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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
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3.1 Introduction
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61
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3.2 Research Philosophy
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61
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3.3 Research Approach
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.62
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3.4 Choice of Method
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63
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CHAPTER FOUR
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.64
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PRESENTATION AND DISCUSSION OF FINDINGS
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.64
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4.1 Purpose of Chapter
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64
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4.2 Description of Findings
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64
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4.3 Discussion of Findings
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...67
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4.4 Conclusion
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71
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CHAPTER FIVE
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72
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CONCLUSIONS AND RECOMMENDATIONS
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.72
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5.1 Introduction
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72
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5.2 Overall Assessment of Aims and Objectives Attainment
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...72
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5.3 Conclusion
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73
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5.4 Recommendations
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...75
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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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