The financial crisis : reforming the South African risk management environment
Esterhuysen, Ja'nel Tobias
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The global financial crisis that commenced in June 2007 has been described as the most serious financial crisis since the Great Depression of the 1930s. It resulted in considerable international distress with almost all major banks experiencing capital shortages and some defaulting outright. Among the principal causes was an explosive increase - by a factor of ten in some cases - in credit defaults precipitated by lax lending standards which prevailed for several years. The crisis caused several major institutions to fail (and be subsequently acquired under duress): many of these were subject to takeovers by their relevant sovereigns, including - amongst others - Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac and American International Group and AIG. The financial crisis is believed to be directly responsible for the bleak forecasts (2009 and beyond) faced by the global economy. The measure of global volatility, the VIX, trebled in the third quarter of 2008, interest rate spreads between government fixed income securities and interbank rates widened to unprecedented levels, global inflation threatened an already fragile, volatile marketplace, corporate and retail loan default rates rose and downgrades of large financial institutions (such as US Monoline bond insurers)and manycorporates were experienced by major rating agencies during the first quarter of 2009. The aim of this thesis was to discuss and critically evaluate how the financial crisis has impacted banking risks and also the effect it had on international banks. This has been accomplished through the modification of existing risk measurement techniques and, in some cases, through the development of new techniques, when older risk models proved to be inadequate. A principal secondary aim of the thesis was the testing of these methodologies - in real-world contexts - to ascertain their reliability and robustness concomitant with the adaptation of these methodologies in the light of the new empirical evidence. Important other secondary objectives were the development of novel approaches w0here the research results required it and and the introduction of practical ways to use the results of the thesis in a post-crisis bank risk management environment. Some of the bank asset portfolios that were investigated in the thesis were generated bysimulated data to replicate specific characteristics during the crisis, while the other portfolios comprised entirelyof empirical data. The first objective, of the thesis, was to determine the effect of stressed economic conditions on b.erational risk loss distributions. The depth and duration of the credit crisis have highlighted a number of problems in modern finance. Banks have been accused of excessive risk taking, rating agencies of severe conflicts of interest, central banks of neglecting the inflation of asset price bubbles and national supervisors of laxregulatorycontrols. Credit and market losses have been considerable. Operational losses have also surged as surviving corporates merge or acquire less fortunate ones without the requisite controls. As more jobs get made redundant it is believed that employees revert to internal fraud as their sources of income have dried up drasticallyand stealing from the institution seems to b.tional losses have been affected has been presented and a comparison has been made between operational loss characteristics pre and during the crisis. Some of the main findings were that operational losses have shown little change in frequency, but shown a significant increase in severity, meaning that their financial impact has been more severe during the crisis. It is safe to saythat the financial crisis most definitelyin.creased operational risk in banks much more severe losses. The second objective was to focus on the effect of the stressed economic conditions on the applicability and effectiveness of the credit risk measurement methodologies and the minimum capital requirements, pre.scribed to banks in Basel II. The robustness of the Basel II accord in protecting banks during volatile eco.nomic periods has been challenged in the ongoing financial crisis. Advanced approaches to measuring and managing credit risk in particular have drawn criticism for being too complexand irrelevant. Despite accusa.tions that the accord was largelyresponsible for the crisis, this studyexplored which of Basel II's credit risk approaches were more successful in measuring the bank?s credit risk and calculating the required minimum capital charge for the bank. It was found that, in general, compliance with Basel II actuallyprotected banks during the crisis with the simpler approaches enjoying greater success than more advanced ones, in protect.ing banks against credit risk. The third objective was to appraise the effect of stressed economic conditions on the systemic risk within the South African Banking sector. The financial crisis resulted in increases in credit-, market-and opera.tional risk, but it mayalso have precipitated a surge in systemic risk. Measuring systemic risk as the price of insurance against distressed losses in the South African banking sector, this studyillustrated that the finan.cial crisis has in fact resulted in an increase in systemic risk. Using probabilities of default and asset return correlations as systemic risk indicators, it was established that the financial crisis has indeed increased sys.temic risk in South Africa. The impact was, however, less severe than that experienced in other large interna.tional banks. The fourth and final objective of this studywas to focus on liquiditycreation in South African banks under stressed economic conditions. The financial crisis placed severe pressure on global bank liquidity. Many banks were unable to create sufficient liquidityand had to receive government support or face default. This studyillustrated the impact of the financial crisis on liquiditycreation within South African banks using a model previouslyapplied to US banks. Four measures of liquiditycreation are discussed and applied to data spanning 2004 ? 2009. Although created liquiditydecreased steeplyfrom 2007, liquidity levels in 2009re.main about 45% higher than those of 2004. The four large South African banks created about 80% of the total market liquidity, and a possible reason for this is that these banks have verylarge retail divisions, which have assisted them in creating much more liquiditythan the smaller banks which have much smaller retail divisions. In conclusion, and as illustrated through the findings of this study, the financial crisis did impact the major banking risks on various levels and it is therefore safe to saythat the financial crisis has reformed the interna.tional risk management environment and will also do so in the years to come.