2003) attempts in

defining/explaining risk from the financial point of view by introducing the notion of return to the definition of risk by stating that:«Risk is the other side of return. Returns comprise of two elements, the periodic payment of interest or dividends (yield) and change in asset values over a period of time (capital gains/losses).»

Judging from all the definitions of risk mentioned above, it is evident that risk is not very simple especially as it is being looked up to by different schools of thought. This then boils to that fact risk itself is subjective and will be very difficult in attempting to manage it.

2.3 Definition and Meaning of Return

The definition of risk provided by Haslem, 2003 whereby risk was defined from a financial perspective point of view leads us to the notion of return. Return, basically is the reward to risk, even though very little has been written about return unlike risk. Never the less, from the normal day to day usage, the word return has so many meanings and definitions provided it is used within the proper context.

According to the Webster's New English Dictionary and Thesaurus (2002), return is defined as: «to come or go back; to repay; to recur. to give or send back; to repay; to yield; to answer; to elect, something returned; a recurrence; recompense; yield, revenue; a form for computing (income) tax.»(p502).

Risk and return are mostly referred to as the different sides of the same coin because in finance and looking at Haslem's definition of risk, return can be considered as the exact opposite of risk. Most economists refer to return as the investors' expected outcome for the risk they are taking and this return is made up of the periodic interest payment (yield) and the change in assets' values over a given period of time (capital gains/losses).

Return is just as risk because it is a double sided coin since return does not imply gaining all the time but sometimes losing. A gain or lost arises from either appreciating or depreciating an asset. As a result of these, investors always try to implement all forms of investment appraisal methods so as to try to be sure that the return at the said stage will only be referred to as the expected return. Note that all projects have a life cycle and it is at the end of the life of any project that the actual return is known which can turn out to be either a lost or a gain or just break-even. This merely lays the foundation for us to know that return must not always be looked at to imply profits since that will just be misleading because sometimes, expected return might show some possibility of profit while the actual return might not thereby taking us back to the idea of danger plus opportunity.

2.4 The Relationship between Risk and Return

Because risk and return are very important aspects in finance, it calls for concern to study the relationship that exists between them. This notwithstanding, it has been brought to our notice that there has been a debate on whether the relationship existing between risk and return is positive, negative or curvilinear (Fiegenbaum et al, 1996). Bear this in mind that as far as issues in finance are concerned, they will always be looked at from at least two different points of view because of the difference between the classical school of thought and the behavioural school of thought.

Statistics has proven that most investors are risk averse. This idea serves as a backbone for looking into the positive relationship existing between risk and return. This is judging from the point that most low risks are mostly associated with low return and vice versa (Fisher and Hall, 1969) thereby leaving investors with the problem of choosing the option that best maximises their abilities (Schoemaker, 1982).

Never the less, this positive relationship of risk and return has been supported by many classical financial theories including CAPM, MPT and EMH and this can be supported by the upward sloping curves of the Security and Capital Market Lines in Figures 1 and 2. Haslem loc also supported the fact that there is a positive relationship between risk and return, where he stated that «the Capital Asset Pricing Model (CAPM) posits that return and risk are positively related, higher return carries higher risk» and this was as well strongly supported by Vaitilingam et al 2006. Using the portfolio theory as a guide for investment decisions, it was suggested that the greater the risk the greater the expected return. This is because, according to Lumby 1988, the basis of the relationship between risk and return has always been justified on grounds that investors are generally risk-averse.

According to Bowman (1980 and 1982), and after carrying out exclusive research and sampling from different industries, Bowman resulted in suggesting the existence of considerable variance with the classical finance theories in relation to risk and return in what became known as the Bowman paradox or the risk and return paradox. It has been evident from his findings that most of the time, when there happen to be a negative relationship between risk and return, that implies investors must have swapped from being risk-averse to risk-seekers and this can be experienced in any institution whether the institutions are performing well or not. This therefore implies there really do exist a negative relationship between risk and return.

2.5 Types of Risks within Financial Institutions

The main objective of financial institutions is to maximise shareholders value by mobilizing deposits and lending to firms and clients having investment projects. Financial institutions always try to make things possible for the income to exceed the interest paid on deposits, borrowings as well as all operating costs. In an attempt to pursuit the aforementioned

objective, financial institutions are faced with a number of risks of which some include credit risks, liquidity risks, interest rate risks, foreign currency risks, operational risks (mistakes and fraud committed by staffs), technological risks (power and equipment failures that lead to data loss), product innovation risks (new products failing), competitive risks, regulatory risks (sanctions for violations of regulatory norms), etc.

Note that of all the risks types mentioned above, the two most important risks however are the interest rate and the credit risks. This is because problems in these areas often lead to liquidity crisis and bank failures. As such, if an institution happens to face an increase in the interest rates on its liabilities and at the same time, fails to increase its interest rate charged on loans to its clients due to competition, then the said institution can become compromised.

Similarly, if an institution results in a series of bad loans that cannot be recovered, its viability can be threatened. Nevertheless, most of the other risks do not usually pose fatal threats. As a result, many of the other risks would need to be combined in order to trigger a crisis. Because risk is considered to involve elements such as feelings of control and knowledge, it is understood that risk perceptions are influenced by socio-cultural factors including trust and fairness. Statistics have proven that the business world (market) is never perfect, that explains the reason of the introduction of the SWOT(Strength, Weaknesses, Opportunities and Treats) analysis since any imperfection caused by any individual will merely be used as an opportunity for some body else (Chromow and Little, 2005).

Some economists claim that one of the causes of the outbreak of the 2007-2009 global financial crises was as a result of some risks taken by financial institutions and banks. As such, because of this crisis, banks have become reluctant to lend to other banks because they are not ready to pay the price for any risk what so ever within the financial sector. As a result of this behaviour, it will be ideal to get an in-depth knowledge of the different risks types existing within financial institutions. Some of the risks faced within financial institutions include:


· Systematic (undiversifiable) risk: this risk type is caused by changes associated with systemic factors. As such, this risk type can only be hedged but cannot be diversified. This risk type come in many different forms, for example, changes in interest rates and government policies.

· Credit risk: This risk arises as a result of the debtor's non-performance. This may arise either from the debtor's inability or unwillingness to perform in the pre-committed contract manner. This is because many people will be affected, that is, from the lender who underwrote the contract to other lenders to the creditors as well as to the debtor's shareholders. Credit risk is diversifiable but difficult to perfectly hedge.

· Counterparty risk comes from the non-performance of a trading partner. This may be as a result of the counterparty's refusal to perform due to adverse price movement caused by some political constraint that was not anticipated by the principals. Diversification is the main tool for controlling counterparty risk.

· Operational risk is the risk associated with the problems of accurately processing, settling, taking and making delivery in exchange for cash. It also arises in record keeping, computing correct payments, processing system failures and complying with various regulations. As such, individual operating problems are small but can easily expose an institution to outcomes that may be very costly.

· Legal risks are endemic in financial institutions. This is in the sense that financial contracting is separate from legal ramifications of credit risk, counterparty risk as well

as operational risk. New statutes and regulations can put formerly well established transactions into contention.

2.6 Definition and Meaning of Risk Management

Risk management has today become a virtual issue for financial institutions because some schools of thought claim that lack of proper risk management practices has been a key factor in the present financial crisis. Generally speaking, risk management is referred to the process of measuring, analysing, controlling and assessing risks as well as developing strategies to manage these risks. Some of the strategies used in managing these risks include transferring the risks to other parties, avoiding the risks, diversifying the risks, etc. Note that financial risk management focuses on just risks that can be managed using financial instruments. All businesses whether big or small do have risk management teams. Sometimes these risk management teams need to use a combination of the risk management strategies to be able to manage their risks.

There are certain principles that must be identified with risk management. As a matter of principle, risk management should result in value creation in any business, be part of any decision making process, be systematic and well-structured and be very transparent. The processes of risk management include the identification of the risk, planning what risk management strategy/strategies to use, mapping out the basis upon which the risks will be evaluated, a definition of a framework within which the `job/task' will be carried out, a development of the analysis of the risks involved in the process and finally implementing the risk management strategy/strategies to be used.

Once the risk management process has been completed, that is to say after the risks have been identified and assessed, all risks management techniques fall into one or more of these categories-avoiding, transferring (for example insurance companies), reducing and retaining (accepting and budgeting). These risk management teams are always faced with a number of

risk options including that of designing a new business process from the start with adequate built-in risk control measures.

In essence, we will like to define the role played by risks within financial institutions, identify when these risks should be managed and when they should be transformed (if possible), as well as the procedures that must be followed for any successful risk management activity of any financial institution. So far so good, it has been argued that risk is an essential factor within the financial sector. It therefore implies that active risk management has a major place in most financial institutions. In the light of this, what techniques/procedures can be used / implemented in limiting and managing these risks?

The answers to these questions are straight forward. It is obvious that if management is to control risk, it has to establish a set of procedures in order to achieve this goal. Note that for each risk type, a four-step procedure is established and implemented to define, measure and manage risk. This will go a long way to assist decision makers to manage risk in a manner that is consistent with management's goals and objectives. These steps include:

· Standards and reports-that is, the creation of a standard setting and financial reporting method. These two activities are the back bone of any risk management system. Therefore consistent evaluation and rating is essential for management to understand the true embedded risks in the portfolio and the extent to which these risks can be reduced if not totally eliminated.

· Position rules-imposed to cover exposures to counterparties and credits. This applies to traders, lenders and portfolio managers. This is so because, in large organizations with thousands of positions maintained and transactions done (on a daily bases), accurate and timely reporting is quite difficult though it is perhaps the most essential.


· Investment guidelines (strategies)-these guidelines and strategies for risk taking in the immediate future are outlined in terms of commitments to particular areas of the market and the need to hedge against systematic risk at a particular time. Guidelines offer advice to the appropriate level of active risk management.


· Incentive contracts and compensation-this explains the extent to which management can enter into incentive compatible contracts with line managers and make compensation related to the risks borne by these individuals, as such, the need for elaborate and costly controls is lessened. These incentive contracts require accurate cost accounting analysis together with risk weighting. Notwithstanding this difficulty, well designed contracts align the goals of managers with other stakeholders.

Risk management need to be an integral part of any institution's business plan. Decisions to either enter or leave or concentrate on an existing business activity require careful assessment of both risks and returns. These risk management procedures must be established so that risk management begins at the point nearest to the assumption of risk. By implication, any trade entry procedures, customer documentation as well as client engagement methods of normal business activities must be adapted to maintain management control and eliminate needless exposure to risk. As if this is not enough, data bases and measurement systems must be developed in accordance with the way the business is conducted. Moreover, for any accurate daily business reports, trades must be recorded, entered and checked in a timely fashion. This helps during an overall effective risk management system put in place by senior management.

There exists three successive levels within any organization corresponding to the levels at
which risk is considered to have been typically managed. The senior management system

used in checking and evaluating business as well as individual performances, need to be sure that these three levels of risks are attained.

Level I aggregates the standalone risks within a single risk factor such as credit risk in a commercial loan portfolio.

Level II aggregates risks across different risk factors within a single business line for instance the combination of assets, liabilities and operating risks in a life insurance.

Level III aggregates risks across different business lines such as banking and insurance. The diagram below summarises the risk management process within financial institutions. Figure 4: Risk Management Procedure.

2.7 Reasons for Risk-taking in Financial Institutions

In spite of the dangers associated with risk-taking and the procedures involved in measuring and managing these risks, some if not all financial institutions still take on to these risks. The question now wondering in our minds is why these institutions need to take on those risks. In order to answer this question, it will be good for us to look into the reasons for financial institutions taking risks. Because this will help us to better understand the need for taking such risks.

It will be ideal to begin by discussing the place of risks and risk management within financial institutions. This can be done by stressing on why `risk' matters and what approaches can be taken to eliminate or reduce these risks. Understanding these, will very much help managers and investors who are faced by these challenges within the financial sector.

The prime goal of every manager is that of profit maximisation. This implies managers ought to maximize their expected profits regardless to the variability of the reported earnings. However, today, there is a growing literature on the reasons for managerial concern over the volatility of financial performance within financial institutions. This is justifiable with the following reasons because any one of these reasons is sufficient enough to motivate management to concern itself with risk and embark upon careful assessment of both the level of risk associated with any financial product as well as any potential risk mitigation. Managerial self-interest, tax effects, the cost of financial distress and capital market imperfections are all potential risk mitigation techniques.

Note that managers have limited ability when it comes to diversifying their investment. This fosters risk aversion as well as a preference for stability. The progressive tax system takes care of the tax effects. This is because, with this system of taxation, the expected tax burden is reduced by reduced volatility in reported taxable income. Financial distress on its own is

costly and the cost of external financing increase rapidly when the financial institution viability is in question. Accepting the fact that the volatility of performance has some negative impact on the value of these financial institutions, leads managers in considering some risks mitigation strategies. Some of these include:

· Risks being eliminated by simple business practices- here the practice of risk avoidance involves actions to reduce the chances of idiosyncratic losses by eliminating such risks that are superfluous to the institution's business purpose.

· Risks being transferred to other participants-there are some risks that can be eliminated or reduced through the technique of risk transfer.

· Risks being actively managed-here there must be good reasons existing for using further resources to manage risks. This is because risk management is central to its business purpose.

In each of the above cases, the goal of the institution is to get rid of the institutions' risks that are not essential to the financial services provided. Financial institutions take such risks because they know how to deal with them either through eliminating, transferring or actively managing the risks. Remember, risks and returns are directly proportionate, the higher the risk the higher the expected return. All in all, precaution is taken that the risk is absorbed and the risk management activity monitors the business activity efficiently as far as risk and return are concerned.

2.8 Definition and Meaning of Financial Regulations

Financial regulation is often reactive with new regulations sealing up leakages in the financial system usually caused by a crisis. As a result of this, it is recommended that regulators should focus on the principal issues that the regulation is intended to address.

Financial regulations are laws and rules governing financial institutions such as banks and
investment companies. Financial regulations aim at maintaining orderly markets, enforcing

applicable laws, prosecuting cases of market misconducts, licensing providers of financial services, protecting clients, promoting financial stability and maintaining confidence in the financial system. However, note that the principal aim of financial regulation is to protect investors who may not be able to protect themselves if left on their own. All these centre on the fact that the recurrent theme in every regulatory report on the causes of the global crisis is the role of lax risk management controls within financial institutions. As such, current financial regulation helps in policing the amount of risk that can be incurred by a financial institution and how that institution manages that risk. The regulatory activities range from setting minimum standards for capital and conduct to making regulatory inspections to investigating and prosecuting misconduct.

Some prominent key advisers (economists, journalists and business leaders) including President Barack Obama have succeeded in introducing a series of regulatory proposals. They also succeeded in mapping out a number of steps that need to be taken in revamping these regulatory systems dealing with financial institutions. Some of these regulatory proposals include consumer protection, expanded regulation of the shadow banking system and bank financial cushions. These are bent on minimizing the impact of the current global financial crisis as well as to try to prevent its recurrence in the nearest future.

The present financial crisis portrayed the inadequacies of financial regulations both at the national and global levels because they failed to license and supervise the financial services providers at all times. A case in point is the boom and collapse of the shadow banking system which according to Krugman, was the core of what happened to cause the crisis. He argued that the shadow banking system expanded to rival conventional banking in importance. As such, politicians, as well as some government officials should have realized they were recreating the kind of financial vulnerability looked upon in the 1930s as one of the causes the Great Depression. This implies these government officials should have responded by

extending some regulations and financial safety so as to protect the new institutions. Therefore, financial regulations should have at least been imposed on all banking-like activities. As if that is not enough, the IMF Managing Director (Dominique Strauss-Kahn) also added that the financial crisis originated as a result of failure on the part of financial regulations to guard against excessive risk-taking in the financial system. Never the less, excessive regulation has also been cited as a possible cause of the crisis. For instance, the Basel II accord has been criticized for requiring banks to increase their capital when risks rise which might result in their decreasing lending when capital becomes scarce. As such, the financial markets only survived after extensive and costly public rescues from the governments and some big banks.

2.8.1 Financial Regulations Methods and Implementations

Basel II financial regulation method is the most commonly used type of financial regulations. Basel II is the second of the Basel Accords which are a set of recommendations on banking and regulators issued by the Basel Committee on Banking Supervision. The purpose of Basel II is to create an international standard that banking regulators can use when creating regulations on how much capital banks need to put aside to guard against the different types of financial and operational risks. Supporters of Basel II believe that such an international standard can help to protect the international financial system from the types of problems that might arise if a major bank or series of banks should collapse. Bear in mind that this Basel II accord made sure the issues of risk measurement as well as risk management within financial institutions were tackled.

One of the most difficult aspects of implementing an international agreement such as Basel II
is the need to accommodate different cultures, different structural models and the already
existing regulations. Bear in mind that regulators can't leave capital decisions totally to the

banks because if they do so they will not be doing their jobs and the public's interest will not be served as well. The Basel II framework is intended to promote a more forward-looking approach to capital supervision, that is, one that encourages banks to identify the risks they may face today and in the future and to develop their abilities in managing those risks. As such, Basel II is intended to be more flexible and better able to evolve with advances in markets and risk management practices.

Following Moody's statistics, it was evident that the CDO market in the Europe, Middle East and Africa (EMEA) grew up to 78% in 2006. This growth was driven by banks in a bid in adjusting to the Basel II regulation. This Basel II regulation forced many banks in 2006 to reexamine their risk exposure so as to limit the amount of capital they will be holding against investments, Crompton, 2007. Crompton looked at securitization and CDOs as means of banks moving some of the risks of their balance sheets into investors hands. All of these centre on Basel II because it has focused its attention on economic capital as well as driving the project market into securitization. This is because securitization is assumed to offer easier access to mortgage assets for investors thereby making things difficult for direct holders of home mortgage loans to procure because of the uncertainty existing in the credit quality of the loans and the problems associated with servicing them.

2.8.1.1 The Growth of CDOs

Table 1: Estimated Size of the Global CDO Market by the end of 2006.

Period

Estimated amount in billions of USD

2002

480.0

2003

570.0

2004

1200.0

2005

1510.0

2006

1980.0

Figure 5: Estimated Global CDO Market Size

Source: Thomson Financial

From the graph above, it is clear that between 2002 and 2006, the CDO market size experienced a steady growth increase. The issuance of the CDOs market experienced a significant increase of about 78% in the year 2006. During this period, most of the CDOs tranches obtained the highest level of credit rating which is the triple A (AAA) rating considered to be the safest by the credit rating agencies. The growth in the CDOs market is as a result of innovation such as the creation and implementation of the Basel II regulation. Thanks to this innovation, the CDO market became one of the most profitable markets for investment banking. The CDO market is now moving towards the direction of on demand credit risk whereby an investor can specify a product's risk/return ratio and the bank merely originates and then distorts this risk/return ratio of the portfolio and delivers a new product to its client. The above mentioned points greatly contributed to the growth of the CDO markets between the years 2002 and 2006 and thereby creating some value to its investors, customers as well as the shareholders hence influencing the investment decision-making process.

2.9 Definition and Meaning of Value Creation

Value creation is the primary objective of any business entity. It is obvious that most successful organisations understand that the purpose of any business is to create value for its customers, employees, investors as well as its shareholders. Because the customers, employees and investors are linked up together, no sustainable value can be created for one unless for all of them. The first point of focus should be that of creating the value for the customer, remember, customers are always right. Value creation for customers will help in selling the services provided. This can only be achieved when the right employees are employed, developed and rewarded as well as when investors keep receiving consistent attractive returns. However, from a financial point of view, value is said to be created when a business earns revenue which surpasses expenses.

Value creation simply put occurs when there is an additional value being added to the bottom line of a business thanks to the creation and use of new methods to maximize the shareholders wealth. Value creation from the customer point of view entails the provision of services that customers will find consistently useful. In today's business world, such value creation is typically based on constant process innovation as well as constantly understanding the customers needs with the ever changing business world. This can be achieved thanks to the commitment, energy and imagination of the employees. In order for these employees to work effectively and committed, they need to be motivated and the best way of doing this is by creating values for the employees as well.

Value creation for employees will include employees to be treated respectively, the provision of continuous training and development as well as the employees participating in decision making processes. Bear this in mind that this only happens when managers decide to define their company's interests broadly enough to include the interest of everybody-from the employees to the customers.

Contrary to the above, things go sour when managers decide not to focus on any value creation strategy but rather make decisions that will in the long run decrease the value of their businesses. This always happens when the managers decide to conceive the self-interest conception. This is because sometimes they decide to ignore employees' satisfaction, learning, research and development effectiveness. Consequently, when these are ignored, the outcomes are horrible because it will definitely result to low employees morals and performances with their associated effects.

2.9.1 Value Creation Strategies

There are different methods leading to value creation in companies and financial institutions. The real value creation - long term growth and profitability - occur when financial institutions decide to develop continuous stream of services that offer unique benefits to their customers. This implies, in order for an institution to maintain an industry leadership position, the institution must establish a sustainable process of value creation. The ability of developing resources and effectively matching them with opportunities is the brain behind any well established institution's value to customers, and the basis of its valuation by shareholders. Note that this value creation process in turn is built on the capabilities and motivation of the institution's employees. No doubt some experts recommend that value creation should be treated as a priority for all employees and institutions decisions. This is because if value creation is put first, managers will know where and how to grow. Also, understanding what creates value will help managers to stay focused. For example, if a customer's value is that of consistent quality and timely delivery then what will be expected of from the manager will be skills, systems and processes that will produce and deliver quality services in time.

In today's business world where nearly everybody is faced with choices, the main challenge for all businesses is to develop and sustain a uniquely and attractive proposition for both customers as well as employees. All the same, the most difficult challenge is doing this in such a way that will result in value creation. This therefore implies managers will continuously be on their feet because they will need to be constantly asking themselves what is to be done that will be different from their competitors and how that will result to value creation? By putting this in place therefore implies you making for yourselves better managers and creating an environment that attracts only people who adhere to very high business performance standards. This more often than not, results with you having more managerial talents than your competitors thereby enabling you to achieve higher levels of

profitable as well as sustainable growth. Lloyds TSB is an example of a financial institution that has made value creation drive to their growth for over decade because at one point in time, they decided to put value creation first.

2.10 The Decision-Making Process

Decisions are not arrived at in a vacuum; they rely on personal resources and some complex models that sometimes do not relate to the situation. This process most of the time encompasses the specific problem faced by the individual as well as extending to their environment. The decision-making process can be defined as the process of choosing a particular alternative from a number of alternatives. According to Mathews, 2005, it is an activity that follows after a proper evaluation of all other alternatives.

However, the Normative Theory of Decision-Making tries to explain the whole idea about the decision-making process and what economists as well as other finance scholars think of it. This theory aims at explaining the actual behaviour of an agent focusing on a rational decision-maker whose aim is that of maximising utility. Applicable to this theory are three economic conditions of risk, certainty (known possible outcomes) and uncertainty (unknown probability distributions). Nonetheless, it is highly argued today that people are highly rational utility maximizers who measure the likely effect of any action on their wealth before deciding. Thanks to the normative theory and the implementation of financial models such as rational decision-making, risk-aversion and uncertainty, the normative theory of decision-making has come under scrutiny.

Making a proper decision involves a trade-off between the risk involve in the decision and the
expected return, no doubt there is a positive shape of both the Security and Capital Market
Lines in Figures 1 and 2 encouraging the fact that investors should be motivated to take

higher risk at least by the promise of a higher expected return although at the same time, this will greatly be determined by the investors' behaviour and attitude towards risk.

As already discussed, most finance theories are based on a number of assumptions of which some include the fact that investors are rational, objective and risk-averse in their behaviour towards risk, and all these come into play in the decision-making process. By being rational implies the reward for an individual's decision is affected by the decisions made by others. Therefore if everything else should remain equal, then all individuals faced with the same situation will make the same decision. Therefore, the optimal choice of the individual is therefore dependent on what they believe others actions are. Cabral 2000 describes this situation as an interdependent decision-making process. Here investors turn to view their actions as being right or wrong depending on the action of others.

The normative decision making theory is of the opinion that individuals try to maximise their utility. This is because, they make economically rational decisions, they can assess outcomes and calculate the alternative paths of these outcomes. This is usually done in a bid of choosing the action that will yield the most preferred outcome.

However, any decision making process is dependent on the individual's attitude and behaviour towards risk with regards to gains and losses. Generally, attitude towards risks when it concerns gains are much more valuable than attitude towards losses. Therefore, making a proper decision involves a trade-off between the risks involve in the decision and the expected return.

Nonetheless, the main assumption of the classical finance school of thought centres on the fact that investors are risk-averse. Risk-aversion is important because it helps us to have a clew as to how investors confront risks and how they behave thereafter. Another assumption of the classical financial theory is that the utility function remains constant overtime and

between situations. As such, if faced with a problem, individual's turn to choose the less risky alternative, at the same level of expected return (Friedman and Sevage 1948), implying therefore that being a risk-averse utility maximizer, investors will turn down any investment option that present a 50/50 lose/gain risk for all initial wealth level (Rabin and Thaler 2000).

2.11 Behavioural Factors Influencing Investment Decision-Making

It has been observed that the behaviour of investors is more dynamic. This behaviour has been a call for concern for numerous researchers in different backgrounds especially within the behavioural and social sciences. However, while sociologists try to explain investors' behaviour by looking at the impact of their social environment, psychologists concentrate on individual characteristics of the investors and economists focus on the rationality and irrationality of investors in the investment decision-making process. All these are geared towards the point that, contrary to the classical finance school of thought, investors are not economically rational and utility maximising.

Behavioural finance is defined by Lintner (1998) as: «the study of how humans interpret and act on information to make informed investment decisions? while Olsen (1998) on his part asserts that `behavioural finance does not try to define rational? behaviour or label decision making as biased or faulty; it seeks to understand and predict systematic financial market implications of psychological decision processes.»

Behavioural finance challenges most of the assumptions of the EMH. It shows that human decision- making process is subject to a number of factors. The behavioural finance scholars use the findings of the so-called Psychology of Choice and Judgement which is considered by them to be the first pillar of the Behavioural Decision Theory. The heuristic factors (the most important findings of the Psychology of Choice and Judgement) claim that the decision making process is not always strictly rational. Here, when all relevant information is collected

and objectively evaluated, the decision maker tries to take shortcuts. Heuristics can therefore be viewed as rules of thumb where decisions are made in situations involving high degree of risk and uncertainty. These shortcuts are mostly derived from some past experiences and they most of the time lead to wrong directions and poor decisions being arrived at. This is because, in trying to adopt these shortcuts in the decision-making process, relevant facts which should normally be included are being ignored. Typical examples of illusions resulted from the use of heuristics in the decision-making processes include overconfidence, gambler?s fallacy and availability bias.

Overconfidence can be described as the belief in oneself and one's abilities with full conviction. This has to do with the way decision-makers believe in their predictive skills and abilities. In some cases, it leads investors to overestimating their predictive skills thereby conceiving the belief that they can `time' the market. The reasons for the existence of overconfidence within experts in their decision-making process include the failure to contemplate that human make mistakes, failure to pay attention to how technology systems perform as a whole, failure to predict how people response to safety procedures and the exhibition of overconfidence in existing scientific knowledge. Investors turn to exhibit to the heuristic of overconfidence when they consider themselves not vulnerable to a specific risky activity.

Anchoring involves a decision making process of thought. This is to say people solve problems by selecting an initial reference point. This occurs when we create a value scale based on recent observations. Once the reference point has been created, there is the tendency that we turn to adjust to correct the solutions that differ from the initial conviction. The anchoring bias is very complex because it is like an addiction so much so that even when the individual realise that they are anchoring, they will still find it hard to quite. Massimo (1994) summarises the whole heuristic idea of anchoring in the following words:

«revising an intuitive, impulsive judgment will never be sufficient to undo the original judgment completely. Consciously or unconsciously, we always remain anchored to our original opinion, and we correct that view only starting from the same opinion». (p127).

Gambler?s fallacy occurs when an individual assumes that a departure from what happened in the long term will be corrected in the short term. Here, people turn to have every poor intuition about the behaviour of random event thereby expecting a reversal of the event to occur more frequently than it actually happened. Secondly, people always turn to have strong reliance on the representativeness.

Availability bias is a human cognitive bias which causes the individual to overestimate the probabilities of an event associated with memorable occurrences. This causes people to base their judgement and decisions on the most recent and meaningful event they can remember. A case in point is one getting involved in a car accident in the course of the week. It is obvious for the person to drive with some degree of care and caution for some time. But with the passage of time, there is a likelihood that the person's driving will go back to the original state. As a result of this availability bias, investors turn to focus primarily on the short term events relating to the immediate past and completely disregarding the long term events. Unfortunately, availability bias can result in investors developing a false sense of security as it can cause people to think that events which have great media attention are more important and pertinent, which is not always the case.

In addition to the above, sometimes in order to make some investment decisions, these investors need to be risk-tolerant. The prospect theory tries to explain how behavioural factors influence risk-tolerance during the investment decision-making process. With the prospect theory, value is assigned to gains and losses with the weights of the decision being replaced by probabilities. This theory best explains why investors are often more attached to

insurance and gambling. The theory came up with the conclusion that investors usually weigh the probable outcomes when compared with certain outcomes.

This prospect theory looks at different states of mind that are expected to influence the individual in the decision-making process and include concepts such as regret (emotional reaction worn by people upon making a mistake), loss aversion (associating greater mental penalty with loss) and mental accounting (attempting to arrange the business into separate accounts).

2.12 Assets Influencing Investment Decision-Making

In spite of the in-depth idea of risk and return, risk management, financial regulations and value creation towards investment decision-making discussed above, some prominent economists still suggest that they are some assets within the financial markets that help in influencing investment decisions-making processes. Some of these include:

2.12.1 Collateralized Debt Obligations (CDOs)

CDOs are investment grade securities which are backed by bonds, loans as well as other assets. Note that CDOs do not specialise in just one debt type rather they are more of non-mortgage loans or bonds. With CDOs, the different debt types are often referred to as `tranches' with each tranche having different maturities and risks associated with it. Bear in mind that the higher the risk the higher the CDO to be paid. These CDOs are very unique in that they represent different types of credit risks and debts. No doubt, they are being looked at as structured finance vehicles aimed at issuing multiple classes of liabilities as well as rating debt tranches having different credit risk/return profiles.

With CDOs, the securities are divided into different classes of risk because the interest and
the principal payments are being made with reference to the risk class with the most senior

classes being looked upon as the safest securities. Some investors warned that CDOs are assumed to be spreading risks through diversification rather than reducing risks of the underlying assets. As a result of this, one of the reasons for the outbreak of the present financial crisis was the failure of the credit rating agencies in adequately accounting for large risks when they were rating these CDOs.

According to Moody's Investors Service, the growth of the CDO markets never accelerated until in the early 2000s when these CDOs were introduced. They got to their peak in the first half of 2007 although it was so short-lived because statistics show that from the first half of 2007 to the second half of the same year, the CDO issuance is assumed to have dropped by 50% . This drastical drop was considered to have resulted from liquidity problems especially as investors disappeared leaving residential mortgage-backed securities to deteriorate (Steven, 2008). Below is a table summarising the global CDO market issuance data for the period of 2006-2007.

Table 2: Global CDO Market for 2006-2007

Period

Total Issuance in millions of USD

2006-Q1

108,012.7

2006-Q2

124,977.9

2006-Q3

138,628.7

20006-Q4

180,090.3

2007-Q1

184,757.4

2007-Q2

179,493.0

2007-Q3

91,529.2

2007-Q4

29,946.7

Figure 6: Global CDO Market for 2006-2007

Source: Thomson Financial

Looking at both the table and the graph, it can be observed that the global CDO issuance was increasing steadily between Q1-06 and Q1-07. It got to its peak during the first quarter of 2007 but this was so short lived because by the fourth quarter of the same 2007, the global market has dropped drastically. Because of what was experienced in the first quarter of 2007, academicians as well as economists have regarded CDO as one of the most important new financial innovations of the past decade no doubt it has registered an increasing number of appeal from many asset managers and investors. This is so because, the CDOs enabled the originators of the underlying assets pass on credit risks to other investors and institutions, thereby making it possible for investors to be forced to understand the in-depth of how the risk for CDOs is being calculated. As if that is not enough, when the CDOs is being issued,

the issuer (typically an investment bank), earns a commission done at the time of the issue as well as a management fee during the life of the CDO.

Note that for any CDO transaction to be effected some participants need to be present. These include investors, underwriters (structurers and arrangers of CDOs- assigning different interest rates to different securities with more risky classes of securities bearing higher interest rates so that investors can be attracted to those securities),(Chromow and Little, 2005), asset managers, trustee and collateral administrators as well as accountants and attorneys with each having different functions and interests. Banks were allowed to participate only at the beginning of 1999 following the Gramm-Leach-Bliley Act (also known as the Financial Services Modernization Act). This is because this Act helped in opening up markets within the banking industry, securities companies as well as insurance companies.

According to Steven, 2008, balancing risk perception, monitoring the performance of underlying assets, getting investors to return to the market and finding liquidity again are some of the things that need to be restructured in the CDO for it to survive. The growth of the CDO was as a result of investors' demand although the issuing of these CDOs were reduced in 2008 because investors had disappeared and liquidity problems began thereby portraying CDOs as greater risks indicators.

CDOs offer returns that are sometimes 2-3 percentage points higher than corporate bonds with the same credit rating. Because of this discrepancy, CDOs have been criticized and looked up to as some sort of complex instruments which are difficult to value. No doubt some economists refer to CDOs as financial weapons of mass destruction thereby blaming them for making the 2007-2009 credit crises more severe than it should have been and led to the subsequent failure of some big financial institutions such as Lehman Brothers.

There exists so many different types of CDOs of which some include: CLOs (collateralized loan obligations)- these are mostly CDOs that are backed up primarily by leveraged bank loans; SFCDOs (structure finance CDOs)-CDOs backed by structured products; CBOs (collateralized bond obligations)-CDOs backed by fixed income securities; CSOs (collateralized synthetic obligations)-implying CDOs backed by credit derivatives, etc as well as there are some CDOs backed by commercial real estate assets, corporate bonds, insurance, etc. With all these different types of CDOs, bear in mind that as of the year 2007, 47% of these CDOs were backed by structured products, 45% were backed by loans and just less than 10% were backed by fixed income securities.

CDOs are known to vary in structure as well as the underlying assets although the basic principle is the same. It is evident that the growth of the CDOs plus the increasing appetite of the CDOs managers for more debt securities are having an important impact in the real estate debt markets (Chromow and Little, 2005). Apportioning different credit rating levels to the different tranches of CDOs makes things easier to be understood since it will be easier for institutional investors to make their investment decisions. This is in the sense that with credit rating agencies rating an asset with AAA signifies the asset is very safe. Therefore, with investors bearing this in mind, they will be able to sell the most risky assets to those they know can withstand high risks while the safest (AAA-rated) assets would be held by the more risk-averse investors.

This credit rating is done so as to get the exact size of classes and this is done with the help of credit rating agencies such as Standard and Poor's and Moody's. These agencies rate the highest/safest class with AAA although this class has the lowest interest, followed by the AA assets. Note that the lowest priority classes are either not rated at all or referred to as the junk class (Chromow and Little, 2005). Because of this increased demand for AAA assets, the lower quality securities that were issued against the initial package of mortgages needed to be

repackage with similar securities from other packages thereby resulting in the creation of new AAA securities referred to as portions of the CDOs since investors used to rely heavily on these securities while the credit rating agencies do their valuations.

Contrary to the above, this process does not work well all the time. Investors have learnt to believe that assets with a triple `A' are always the safest. Unfortunately, this was not the case all the time. These credit rating agencies did rate some toxic assets with AAA, which was therefore misleading. Hence one of the causes of the global financial crises was as a result of this mistake done by these credit rating agencies. This is because investors hurried up to these assets thinking they were safe not knowing that they were toxic assets whose financial values have significantly fallen.

2.12.2 Credit Default Swaps (CDSs)

CDS is one of the most common credit derivatives and these credit derivatives are considered as instruments used in moving risk over from one party to another. This is because they are simple in structure and have very flexible conditions whereby banks as well as investors can easily use in hedging their exposure to credit risk. CDS exchanges streams of payments for agreement in repaying the specified notional amount (face value of an asset/instrument used in calculating payments made) if there is a default payment on the loan caused by a `supposed' third party. Bear in mind that, the protection buying price with a CDS is strictly based on basis point spreads (the annual amount the protection buyer must pay the protection seller over the length of the contract expressed as a percentage of the notional amount) with the basis point being just 0.01% of the contract's notional value of the supposed deal because 1 basis point=0.01%. Note that the premium is usually quoted in basis points per year of the contract's notional amount whose payment is made quarterly. For instance, consider the CDS spreads of the risky corporation to be 25 basis points, that is, 0.25% remembering that 1 basis

point=0.01%, then an investor wanting to buy a $10million worth of protection from a triple `A' bank, must be ready to pay the bank $25,000 per year and these payments continue until the CDS contract expires or a default occurs.

2.12.2.1 How CDSs Work

CDSs allow the contracting partners to trade or hedge the risk that an underlying entity defaults. Here, the protection buyer pays a yearly premium until the contract matures. In return, the protection seller assumes the financial loss in case the underlying security becomes insolvent. As a result of this, a CDS contract resembles an insurance policy whereby one side assumes the risk and the other pays an insurance premium. When signing the contract, the protection buyer and seller agree upon a premium which will remain constant until the contract matures and which compensates the protection seller for bearing the risk.

A typical CDS contract, is bounded with some terms and conditions usually documented under a confirmation referencing the credit derivatives definitions as published by the International Swaps and Derivatives Association (ISDA). In the confirmation, we will have the reference entity specified, be it a corporation or sovereign body generally being identified with outstanding debts plus a reference obligation, usually unsubordinated government bond. Within the confirmation there is a specification of the calculation agent responsible for making the determinations as to successors and substitute reference obligations as well as performing the various calculations and the administrative functions regarding any transaction.

As if that is not enough, in the CDS confirmations, all credit events giving rise to payment obligations by the protection seller and delivery obligations by the protection buyer are being specified. Some of these credit events include bankruptcy with reference to the supposed reference entity and its failure to pay with respect to its direct loan debt. The contract's

effective date and scheduled termination date is always referred to the period over which the

default protection extends. The following diagram illustrates a summary on how CDS works.

Figure 7: A Summary on How CDS Works

Premium

Protection Buyer No credit event: no payment

Credit event: payment Protection

Protection Seller

Reference entity

From the diagram above, it is clear that there is a relationship between the protection buyer and seller whereby a premium is paid to the seller. The seller in return is protected because he has an option of repaying or not depending on the state of the financial market. All of these are sealed in the presence of a reference entity which is usually a corporation or a government. CDS simply put, is a contract of protection between two counterparties-the protection buyer and the protection seller. Note that the protection buyer is the one responsible for making the payments to the protection seller but in case of a default, the seller pays the par value of the bond in exchange for any physical delivery of the bond.

2.12.2.2 CDS Netting

As far as any CDS contract is involved, the protection buyer as well as the protection seller of credit protection takes on counterparty risk in which it is spelt out that the protection buyer needs to take the risk which the protection seller will default in future. There exists this `double default' that only pops up when the triple A bank and the risky corporation default at

the same time thereby resulting in the protection buyer losing his protection against default by the supposed reference entity. At the same time, if either the triple `A' bank defaults but the risky corporation does not, then the protection buyer might need to replace the defaulted CDS but doing so at a very high cost.

Contrary to the above, the protection seller sometimes take the risk assuming the protection buyer will default on the contract thereby depriving the protection seller of any expected revenue stream. The protection seller and protection buyer both have different ways of handling the risks. The protection seller limits his risks by buying protection from another party hence hedging its exposure. If the original protection buyer drops out as a result of this, the protection seller doubles his position by either unwinding the hedge transaction or by selling a new CDS to a third party. Pending on market conditions the price at the time may be lower than that of the original CDS thereby implying a loss to the protection seller and vice-versa.

For instance let's consider an investor buying a CDS from a triple `A' rated bank having a risky corporation as the reference entity. In this case, the protection buyer of the protection is the investor who will make regular payments to the triple `A' rated bank-the protection seller of the protection. Note that should the risky corporation default on its debt, the investor will eventually receive a one-time payment from the triple `A' bank terminating the CDS contract.

The first ever existed CDS was in the early 1990s although the market only increased at the beginning of 2003 up to the end of 2007 and fell by the end of 2008. The increase of these CDSs during this period is because the CDSs help in completing markets to investors since they provide effective means to hedge and trade credit risk. This is achieved by the CDSs allowing credit risk to be hedged separately from interest rates. Also, CDSs allow financial institutions to manage their exposures better thereby making it possible for investors to

benefit from enhanced investment. In addition to this, CDSs spreads provide a valuable market-based assessment of credit conditions. The strong growth of this CDS market is because of financial institutions' desire of better managing credit risk and of traders gaining exposure to the credit markets. All in all, the main reason behind the growth of the CDS markets during this period was because most banks used the CDS spreads as a measure of their credit risk as well as their risks management tool (buying credit protection through CDS). CDSs were used as trading tools as well as a means of allocating risks efficiently.

The major reason for the fall of the CDS markets by the end of 2008 was as a result of the collapse of Lehman Brothers. As if this is not enough, it is argued that the enhanced transparency in CDS would instead result in lowering the risks of excessive market reactions. A case in point is the collapse of Lehman Brothers which provided a vivid example on how insufficient transparency may result to market reactions overshooting.

Table 3: The ISDA Market Survey for CDSs

Notional amounts (in billions of US dollars), semiannual data, all surveyed contracts, 2002- 2009

Period

CDS Outstanding (billions of USD )

2H02

2,191.57

2H03

3,777.40

2H04

8,422.28

2H05

17,096.14

2H06

34,422.80

2H07

62,173.20

Figure 8: Increase in CDS Markets

Source: ISDA Market Survey

The graph above illustrates an increment in the CDS markets. The increase was as a result of how investors used these CDSs for many reasons such as hedging and trading risks as well as in managing their exposures.

Most of the time, credit events are referred to as defaults and they include events such as failure to pay, restructuring and bankruptcy. In situations where the reference entity defaults, the triple `A' bank pays the investor the difference between the par value and the market price of the specified debt obligation. This is mostly referred to as cash settlement.

The major difference existing between insurance and CDS is that insurance contracts provide indemnity against losses suffered by policy holders while the CDS contracts provide equal payout to all holders, using the agreed, market-wide method of calculation. As if that is not enough, with insurance contracts, all the risks involved needed to be disclosed whereas with

CDSs they are no such requirement. The CDSs protection sellers are not required to maintain any capital reserves to serve as guarantee payment of claims unlike the insurance companies where it is a necessity.

Defaults are usually referred to as credit events since they entail events such as failure to pay, restructuring and bankruptcy. Statistics show that most CDSs range between $10 to $20 million with maturities varying between 1 and 10years. Most of the time, the bond holders buy protection so as to hedge their risks of default thereby making CDS to be similar to credit insurance though different from some other governing regulations.

2.12.2.3 Naked CDSs

CDSs are considered as `naked' when they allow traders to buy CDSs who neither own the underlying bond nor is otherwise exposed to the credit risk of the reference entity. Hence making it possible for investors to be able to buy and sell protection without owning any bonds. Usually, the buyer of the naked CDS protection tries to exploit the arbitrage opportunities that are taking advantage of the differences in the risk pricing between the bond and the CDS markets and trying to benefit from the rise in credit risk. Naked CDSs are considered as not serving any useful purpose and are therefore looked upon as to be dangerous. They do not help in either price discovery or in any liquidity because they might instead affect the funding cost.

The most important and obvious argument against naked CDSs is related to their moral hazard. This usually arises when it is possible to insure without an `insurable interest'. This therefore implies they do not create any values. They influence the interest level of original transactions which can be compared to taking out life insurance on someone else's life. Naked CDSs increase leverage which usually comes at low costs to the default of the reference entity. This implies they can substantially increase the losses that come from defaults.

Therefore naked CDSs should be forbidden because they do not have a purpose in the society and the society does not benefit from them. With naked CDSs, only one party is the winner while the others lose.

To an extent, these naked CDSs contributed to the out break of the present global financial crises. This is because they involved a lot of gambling with no social or economic benefit. As a result of this, naked CDSs have played an important role in destabilising the financial system. Note that these naked CDSs constitute a large part of all CDS transactions and CDS as whole is being associated with insufficient transparency. The collapse of the Lehman Brothers was as a result of this insufficient transparency portrayed by these CDSs. The problems encountered by Lehman Brothers and its eventual collapse were the onset of the present global financial crisis.

2.12.2.4 Uses of CDSs

Investors use CDSs to speculate on changes in the CDSs spreads of single names thereby creating a more competitive market place where the prices are kept down for hedgers. Investors do belief that any entity's CDSs spreads are either too high or too low compared with the entity's bond yields. With the help of CDSs spreads, investors can speculate on an entity's credit quality because it is generally belief that CDSs spreads increase as creditworthiness declines and vice-versa. CDSs are known to be used to structure synthetic CDOs. This is in the sense that, instead of owing loans, a synthetic CDO gets credit exposure to a portfolio of fixed income assets without owning those assets through the use of CDS.

Most of the time, CDSs are used in managing risks of default arising from holding debts. For instance, let's consider a bank hedging its risks on a borrower being at default on a loan by entering into a CDS contract as a protection buyer. If the loan happens to go into default, the proceeds from the CDS contract will eventually cancel the losses on the underlying debt.

2.13 Conclusion

The review of the existing literature has revealed that the whole notion on financial regulations, risk management, value creation, risk, return and investment decision-making is so complex. This is therefore viewed differently by the different schools (classical and behavioural) of finance. According to the classical school of thought, risk is purely objective. The investment decision-making process is dependent on the risk and return trade-off and this is also largely dependent on the investor's attitude towards risk which might be risk-averse (hate risk), risk-neutral (risk tolerant) or risk-seeking (risk lovers). This either accounts for the existence of a positive relationship between risk and return, or a negative relationship or a curvilinear relationship. The review equally reveals that the process of decision-making is as well dependent on some socio-psychological illusions collectively referred to as the heuristic factors and the prospect theory. However, there is no existing research reveal by the review of the existing literature that has tested the extent to which a blend of the classical and behavioural finance theories can influence the investment decision-making process.

CHAPTER THREE

METHODOLOGY

3.1 Introduction

All in all, a research is looked at as an art of investigation in search of pertinent information regarding a specific topic, hence making it possible for a researcher to take into account all available information at his disposal. It is therefore the art of investigating into the truth. It is a systematic approach to finding answers to certain (research) questions. This therefore implies that a good a research needs to be logical, systematic and replicable. It is being suggested that a good business research should require some sound reasoning, (Cooper and Schindler, 2008). According to Bryman and Bell, 2003, a good research should have a systematic approach with concepts being generated and defined, with ideas within a particular study content communicated. This chapter centres on discussing and providing justification for the methodology used as well as also exploiting some of the already existing flaws.

3.2 Research Philosophy

The research philosophy is considered the main aspect influencing the way in which a researcher views the world and undertakes his research strategy (Saunders et al 2007). There exist two schools of thought within the content of research in social sciences regarding the research philosophy-the positivism school implying that the researcher is working within an observable social reality. This best suits researchers carrying on research that has to do with the implementation of scientific methods used in testing social problems, researchers dealing with qualitative and quantitative information and statistical data (Smith et al 2008). According to Smith et al, 2008, the point of focus of every research should centre on the identification of casual explanations.

The positivism school looked at the existence of the socio-psychological factors which might influence the investment decision-making process alongside financial regulations, risk management and value creation as well as the extent to which all these influence the investment decision-making process.

The other school of thought talks about studying through gaining an insight through the discovery of meaning by way of improving people's understanding as a whole. This school of thought is known as the interpretivism. According to Husserl, 1965, the interpretivists belief that the world can not be objectively determined but rather socially constructed. According to the interpretivists, the promotion of values of qualitative data in the pursuit of knowledge is what matters most. It is with this uniqueness plus its assumption of the fact that by placing people within their social content, that made Hussey & Hussey, 1997 to conclude that there is a greater opportunity in understanding what conception people have regarding their own activities. As such, the interpretivists try in providing a platform for a better understanding on how investors make sense out of the world around them. Note that this research will be a blend of both schools of thought.

3.3 Research Approach

Reading from Saunders et al, 2007, it is evident that the general research approach adopted just for study purposes is based mainly on the philosophical stance which is adopted for the research with the deductive approach normally based on positivism and the inductive approach on interpretivism. Contrary to the deductive approach which focuses on the formulation of the hypotheses and the use of statistical methods in the data analysis process, the inductive approach helps in establishing links between the research objectives as well as assisting in the production of reliable and valid findings. Note that the deductive approach will be used in presenting the findings and conclusions.

3.4 Choice of Method

According to Trow, 1957, the application of the philosophical assumptions of positivism and interpretivism to this study is an indication that this study took a pluralist methodological stance. This is so because this study focuses on understanding, interpreting, describing and explaining how financial regulations, risk management and value creation influence investment decision-making combine with some socio-psychological factors.

For the purpose of this study, we will be using the secondary and tertiary methods of data collection. Reading from Saunders et al, 2003, secondary data is a form of data that has been collected for use for other purpose(s) but can still be used in answering the designed research questions. In other words, these are can be referred to as ready-made materials. These are often used in providing foundations for present day studies by helping in the investigation and provision of some already existing theories in classical and behavioural finance that relate to the study. While secondary data is mostly gotten from textbooks, newspapers, journals and magazines, tertiary data is gotten from the internet and encyclopaedias.

CHAPTER FOUR

ANALYSIS AND DISCUSSION OF FINDINGS 4.1 Purpose of the Chapter

This chapter will focus on the presentation of the results obtained from the findings. These results will be analysed by bringing out the difference between the classical and behavioural schools of finance as well as testing the hypotheses. Also, within the content of this section, we will be explaining how the concept of behavioural finance best explains and contributes to the outbreak of the present global crisis. Note that the analysis and results are dependent upon the findings of this study. In this chapter, the results of the findings will be described and presented.

4.2 Description of Findings-Classical Finance Vs Behavioural Finance

Statistics has proven that risk plays a very important role in investment no doubt it is considered to be a very important topic in investment. This is because an understanding of risk and how it is measured is cardinal to the development of investment strategies and the subsequent making of investment decisions. As pointed out by Blume (1971), risk constitutes a controversy amongst different financial theories which can all be classified under the classical and behavioural schools of finance. Based on these differences, this section of the study will be responsible for the on going debate on the existing views of the risk concept.

Levy and Sarnat (1972) stress on the fact that some already existing classical financial theories such as the CAPM, MPT and EMH are all moving towards the direction of risk being a uni-dimensional concept since its measurement is so purely objective. Based on this, they try in providing very basic description of the classical finance school of thought's approach towards risk as follows:

«Subsequently, various economists have tried to evaluate investments with the aid of two (or more) indicators based on the distribution of returns. Generally one index reflects the profitability of the investment while the other is based on the dispersion of the distribution of returns and reflects the investment?s risk. The most common profitability index used is the expected return that is the mean of the probability distribution of returns; the risk index is usually based on the variance of the distribution, its range and so on». (p.303)

Following what Levy and Sarnat mentioned above, it is evident that risk has to do with; the standard deviation where by the volatility of the return can be measured with the beta coefficient responsible for comparing the volatility of the different security and portfolio within the market with that of the market as a whole. Risk is most often than not evaluated following the different variations of returns of an investment with reference to its expected return, hence confirming the fact that risk is a double sided coin. The main reason behind risk centres on the fact that risky investments stand better chances of higher expected returns unlike a risk-free investment. This is because it is assumed that during decision-making, investors try to make decisions with possible outcome being associated with specific expected return.

As such, there are two categories of risks as far as the classical financial theories are concern-systematic risk also known as non-diversifiable risk, is the risk type that can not be eliminated hence it is associated with the entire market. On the other hand, we have the unsystematic risk which is entirely associated with particular companies, thereby making this risk type unique and diversifiable (Bodie et al, 2008).

Within the content of the classical financial investment decision theories, it is assumed that individual investors behave in a rational manner and make optimal decisions when confronted with judgements regarding risk and uncertainty.

In addition to the above, this research equally revealed the fact the behavioural finance scholars just as the name `behavioural' try to provide an absolute understanding of the behaviour of investors in general. As a result, they look into the general idea on risk and investment from all fields of life no doubt it is mostly referred to as an interdisciplinary field which developed from all subjects in life be it sociology, psychology, finance as well as behavioural economics hence greatly influencing some investment decisions.

This boils down to the fact that behavioural finance, unlike classical finance, takes a completely radical view when it comes to the subject of decision-making. As if that is not enough, behavioural finance researchers claim that investors do not need to always seek the highest return for a given level of risk at any given point in time as assumed by MPT.

In the course of our study, it was realised that unlike the classical financial school of thought, the behavioural financial school of thought views the decision-making process to be a rationality bounded process. This is fully supported by Bajeux-Besnainou and Ogunc, 2003 when they stated that:

«Satisficing? is an optimization methodology that involves emotions, adaptive learning and cognitive biases. Simon calls for individuals to satisfice?, that is, to optimize until it is close enough in the traditional sense of optimization. By contrast, the traditional way of optimizing is a maximization of a utility function subject to budget constraints, as in the classic economics framework». (p.119)

Contrary to the views of classical finance, with behavioural finance, it is assumed that an important aspect in investment decision-making process is subjective to aspects perceived by risk investors. No doubt they look at risk to be multidimensional unlike it being unidimensional therefore implying a blend of accounting and financial variables. Looking at risk at a greater in-depth, it has revealed that individual attitudes towards risk are far from being

Other Factors:

Investment
Decision-Making

Financial Regulations

Risk Management

Value Creation

logical. This is so because in real day to day decision-making situation, people are faced with the need to address risk in situations that they have never come across and which they might never encounter thereafter, thus the reliance on statistical techniques is sometimes largely irrelevant and can hardly have any impact on their decisions. As a result, behavioural finance stands a better chance of providing very convincing explanations for the causes of the global financial crisis.

All in all, through out our study, we realised that everything on the investment decision-making process centred on these two schools of finance. Both schools stressed on the fact that some aspect of risk needs to be taken in order to expect any form of return, therefore investors need to take on to the risk in order to create an expected return.

4.3 Discussion of Findings

From the study so far, it is evident that the investment decision-making process is influenced by financial regulations, risk management and value creation combined with some other socio-psychological factors as shown in the figure below.

Figure 9: Factors Influencing Investment Decision-Making

From the assumptions of the CAPM and MPT theories, this study revealed that investors are risks-averse in their behaviour in making investment decisions although these investors can be risks tolerant sometimes thereby portraying the fact investors still have different perceptions in their attitude towards risk. This is because personal qualities have a lot to do when it comes to determining the likelihood of losses and exposure to loss.

Regarding the impact of other factors influencing the investment decision-making process, this study also revealed that investors are influenced by socio-psychological factors which include a number of cognitive illusions grouped into heuristic factors and the prospect theory (as explained in chapter two). Within the content of this study, it was revealed that all the factors are important in influencing the investment decision-making process. This study also revealed that the near collapse of some big financial institutions and massive public rescue packages proved that the continuing operation of the banking system is impossible without the state guarantee especially in times of crisis.

In chapter two of this study, we were able to bring out the different risks types existing within the financial sector and how these risks can be managed and why financial institutions need to take on such risks in the first place. It was also realized that there exists a relationship between financial regulations, risk management and value creation and how they all have a common goal which is being geared towards making investment decisions for the institution.

This study also revealed that the global crisis to a large extent is as a result of investors and financial institutions' attitude towards risk control. From our understanding of behavioural finance, it is evident that behavioural finance provides very convincing explanations regarding the causes of the global financial crisis. Therefore most of the causes of the present financial crisis can be identified with factors within the content of the study of behavioural

finance. As such, the biggest proof of the strong influence of behavioural factors/finance to the amplification of the crisis was the collapse of Lehman Brother.

The root cause of the 2007-2009 global financial crises was the liquidity shortfall in the US banking system caused by the overvaluation of certain assets which unfortunately led to the collapse of some very large financial institutions. As a result of this, the confidence that used to reign in financial institutions began to shake thereby resulting to a reduction in the value of shares as well as a fall in share prices for large, small and investment banks between July 2007 and March 2009. This made it possible for the interbank lending services to be disrupted because banks stopped trusting other banks and the trust in the whole financial system started failing, (Shah, 2009). According to Taylor, 2009, the 2007-09 global financial crises became severe as a result of the sudden and an unprecedented surge in the interbank rates. No doubt he argues that the surge in these interbank rates was as a result of counterparty risk hence banks became reluctant to lending to other banks because of fear of the perception that the risk of default on loans had increased implying an increase in the market price for such risks. This strange behaviour of banks caused other banks to suffer from the combination of liquidity, balance sheet pressures as well as becoming concern about the solvency of their counterparties, and hence became reluctant to provide other banks with funding as well. These banks were left with no other option than to get up and dance as the music was playing because it became obvious that if bank A is being refused a loan, it will definitely refuse to loan out to B and C likewise B and C. Therefore, the inter-bank loans' market either became very expensive (high interest rates) or dried up completely. This unwillingness of banks to loan to each other implied that the credit markets were gripped by an irrational panic and this scared away potential lenders because they assumed they will never get back their money.

It is widely accepted and acknowledged that excessive liquidity and overconfidence was one
of the main causes of the massive credit expansion which unfortunately resulted to the present

financial crisis. One of the reasons for the supposed credit expansion was that the market actors were suffered from short memory and became increasingly irrational and overconfidence that liquid markets could continue indefinitely, but unfortunately it did not turn out as anticipated because this overconfidence in the markets was further refuelled by financial innovations such as the development of funding calls on behalf of the banks, keeping of securities as collaterals and creation of CDOs. As a result of this down turn in the markets and because of overconfidence, (the concept of overconfidence is explained in chapter two of this study as the belief in one's skills and abilities) in early 2007, mortgages were extended to borrowers with even dubious credit histories. Because the investors were overconfident with what they were doing, mortgages were given out to people with dubious credit histories which eventually let to the outbreak of the crisis. This of course had to unfortunately spread over to other parts in the western world whereby other mortgage borrowers became scared of the fact that the rising housing prices would last forever and had to rush to jump onto the property wagon because they did not want to be left behind.

Another major cause of the 2007-09 crisis was the lost of confidence in the credit rating agencies. This is because, before the outbreak of the crisis, the credit rating agencies used to be looked upon as the backbone behind any effective operation within credit markets and any activities associated with them. Investors used to use credit rating done by these credit rating agencies in valuing and pricing credit products. When it became obvious that some AAA rated assets by these credit rating agencies were to face large write-downs, investors began losing faith in these credit rating agencies. Consequently, since these investors were no longer willing to rely on the ratings done by these credit rating agencies, they were unable to perform their credit analyses, therefore they had to withdraw. The act of these investors withdrawing implied that the recycling of bank assets to fund business expansion became almost

impossible thereby resulting in a serious liquidity crunch since banks also became reluctant to loan out money to other banks.

4.4 Conclusion

This study to a large extent, succeeded in establishing a relationship between financial regulations, risk management and value creation bearing in mind that these are not the only factors influencing the investment decision-making process. It was revealed in this study that financial regulations, risks management and value creation are the most influential factors influencing investors in the investment decision-making process although there are some other socio-psychological factors alongside. This study also revealed that the behavioural school of finance is in support of the observation that if the `music is playing you have to get up and dance'. Note that the risks involved and the expected return need to be clearly established first before any investment decision can be made. Therefore, it is the starting point in the investment decision making process.

CHAPTER FIVE

CONCLUSIONS AND RECOMMENDATIONS

5.1 Introduction

In this chapter, the findings and analysis in the other chapters together with the review of the existing literature brought out in chapter two will be use for conclusions and in establishing whether or not there exist a relationship between financial regulations, risk management and value creation within financial institutions. This chapter should also be able to tell whether the research questions were answered as well as confirming whether the objectives of this study were achieved. In this section of the study, some recommendations will also be made which can be helpful for future research.

5.2 Overall Assessment of the Aims and Objectives Attainment.

This study was aimed at understanding how financial regulations, risk management and value creation together with other factors influence the investment decision-making process of financial institutions. This section of the study will examine the aims and objectives of the study as well as proving whether or not these aims and objectives were attained. This goes alongside making sure that the research questions asked at the beginning of this study have been answered. If these questions have been answered, then it justifies that the aims and objectives of this study have been attained.

In chapter two of this study, the meanings of financial regulations, risk management and value creation were explained. Also the reasons for financial regulations, risk management and value creation were brought out. In addition to that, the methods of financial regulations, risk management and value creation were brought to light. Still within the contents of chapter two, the different types of risks affecting the performance of financial institutions and how these

institutions manage these risks were explained. By implication, it is obvious that the finding was able to provide answers to all the research questions raised at the beginning of this study as well as meeting the aims and objectives of this study.

5.3 Conclusion

The global crisis has proven that systemic threats posed by irresponsible practices within the financial services industry can cause the collapse of the international financial system. Owing to the behavioural factors discussed above, any proposed reforms may prove insufficient to prevent excess risk-taking. Owing to the above, this study suggests the creation of a new global regulatory consensus with respect to redrawing the current model of the national as well as international financial regulations. Under the suggested model, the high risk/ high return activities will be monitored and banking institutions involved in higher risks activities would be obliged to buy excessive liquidity insurance as well as having limited access to cheap funding basis. Arguably, the combined outcome of any suggested measures would result to a safer banking industry and better customer services.

The consequences of the financial crisis on the global economy and the fragility of the global financial system have proved beyond doubts that doing much of the same is a gamble which western governments will not like to participate. Therefore this is the right time to advance regulatory reforms seeking to replace the `failed' model of the financial regulations with a new one that will be able to liberate the creative forces of the market as well as containing the social costs. The following diagram provides a summary of this study.

Figure 10: Summary

Other Factors:

Financial Regulations

Investment
Decision-Making

Risk Management

Value Creation

All in all, financial regulations are cushions struggling to limit investment decisions which do not comply with the law. Value creation is the primary objective of any business entity and is geared towards adding an additional value to the already existing bottom line. With all these in place, the risk management team trying to comply with the government and its financial regulations as well as creating value within its institution implies that there exist a relationship between financial regulations, risk management and value creation. The question being asked by this risk management team is whether it is actually worth taking such risks.

The diagram above tells us that the investment decision-making process within financial institutions is made possible with the combination of financial regulations, risk management, value creation and other factors (behavioural factors). Note that, any thing done within any business be it in a financial sector or elsewhere is directed towards investment decision-making as shown in the diagram above.

5.4 Recommendations

In spite of the fact that there has been a number of studies conducted on financial regulations, risk management and value creation on how investors behave towards making investment decisions, there is no existing research on how these factors combined with risks and return can influence the investment decision-making process. It is hoped that this research will help create this awareness. Some of the recommendations arrived at as a result of this study include the following:

1. This study suggests that financial regulations should work within the scope of their aims and objectives of licensing and supervising providers of financial services at all times, protecting clients, promoting financial stability and maintaining confidence within the financial system. This is because with these put in place, these financial regulations will be able to eliminate the shadow banking operations. As such, this will go a long way in rebuilding the confidence and trust lost in financial institutions as a result of the outbreak of the global crisis as well as preventing the recurrence of another crisis in the nearest future.

2. It is evident that one of the causes of the 2007-2009 global financial crises was as a result of poor credit rating by the credit crating agencies. It is evident that this credit rating industry/market is still highly oligopolistic since it is dominated by just three main credit rating agencies namely: Standard and Poor's, Fitch and Moody's. This implies this industry is suffering from lack of tight competitions and incentives. I think it is time for more credit rating agencies to come into the business scene so that the methodologies can be scrutinized as well as giving room for some tight competition within the industry. Also, it is proposed that these credit rating agencies be registered. These registered agencies will need to appoint at least three independent directors and

these directors should be able to disclose the methodologies used in producing these ratings including the rating criteria.

3. It is also recommended that some changes be made to the Basel framework thereby making capital requirements more counter-cyclical and forcing banks to reserve larger amounts of capital in good times. This is because should this be implemented, it will go a long way to undoubtedly improve the Basel framework and help to reduce financial institutions' leverage which according to IMF was one of the major causes of the 2007-2009 global financial crises. However, this can only be effective only if the current business model in the financial industry is altered because just a higher capital ratio is not strong enough to prevent the re-occurrence of the crisis.

4. Value creation is the primary objective of any business entity as such; most successful businesses understand that the purpose of any business is that of value creation for its customers. In order for this to be achieved, it is recommended that the right employees are employed, trained, developed and rewarded.

5. It also recommended that any successful risk management process must be able to identify the risks types, the risk management strategies to be used, evaluate the risks, define a framework and then implement the strategies.

6. Because risk management is an integral part of any institution's business plan, it therefore implies any decisions leaving or entering an already existing business activity must require a careful assessment of risks. As such, it is suggested that financial institutions should improve their internal systems devoted to risk evaluation, pricing and control

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Appendix 1:

ISDA Market Survey

 
 
 
 
 
 
 
 

Notional amounts outstanding, semiannual data, all surveyed contracts, 1987-present

 
 

Notional amounts in billions of US dollars, adjusted for double-counting

 
 
 
 
 

Interest rate swaps

Cross-currency
swaps

Interest rate
options

Total IR and currency

Credit
default
swaps

Equity
derivativ
es

 

Activity

Outstandi
ng

Activity

Outstandi
ng

Activity

Outstandi
ng

Activity

Outstand-
ing

Outstand-
ing

Outstand-
ing

1H87

$
181.50

 

$
43.50

 
 
 

$
225.00

 
 
 

2H87

206.30

682.80

42.30

182.80

 
 

248.60

865.60

 
 

1H88

250.50

 

60.30

 
 
 

310.80

 
 
 

2H88

317.60

1,010.20

62.30

316.80

 

327.30

379.90

1,654.30

 
 

1H89

389.20

 

77.60

 

186.80

 

653.60

 
 
 

2H89

444.40

1,502.60

92.00

434.80

148.70

537.30

685.10

2,474.70

 
 

1H90

561.50

 

94.60

 

138.00

 

794.10

 
 
 

2H90

702.80

2,311.50

118.10

577.50

154.30

561.30

975.20

3,450.30

 
 

1H91

762.10

 

161.30

 

198.80

 

1,122.20

 
 
 

2H91

859.70

3,065.10

167.10

807.20

183.90

577.20

1,210.70

4,449.50

 
 

1H92

1,318.30

 

156.10

 

293.60

 

1,768.00

 
 
 

2H92

1,504.30

3,850.80

145.80

860.40

298.80

634.50

1,948.90

5,345.70

 
 

1H93

1,938.40

 

156.80

 

509.70

 

2,604.90

 
 
 

2H93

2,166.20

6,177.30

138.40

899.60

607.30

1,397.60

2,911.90

8,474.50

 
 

1H94

3,182.90

 

181.00

 

850.20

 

4,214.10

 
 
 

2H94

3,058.00

8,815.60

198.30

914.80

663.00

1,572.80

3,919.30

11,303.20

 
 

1H95

3,428.90

10,817.00

153.80

1,039.70

675.80

2,066.20

4,258.50

13,922.90

 
 

2H95

5,269.90

12,810.70

301.30

1,197.40

1,339.60

3,704.50

6,910.80

17,712.60

 
 

1H96

6,520.30

15,584.20

374.00

1,294.70

1,415.70

4,190.10

8,310.00

21,068.90

 
 

2H96

7,157.90

19,170.90

385.10

1,559.60

1,921.50

4,722.60

9,464.50

25,453.10

 
 

1H97

10,792.20

22,115.40

463.10

1,584.80

2,566.60

5,033.10

13,821.90

28,733.30

 
 

2H97

6,274.90

22,291.30

672.30

1,823.60

1,411.80

4,920.10

8,359.00

29,035.00

 
 

1H98

 
 
 
 
 
 
 

36,974.00

 
 

2H98

 
 
 
 
 
 
 

50,997.00

 
 

1H99

 
 
 
 
 
 
 

52,710.50

 
 

2H99

 
 
 
 
 
 
 

58,265.00

 
 

1H00

 
 
 
 
 
 
 

60,366.00

 
 

2H00

 
 
 
 
 
 
 

63,009.00

 
 

1H01

631.50

 
 
 
 
 
 

57,305.00

631.50

 

2H01

918.87

 
 
 
 
 
 

69,207.30

918.87

 

1H02

1,563.48

 
 
 
 
 
 

82,737.03

1,563.48

2,312.13

2H02

2,191.57

 
 
 
 
 
 

101,318.49

2,191.57

2,455.29

1H03

2,687.91

 
 
 
 
 
 

123,899.63

2,687.91

2,784.25

2H03

3,779.40

 
 
 
 
 
 

142,306.92

3,779.40

3,444.08

1H04

5,441.86

 
 
 
 
 
 

164,491.72

5,441.86

3,778.15

2H04

8,422.26

 
 
 
 
 
 

183,583.27

8,422.26

4,151.29

1H05

12,429.88

 
 
 
 
 
 

201,413.54

12,429.88

4,825.98

2H05

17,096.14

 
 
 
 
 
 

213,194.58

17,096.14

5,553.97

1H06

26,005.72

 
 
 
 
 
 

250,829.99

26,005.72

6,383.03

2H06

34,422.80

 
 
 
 
 
 

285,728.14

34,422.80

7,178.48

1H07

45,464.50

 
 
 
 
 
 

347,093.64

45,464.50

10,012.90

2H07

62,173.20

 
 
 
 
 
 

382,302.71

62,173.20

9,995.71

1H08

54,611.82

 
 
 
 
 
 

464,694.95

54,611.82

11,888.13

2H08

38,563.82

 
 
 
 
 
 

403,072.81

38,563.82

8,733.03

1H09

31,223.10

 
 
 
 
 
 

414,089.08

31,223.10

8,788.36

2H09

30,428.11

 
 
 
 
 
 

426,749.60

30,428.11

6,771.58