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
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
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.