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

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par Agborya-Echi Agbor-Ndakaw
University of Sussex - Master of Science 2010
  

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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.

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