Efb201tut11sol - week 11 tute solutions PDF

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EFB201 Tutorial 11 Questions

1. What impact did the GFC have on the global financial system? What will the long-term implications be for the members of the sector? 2. What are the major lessons that have been learned from past bank failures? Do you think that history can or will repeat itself? Why did the Australian financial system fair comparatively well in the 2007–09 financial crisis? 3. What impact did the financial crisis of 2008–09 have on international banking? 4. How has the role of the corporation changed over time? 5. Why has corporate governance received increasing attention in recent years? 6. Discuss the major reasons put forward for the large derivative losses that have occurred. 7. Outline the concept of “Double Sold” as it relates to the Namoi Cotton situation. 8. Compare and contrast the Orange County and Hammersmith and Fulham Council derivative losses. 9. Discuss how Bernie Madoff’s investment scheme worked. 10. Following the appropriate laws is sufficient to be exhibiting ethical behviour in financial markets. 11. Discuss briefly the trading activities of Nick Leeson and the subsequent fall out from these. 12. It would appear that financial crises repeat themselves. Discuss.

EFB201 Tutorial 11 Solutions 1. What impact did the GFC have on the global financial system? What will the long-term implications be for the members of the sector? The GFC bought the global financial system to the brink of collapse with significant impacts on:  asset values (share markets declined dramatically, bond values collapsed as interest rates were moved, international finance declined as international trade declined, mortgage finance stopped as asset value and available capital declined for example)  Financial institutions around the world collapsed and many were either merged or required significant government bailouts to keep them afloat. This also meant a great deal of job losses in the financial sector  confidence in the financial system declined and capital flows between institutions, into capital markets and across borders changed significantly.  The required government intervention and extension of sovereign debt (to significant levels in some areas – particularly Europe), had a long term effect that will also drive government reregulation of the financial sector.  A significant repricing of risk in all asset classes The long term effects were at the time of writing still being established, however several things are clear:  Reregulation globally is likely to lead to more stringent control of risk, mix and type of operations and level of oversight of financial institutions.  The medium to long term impact of government debt and ownership/intervention in the financial sector may subdue markets and economic activity (and therefore financial activity) for some time.  The repricing of risk in all asset classes will change market behaviour for some time and subdue both retail and wholesale market activity  The negativity surrounding the financial institutions has exacerbated consumer distaste and mistrust in financial institutions which will continue to be a public relations battle for some time.

2. What are the major lessons that have been learned from past bank failures? Do you think that history can or will repeat itself? Why did the Australian financial system fair comparatively well in the 2007–09 financial crisis? One lesson from past bank failures is that, by guaranteeing deposits, prevents bank runs. In the USA, depositors know the FDIC will pay them in an orderly manner. Runs in recent years have been limited to a single bank and have not spread to other insured banks. This has not been an issue in Australia in recent times. Another lesson is that regional or industry depressions are a major cause of bank failures. Another lesson is that fraud, embezzlement, and poor management are the most notable causes of bank failure. As long as these causes remain possible, then bank failures by definition remain possible. If regulators are proactive in applying these lessons,

however, then mass failures on a scale reminiscent of the 1930s or the 1980s are unlikely. The Australian financial system bore up well during the GFC due to the sound foundations of the system (e.g. regulatory framework) and the capital adequacy of the banks.

3. What impact did the financial crisis of 2008–09 have on international banking? The financial crisis has a significant impact on international banking:  Large international banks found themselves in a liquidity crisis and were unable to extend further credit and/or were not prepared to enter into transactions with other institutions  A number of global banks withdrew operations from foreign countries and/or sold operations to other providers.  Regulators imposed restrictions (both directly and indirectly) on transactions  The appetite for risk declined significantly and hence the preparedness to enter into international transactions dissipated.  The crisis resulted in a global recession and hence the demand for international finance declined

4. How has the role of the corporation changed over time? The role of the corporation has changed from that of a purely profit maximisation one to one where the community now expects business to be engaged with the community, to contribute to environmental and social issues and to govern themselves responsibly. This is the so-called corporate social responsibility (CSR) of business.

5. Why has corporate governance received increasing attention in recent years? There has been a gradual evolution in the best practice expectations for corporate governance and high profile organisations such as the OECD, the World Bank and the UN partaking in the debate and discussion. In addition, in the general public arena it has been the corporate scandals, frauds and losses which have put political pressure on governments around the globe to reign in the excesses of the corporate and ensure they are well governed (and in recent times more socially minded). This is primarily within the context of protecting all stakeholders, not just the shareholders.

6. Discuss the major reasons put forward for the large derivative losses that have occurred.

Three broad categories of reasons can be put forward for many derivative losses:1. Fraud 2. Organizational Reasons Lack of Education of Senior Management Internal Controls Lack of Supervision Separation of Duties Limits Remuneration of Employees Counterparty Risk 3. Systemic Reasons Size of Market OTC Market Invisibility Ease of Trading Complex Securities

7. Outline the concept of “Double Sold” as it relates to the Namoi Cotton situation. Namoi Cotton was attempting to hedge cotton prices for a large number of cotton producers. To protect growers against a fall in the price of cotton, cotton futures were sold. The price of cotton actually rose, so a loss was realized on the futures and a profit in the spot market. However, the actual cotton crop turned out to be only half the size of the futures contracts (hence the term “Double Sold”). Thus the futures loss was twice the size of the spot market gain. This turned out to be a disaster for producers as even though prices had risen, they ended up with a much lower price than the futures were hedged at. The lessons learned from this case are that either options could be used to hedge where the size of the exposure is unknown or that a smaller percentage of the exposure is hedged (i.e. not 100%).

8. Compare and contrast the Orange County and Hammersmith and Fulham Council derivative losses. Similarities Both were local government authorities They both used interest swaps or swaptions Both took extremely leveraged positions Both sustained large losses Differences

Robert Citron at Orange County had a long history of success in fixed interest, Hammersmith and Fulham did not. Hammersmith and Fulham had their losses negated as they were found to be legally unable to enter into the contracts.

9. Discuss how Bernie Madoff’s investment scheme worked. Bernie Madoff ran an asset management fund from 1960 until it collapsed in 2008. The fund produced consistently high returns over this period, but when it collapsed had a shortfall of $18b. His fund turned out to be a Ponzi scheme, whereby early investors received high returns which encouraged new investors to invest. Basically the returns to investors were not generated by market transactions, but rather by the contributions of new investors. A number of investigations failed to turn up any evidence against Madoff, although a number of analysts suggested his returns were impossible given the strategies he employed. Madoff eventually turned himself in and was sentenced to 150 years jail.

10. Following the appropriate laws is sufficient to be exhibiting ethical behviour in financial markets. Whilst behaving in a legally correct way may ensure no legal censure follows, it isn’t the only way for market participants to exhibit high ethical values. It may be argued that the legal framework only sets a minimum standard of behaviour for market participants. In addition what is legal or illegal may be somewhat blurred in many instances in financial markets. Having a well-developed sense of ethics is likely to ensure there are no legal ramifications of your behaviour but also increase the collective confidence in the integrity of the market. This confidence in the integrity of the market is likely to result in greater market efficiency.

11. Discuss briefly the trading activities of Nick Leeson and the subsequent fall-out from these. Leeson was trading derivatives (futures and options on equities and fixed interest) on the Singapore and Osaka exchanges and fraudulently covered up losses in an unreported error account. His strategies resulted in cumulative losses of US 1.4b. As a result Barings Bank was eventually sold to ING for £1. Subsequent investigation found an almost complete failure of risk management systems and controls. There was no separation of duties, a lack of supervision of activities and no appropriate limits on the

size of his trading. A driver of these fraudulent activities may have been a desire to maintain a reputation of a top trader, but also to maintain and increase performance bonus payments. Following his activities, moves were made across organisations to strengthen management and board knowledge of derivative products, ensure clearer articulation of risk management objectives and policies, have appropriate segregation of duties, and review remuneration practices.

12. It would appear that financial crises repeat themselves. Discuss. The fact that financial crises periodically occur would seem to indicate that unless each crisis is completely different, then the lessons of previous crises have been ignored or forgotten. Crises often occur in a 7 to 10 year cycle. This may indicate that history repeats itself as the experienced generation retires and a new generation takes over the decision and risk management processes. For example, the Asian financial crisis began in mid-1997 and the global financial crisis began in mid2007.When markets are growing strongly there is a natural human tendency to believe that the positives will continue. A common belief is that the financial and economic environments are stronger/more robust this time and a crisis could not possibly occur. Most market participants make money in a booming market. The words of warning of doomsayers are not welcome. It takes a great deal of courage for governments, central banks, bank supervisors and business managers to implement policies that constrain an organisation or the economy in the good times. By the time it is obviously apparent that a crisis is evolving it may be too late to prevent it....