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Content: Page No.


Executive summary..................................................................2


Chapter1: Introduction.............................................................3


Chapter 2: Literature Review.....................................................6


Chapter 3: Methodology ...........................................................17


Chapter 4: Analysis....................................................................19


Chapter 5: Financial Crisis in UK and Rest of the World.............29


Conclusion............................................................................... ..36


References............................................................................... ...37

Executive Summary:
There is a high possibility that the gap between the theory and the practice of Risk management can never be filled, given that the real world is always different than the theoretical. But the market will bounce back if there starts the violation of the basic concepts and rules of Risk management. This is what we noticed in the practice of Risk management in last decade, the financial institutes around the world (backed by MBS) took this gap to the extent when their practice started violating the Risk Management teachings. That is the reason why many financial institutes and the economies have suffered the most in the last decade, as the practice of the risk management have never gone this far from the theory of risk management.

Chapter 1 Introduction:
Risk is the fundamental element associated to the business. Irrespective of the nature of the business today, these businesses are associated and occupied by certain risk which threat there profitability in short run and their existence in long run. Although it is matter of fact that few of these organisations are less risk involving in their nature as others. In the modern mind-set of business world, the financial institutes and organisations involve larger risk as they consume higher profits. And no doubt higher profits involve taking big risks. So it is obvious that financial organizations can endure massive losses even in the circumstances if they take risk management on the board at the first priority. They are; after all, in the business involving taking large risks. History witnessed the concept of risk management was first introduced in 1990.The heads of different financial institutes decided to share and collect the combined data base of risk information. It was not only suggested to collect the historical data from the risk information but also to update in regularly with the changing times (S.Allen, 2003). The concept was further taken as professional studies in academic institutes to produce some highly qualified risk managers for the industry to practice this theory. Alongside theory in this field was further tested and examined by the researchers and many models and theories were suggested. That is the part of scheme of Risk management that is known today as theory of Risk management. Whereas the practice of risk management in the organisation was the implication of the suggested theories along with the practical knowledge of the day to day changes in the market and products.

In order to encounter these risks these organisations have risk management team equipped with qualified risk manager having years of expertise in managing risk at financial market and furnished with specialized education in their expertise (S.Allen, 2003). But how was that possible that in year 2007, financial crisis collapsed the whole market. The crisis not only collapsed and bowed the certain market of certain geographical countries but it wrapped the whole financial market of the world. Losses in number and number of jobs, closing down of many organizations particularly financial institutions were among the big casualties of the incident. And the firms that survived this storm were shattered with huge loses that even after 3 year have not been able to sustain their previous position again. The theory of risk management have never predicted similar incident before, although has always warned the organisation that had lost their way in their practice of risk management and have violated the risk management rules in their practice, about leading to the threat which may cost them their survival. Even just before the storm of financial crisis came in November 2007,Clive Crooks a critic argued in in Financial Time (2007) It is obvious there has been a massive failure of risk management across most of the Wall Street. And many other examples spot the times when critics and academic writers mentioned the gap between theory and practice of risk management. And they clearly linked this gap with a massive threat of leading these organisations towards financial crisis. But interestingly, as in those day asset backed financial market was experiencing the boom, they did not considered such critics and warnings (S.Allen, 2003). Isnt that situation put a question mark about the practice of risk managers and their teams in the field? The very first question that comes to mind after the incident in such a modern world of academic research and experimental studies that is there any role; theory could have played to escape these crises? And the logical answer to this query is yes. Theory could have played an important and major role to save these organisations from collapsing and shattering of the whole global financial market (S.Allen, 2003). And no doubt theory was playing its part by that time, but to be realistic about the facts, theory of risk management cannot add any value to organisations unless they match their steps with it and practice it with no gap in between. But on the other hand the history witnessed the practice of financial institutions were remarkably against

the theory, given the high concentration of mortgage market funds based on artificial increase in house price. So, we can argue that these practices are an open violation of the basic lessons of risk management (Mian, & Sufi, 2009). But the way theory is practiced, matters to encounter such collapse. Sometimes the potential risk is located just within the data and its measures that the organisation rely on. And it does also heavily depend on how this data is communicated through the organisation. Creating the synergy within the departments and the subsidiaries/branches by sharing the risk data can also play role as safeguard from financial collapse. But at the similar time the recent organisational history is full of the events that figures out many renowned financial institutes communicating very important and significant risk information to the wrong audience in a very complex manner. And that is how the theory did not add any value to the immune of risk management in these organisations. Financial risk management is not merely about the risk evaluation of an organisation and risk minimising but it deals with the great sense of timing too. If the risk management is the knowledge that can only be learnt through experiences (positive in results or negative) than there is no room for such knowledge to practice or study. Rather risk management is the subject area that predicts and evaluates the potential risks and its effect on an organisation while considering the historical risk data and addressing the everyday changes in the organisation and its related factors (S.Allen, 2003). Hence it is highly important for risk information to be in time and significant for risk managers to prepare (i.e. hedging against the potential risk) for it. That is the reason why financial risk management is effort taking, to acquire right in the best of times. If the right action is not taken in right time, the whole risk management process collapse, as it did in 2007. Research, post 2007 financial crisis have heavily ponder the attention and have targeted the reasons of the incident and it effects. This approach has clearly identified a fact related to this incident that is accepted and agreed upon by almost all the researchers, critics and academic writers that there tend to happen a big gap between theory and practice of risk management. Taking the same context further to investigate many researchers have approached in their

research to identify the key elements and factors that played role in bringing the gap between the theory and practice (S.Allen, 2003). Many of these researchers have identified some of the similar elements, combining together to do this disastrous job. Few of them are listed below.

Over relying on historical Risk data. Over relying on untested data models.
Quantitative-only (numerical) approach towards risk management.

Focusing on narrow measures for risk data modelling. Overlooking knowable and concealed risks. Failing to communicate the accurate data to right audience. Not managing the counter action in real time.

This report will further investigate into these factors with a particular approach of keeping the British banking sector in context. It will also analyse the impact of these gap creating factors in the rest of the sectors and industries not only in Britain but around the global financial market (Canada, USA and Australia). This will help us to investigate the research topic of risk management failure in British banking Sector and also assist in comparing it to the other business areas around the world. The report will approach to the argument in way that it will first try to investigate the modern theory, given the academic suggested models and complex structured models of risk data. It will elaborate the contribution made by academic writers, researchers, and critics in the field of risk management. The second chapter of report literature review will also discuss the similarities among these theories that make bunch of the researchers stand on a same view point about the risk and its potential disasters. It has discussed the suggested models and techniques that have specified the risk factor related to the inexperience of risk management in the practice. Later, in the second chapter of Analysis the practice of risk management in particular at British banking sector will be analysed and will be compared to the theory. Very particularly the certain corporate actions that have clearly created the difference between the theory and the practice of the risk management will be examined and explained. Alongside, it will argued that how the modern practice of risk management in contemporary financial organisations deferred and

violated these academic suggestions, critics and warning. As an outcome of the argument and its analysis this report will summarize its discussion as conclusion. Given the actual results of this negligence and violation, it will be discussed that how this gap can be filled in order not to leave any room for future disasters like 2007.

Chapter 2 Literature review:

2.1 Risk Management and its background: Every sector such as statistician, risk management, and economist has their own style of understanding on the topic of risk and its handling process. Banks target is to run its industry very comfortably without any complications by managing risk expertly and magnify the profitability. Suwailem (2006) clarified regarding risk that before risks reach its extreme position to harm you, you should take all the possible steps to damage risk. To keep away from losses banks have to catch their dimensions to face the risks boldly (Kumar & Ravi, 2007). Accepting risks is a way to achieve economic expansion as initial stage of the investment is NO GAIN WITHOUT PAIN. It is risk through which business can be beneficial and supportable. If we peep into the pages of history of the corporate finance, we will come to know that in year 1990 the heads of corporate governance, stressed and emphasised the importance of collecting and analysing the risk information from organisations (S.Allen, 2003). The actual concept suggested sharing the information and creating the synergy among these organisations, resulting as creation of the massive data base, containing easy and comprehensible format of information regarding key risk involved in these organisations. In simple words we can say that it was an argument to manage the information about the risk by sharing experiences regarding risk for these organisations. Learning from each others experience, further using this data to speculate any future risks involved and projecting the possible precautionary actions while exploiting the

existing and potential resources. That is the instant where we find the concept of risk management first came in to being. Redja (1995) assert risk has been speculated as the prioritization, estimation and detection followed by economical and related utilization of skills and reserves to control the likelihood, maximize the apprehension of opportunities, observe and chop down the impact of adverse events. Risks can result from the financial markets instability, failure, natural factors, credit risk, liquidity risk, operational risk and incursion from an antagonist. Risk management is an extensive mechanism to sustain and build a generous control system, examining process, mitigating risks involved, establish a satisfactory internal control structure and making professional risk measurement (Altman & Saunders, 1998). The current economic situations caused by financial shifts, the output of businesses in large numbers are sinking. Poor conditions, deficiency of resources, choice of incorrect techniques, impracticable schedules and lack of expertise are involved in the majority of collapses. To secure the banking sector from the unfavorable effects of the global nancial disaster, the rations need to be dealt with risk assessment and controlling actions. Risks are typically identified by the adverse impact on effectiveness of a number of discrete sources of ambiguity. Financial risk in banking is likelihood that the outcome of an action or incident could initiate discouraging impacts. Such results could either bring up a direct loss of income/investment or may induce imposition of restrictions on bank's capacity to meet its business targets. Such restrictions proffer a risk as these could obstruct a bank's capability to perform its evolving business or to make use of favorable circumstances to expand its business. Risk management represents the background, approaches and plans that are indicating towards the successful administration of buried opportunities as well as hazards. Determinative risk managing optimizes the persistence between threats and control. Risk management agenda can be accepted as a "path which will assist the bank owners to effectively and expertly administer the resources, program, and quality of core actions. The magnitude of risk management cannot be underrated at any stage. Though banks might have reasons to consciously perform an unsatisfactory job so as to meet cost reduction targets, a surplus of calamities have revealed that these attempts rush at great risk (Kumar & Ravi, 2007). Even the potential of some mega players

has been in danger: some carried on; while the others were put under close watch and/or were disowned. The course of financial risk management consists of policies that allow an organization to control the risks linked with financial markets. It engages and effects many divisions of an organization including depository, retail sectors, advertising, legal, tax, property, and corporate finance. It seems correct for any debate regarding risk management procedures to start on with why the firms deal with risk. As stated by standard economic theory, directors of cost maximizing firms should magnify projected profit without observing the changeability around its estimated value. Hancock (1991), Avery and Berger (1991) and Marshall and Siegel (1996) are a few names to mention who put their outstanding contributions for providing an emergent literature on the explanations for active risk management. In fact, the latest analysis of risk management documented in Bhattacharya and Thakor (1993) enrolls dozens of offerings to the area and at least 4 distinctive justifications presented for active risk management. These contain supervisory self interest, the non-linearity of the tax composition, the overheads of financial desolation and the existence of capital market fallibilities. The risk management procedure entails both interior and outer analysis. The opening part of the process entails determining and prioritizing the financial risks facing by an organization and comprehending their consequence. Risk identification covers observing and documenting risks that will liable to have a damaging effect on the business. The detection and related scrutiny is a usual practice that should be done constantly. Both internal and external risks should be distinguished. Internal risks are those that can be easily manipulated within the bank environment. There are various methods available to assist in recognizing risk areas that comprise historical facts, work breakdown structure, risk record and business policies. It may be crucial to check the organization and its products, supervision, clients, providers, opponents, pricing, industry movements, balance sheet configuration, and position in the business. It is also obligatory to think about stakeholders and their aims and sensitivity for risk. Once a genuine understanding of the risks comes forward, proper strategies can be executed together with risk management policy. For instance, it might be the likelihood to adjust where and how business is performed, in so doing dropping the organizations exposure and threat. A different strategy for

coping with risk is to welcome every risks and the option of losses silently. There are three open substitutes for managing hazard: 1. Do nothing and aggressively, or inactively by default, receive all risks. 2. Hedge a section of vulnerabilities by finding out which vulnerabilities can and must be hedged. 3. Hedge all potential weak spots. Assessment and reporting of risks facilitates conclusion makers with data to perform decisions and observe outcomes, both before and after approaches are taken to lessen them. As the risk management process is unending, reporting and remarks can be used to improve the system by amending or refining strategies. A dynamic decision-making process is an imperative constituent of risk management. Decisions on probable loss and risk mitigation provide an opportunity for discussion of central issues and the unfixed standpoints of stakeholders. Risk management is performed centrally employing policies designed by the General Management. Such guidelines classify the categories of risk and identify the procedures and operating limits for each form of business deal and/or mechanism. Financial risk management is integrated at the Treasuries Zone which has the chore of measuring the risks and locating into place the respective hedges under the synchronization of Group Treasury. The Treasuries Zone manages directly in the market for the Operating Units and, where they cannot control directly because of external limitations, they attune the actions of Local Treasury Sectors. One more way of detecting risk, again highly important for risk management and risk perception chiefly in our perspective of public procurement, is to consider demand and supply as foundations for risk. Jorion (1997), after evaluating the position in the toy industry, examines that the order for faddriven goods can swing from moderate to boiling at once and then abruptly evaporate as the next hot product launches in the market. Considering supply, supply chain risk designates a vagueness or unpredictable incident affecting several bands within the supply chain, which can harshly impact the success of business goals. As the supply chain grows to be at large-scale, risk management and risk lessening has to be element of the supplying policy. Supply risks involve

e.g. those that potentially obstruct or postponed operations like political insecurity and unstable labor market; possible hazards that an opponent will take over a broker and potentially freeze supplies, risks interconnected with delays and unsatisfactory quality. Inbound supply risk has been described as the likely happening of an event linked with inbound supply from individual brokers or the supply bazaar, in which its results cause the failure of the purchasing organization to accomplish customer request or result in threats to customer life and wellbeing. What can be executed to alleviate such insecurity and risk? Best organizations are reviewing their supply chain and are modifying the talents, methods, and tools required to struggle in these days unstable global market. They are raising themselves robust questions and analyzing their supply chain from various aspects. These consist of: How do we calculable identify risk, and are we aligned and unvarying in our definition? Are our providers meeting our targets on value, cost, deliverance, scale and protection? Is our used contemplation by category, geography or supplier producing additional risks? Do we consider more than spend relating to risk (i.e., quality, consistency, business stability, etc.)? How do we mitigate risk from lower-tier service providers? Do we have to upgrade the abilities and potentials of our supply chain and procurement team to meet the multifaceted demands of our recent setting? Do other sectors realize their responsibility in sponsoring a top-in-class supply chain? Have we documented and trained every single supplier against conditions for a range of regulatory actions and do they meet inspection prerequisites? Until any party can answer these questions in the positive, the risk of crash exists there. Through a practical, fair evaluation of all attachments in the supply chain, the risks can be totally recognized and minimized. Basically, the purpose of any supply chain risk management plan should be to observe, control and figure out supply chain risk, which will serve to maintain stability and magnify productivity. The product of not executing these key steps could bring about a serious collapse in supply chain functioning further trimming down your competency to optimize the continuation of product to the client. Valuable supply chain risk management offers the facility to predict and respond quickly to external developments and activities. It sets an

emphasis on perplexities and the unforeseen. This in turn, will help organizations to resist with the existing economic hurricane and remain a workable business unit. In 1993 Froot attaches a vital property of risk to the theory of risk management. For him, risk occupies not simply the doubtfulness, but the fact that should an incident take place (in other words, should something go awry) as well. The banking sector is constantly procure tougher challenges in meeting different risk management provisions, and regardless of how tough it is, the existing operations forces the risk managers to be attentive, and extraordinarily sharp towards the causes of defending the interest of the people involved. If the outcomes do not change the cost-benefit estimations, we may face ambiguity that something goes on and transforms things, but there is no threat, as there are no discouraging outcomes. As said previously, risks in public acquirement can only be appraised if they are balanced and related against the benefits connected with a definite procurement. For example, the possibility of failure to distribute a public service or to deliver it behind time or much high-priced, must be evaluated against the comparative benefit outside this productive service for the organization and the private stakeholders plus against the expenses of evading threatening events to occur and - if they take place - to curtail their disadvantageous results. In Froots justification, the risk would alter the effectiveness of an action, but if this effectiveness is still high, if the costprofit considerations are still encouraging even though the incident of the risk to take place, the function may still be performed. Similarly, if the service without the risk to happen is tremendously high, and the possibility of the risk to take place is esteemed to be pretty low or the unconstructive consequences of failure are reasonably priced, there is no hesitation to accept risk. As Hancock, Avery and Berger (1991) indicated that risks involved in drastic improvement normally have been designed according to three aspects, the level of ambiguity, the extent of manageability and the relative weight (in other words: profit). If the chances of a shocking result is high, the talent and resources offered to manipulate and tackle outcomes are limited, and the likelihoods of collapse is high, a project should be tagged hazardous. Efforts to determine risk sensitivity and risk horror made through inspecting behavior of game show contestants create risk aversion within folks.


It has been asserted that risks facing all financial institutions can be divided into three independent types, from a management standpoint. These are: (i) Risks that can be removed or hedged by plain business practices, (ii) Risks that can be assigned to other contributors, and, (iii) Risks that must be passionately handled at the firm level.

2.2 Banking Sector: The risks enclosed in the bank's major activities, i.e., those concerning its own financial statement and its central business of lending and borrowing, are not totally entertained by the bank alone. In various cases the institution will remove or lessen the financial risk linked with a transaction by suitable business doings; in others, it will transfer the risk to other delegates through a blend of pricing and product design. The banking sector identifies that an institution need not participate in business with an approach that without reason enforces risk upon it; nor should it take up risk that can be resourcefully handed over to other participants. Rather, it should merely deal with risks at the organizational level that are more easily handled there than by the market itself or by their holders in their own groups. To sum up, it should readily undertake those risks that are completely a feature of the bank's range of services. In banking, the core attraction is primarily on risk factors contained within traded financial mechanisms. In meeting the necessary attributes in banking sectors, there is a need to supply human and financial resources everywhere in the firm, an ample amount to meet the objective of an effective risk management structure. In proving these funds, it is required to assign proper command and liberty in the working process. There needs to be a responsibility of 'possessorship' in the fulfillment function, with the aim that the organization can maintain itself allied with its compliance risk management duty (S.Allen, 2003). A complete database should be prepared, together with screening and evaluating of the risks occupied in any sort of incidents, which collectively, may provide purposeful reports based on the acts and conventions directing compliance risks, coupled with on hand or new products, and upcoming business movements. The banking divisions need to comprehend operational risk at the organizational level, where the

involved risk factors are compacted into one, making it a bit obvious to have an authentication of operational risk engrossed. Banks exploit a choice of sources to recognize, examine, and calculate risks to understand their probable profits or losses on banking dealings. This is why banks check credit information, employment record, earnings, and other sources to find out the risk level of every consumer (Kumar & Ravi, 2007). Banks deemed they were curtailing risks and rewarding their combating behavior by selling their mortgages to others and gambled on the incessant generation of interest revenue. As the markets deflated, the amount of wealth spent openhandedly in lending activity blocked unexpectedly. The Federal Reserve restored this condition by offering lines of credit and promises of liquidity to leading banks, assisting them to start again lending to smaller banks immediately. If a bank is passionate to carry on business with a customer who has not a stimulating financial set up, they will normally reduce their risks by charging high prices or interest rates or even involve a subscriber (Jorion, 2009). Additionally, interest rates also cause a risk to the banking industry. Generally it is noticed that as interest rates boosts, lending activity falls down as numerous borrowers are not prepared to finance supplies or services at a higher expense. When interest rates drop, a raise in lending activity is observed primarily. In general, risk is a conception not exclusively properly covered in the literature. Our perceptive for the rest of this report is that risk is measureable ambiguity for something to take place that lets missions stop working, cuts their efficacy or magnifies their overheads and time period. Motivate, strengthen and modernize extraordinary operations in risk management. Risks can almost never be fully eliminated; however they can be narrowed down. 2.3 Role of Technology and Banking: Moreover, we have the role of electronic components. Telecommunications formed a world where screen-based merchants working in high frequency trading chambers could achieve or lose billions instantly. So there are numerous big discrepancies between this devastation and prior ones: First, industrial science has dissociated trading from realism; second, the disaster is on a large-scale, not just associated to a particular geography or land, as all countries are united through technology and trade this time all over; third, that risk models and risk management

were gravely inconsistent; and in conclusion, that the opportunities to express voracity have grown very much. The outward appearance now is same as casino capitalism, where bankers carried out their barter via screens of integers. (Jorion, 2009). In real life, we can perceive the actual importance of our goods and services, finances and manoeuvres; in a pure play domain of computer-assisted trading using investment mediums that are one time, two times or three times separated from the real belongings they connect into, it is not easy to distinguish the risks involved or the veracities. Although at present, bankers have still been dutiful for the public. They have allowed the access of trade and exchange to switch from provinces to networked industries; they have encouraged work and standards of living for many to benefit from an unmatched period of permanence in the worlds economies with luxury and contentment for many; whilst also considering producing new techniques of working completely through the globalized economy; and the amalgamation of advancements in technology and financial markets has indicated that we can witness massive expansions in attaining avenue to capital and liquidity when obligatory. But bankers these days have also been dreadful for the community. They have waste their decent compass and become voracious to the point of inflaming civil disturbances; they have behaved foolishly without any awareness of the risks they are accepting; they have rely upon world markets with capital and resources that are the property of others; and they have demolished companies, lives and markets through unwise trading with risks that are out of control.

UK banking Sector: A British bank is run skillfully. Tradition, obedience, and set of laws must be the driving engines, excluding them - disorganization! Hostility! Moral breakdown! To be brief, we have a horrible mess! When investors are allowed to be revolting, then we have a ghastly disorder. And that is just what we have right now: a horrible unruliness. This ghastly anarchy is to reproach on the bankers moral extent losing its track and not having strong bindings to obtain it back. Even though most dominant financial institutions in the UK have deteriorated due to the banking disaster, the degree to which they have been affected fluctuated extensively. In assessing how the

failure of British Banks had an impact on the associations which are now partially or totally publicly owned, it becomes noticeable that numerous factors caused different banks to stop working (Demyanyk, & Hasan, 2009). Thousands of employments in the financial zone have been depleted. Joblessness rate is growing high day by day. Land prices have descended sharply and loans are much difficult to achieve. It is not simple to compute approximately what will be the overall expenditure to public funds of the banking crisis but the detriment will be massive. Consider the example of Royal Bank of Scotland (RBS). One of the two British Bank giants: The Royal Bank of Scotland (RBS) engaged in retail banking in the UK, largely in Scotland and northern England. In 2005, RBS was reorganized and a Global Banking division was formed which is a dominant banking collaborator to prime corporations and financial associations all through the globe, providing a wide collection of debt financing, risk control and loan services to its clients. Here we mention a few explanations that led RBS near crackup. RBS led a cartel which paid 71.1 billion Euros (64.7 billion) for the Dutch bank, and later divulged that they had overpriced by between 15 and 20 billion and additionally the transaction was finally approved in October 2007 at a time when the fiscal markets started to decline. This designates that RBS disbursed the faulty price for ABN Amro and at the inoperative occasion. As mentioned in Wall Street Journal (2008) one more reason perceived for RBS collapse was the existence of incompetent risk management plans, which required a lot of modifications. Actually, there had not been a lawlessness of merchandising decisions, but that the controls themselves were formulated in an incorrect manner, which means - there was a concern not regarding risk identification but about how the risk was fixed. The risk was detected but in the risk systems it was computed as being negligible: it eventually became sizeable and it was wrong. Chief executive of the bank verified that there had been no alarm bells from the risk management division within the bank that had been ignored. It is unbelievable that Boards of Directors and even high-ranking executives have the basic level of capability required to drive the budding system. To conclude, handling such a multifaceted system requires a vast awareness of the risks considered and the techniques exploited to assess them.


Chapter 3 Methodology

3.1 Introduction: Saunders (2003) has argued that a research having no clear purpose and direction is of no interest to the target audience. Such research is regarded as aimless shooting while consuming the time and money and ending with no value produced by the research report. Saunders (2003) reasons that an eminent research report always contains two elements in its preparation formula, they are as following.
1. It should have clear purpose to finding out things

2. Data for research should be accumulated and represented in a systematic manner. 3. This part of the report will define that how the research on the given topic will be conducted. It will define the considered approach and the portfolio manner taken in account to answer the problem question (Swetnam, 2004). 3.2 Research Design The current study is explanatory in its nature. It will address and explain the subject question of theory and practice of in risk management at UK banking sector and other business areas around the world. It will try to discuss the dimensions of the question. 3.3 Sources of Data


The source of this research is set to be the secondary data. A literature review approach will be adopted to collect the information about the theory and practice of the risk management, extracted from the pre-existing and published reference material. 3.4 Analytical Approach: The sourced data will be examined with qualitative approach. No numerical calculations will be made and suggested as an answer to the research question.

3.5 Research Objective:

Look in to the theory of Risk management and its development over the period of time. Examine the practice of Risk management in UK banking sector (pre 2007 financial collapse). Examine the practice of Risk management in the banking and other business areas around the world. Identify the gap between the theory and practice of Risk management. Relate this gap with the financial downturn started 2007. Highlight the casualties of the financial incident.


Chapter 4 Analysis.

4.1 Opening Statement: No doubt financial institutions and organisations can endure enormous losses even in the situations they take risk management on the board at the first priority. They are, no doubt , in the business of relating to risks. But the way theory is practiced matters to encounter such collapse. Sometimes the potential risk is located just within the data and its measures that the organisation rely on and it does heavily depends on how this data is communicated through the organisation. Financial risk management is not merely about the risk evaluation of an organisation and risk minimising but it deals with the great sense of timing too. That is the reason why financial risk management is effort taking, to acquire right in the best of times. If the right action is not taken in right time, the whole risk management process collapse, as it did in 2007.

4.2 Argument: Lets analyse the character of risk management and corporate governance as the fundamental elements in the commencement of the recent financial crisis of 2007. And evaluate the role of Risk management theory to handle this. No doubt, most of us when we first heard of the financial crisis of 2007, the first though came to our mind was; what actually went wrong with the detailed and complicated models of risk managements? Did they fail? Even if they failed but why does it ended as a financial crisis for whole market. And the brain replies that this incident must have accumulated a big and potentially dangerous risk behind it. So, have these risk managers to the collapsed financial institutes ever been to the school of Risk management. Or all the data modellers for risk management in these organisations were alien to the theory of Risk management.

As we discussed in literature review that many authors and academic researchers have specified in their writings and research (in post crisis situation) that the practice of risk management and the data modelling for risk data were not only in gap to the theory of academic models of the subject but few were even opposite to it. Few of these organisations, amazingly the most financially recognised institutes were violating the rules of risk management in their practice and still their risk manager speculated no risk to their future. Even just before the financial crisis in November 2007, it was argued that it is apparent there has been a enormous disaster of risk management in most of the Wall Street. So was that really clear that there is a massive shift coming to knock down the financial market. Was it been speculated beforehand that the financial downturn and the market crisis have to hot Wall Street? It is believed that accumulation of the risk caused by gap between the theory and the gap resulted this collapse. The theory has not to be blamed for this the incident. Although it should rather be appreciated on the account of the fact that theory predicted and forecasted the financial crisis that the negligence to the theory by the organisations in their practice is leading the organisations to the financial collapse and such organisations with certain practice are a norm in modern business world. And the time came when Wall Street collapsed in 2007. On the discussion above, the argument of this project is constructed that the difference and gap between the theory suggested by risk management & corporate governance and the practice in organisation (i.e. financial firms) is the key responsible element behind the failure of these financial and commercial organisations. Although the basic factors may further be divided and explained as the internal principal-agent complications of the organizations and ineffective breakdown of corporate governance system, which is actually designed to tackle these internal principal-agent complications of the organisations. 4.3 Theory & Practice Gap. The modern concept of risk management which may be called as mutual part of modern theory and modern practice in organisation believes in three major practice additional to the basic concepts of risk management. (1) The risk data model for should not only encounter the

unexpected losses but they should also keenly look into the exactly expected loss figures. (2) Risk should be encountered with a portfolio approach having co relation of assets, existing risk factors; (3) Constructing the data measure for tail risk of required capital will develop an effective risk portfolio for risk management. But as the history witnessed the collapse of various financial institutes in 2007, in the presence of these models and its modern and so called effective changes. This report suggests that these models and descriptions are not sufficient enough to describe exactly what went wrong with these organisations and institutes so they could not avoid the disaster of financial market in 2007 even all of these organisations had a devoted department and a qualified team to assess their related risk. Later in this section we will discuss some of the major mistakes and lacks in organisational practice of risk management that theory has suggested beforehand the collapse happened in 2007. (a) Unreasonable and over relied exuberance on the untested data models. (b) The originate-to-distribute business model. (c) Purely statistical approach towards financial risk management (quantitative methods). (d) Using agency ratings as the major data source and over reliance on these sources. In this section we will try to explain particular part of theory has tried to explain the reason and the factors that academic researchers have identified over the period of time in order to encounter any situation like financial collapse in 2007. This approach will not only help us to identify the key reasons and background elements of the incident explained the warning statements before the disaster happened. But will also help us to construct and support our argumentative statement that what is the actual gap between theory and the practice of the risk management. Give the negligence of the theory and the open violation of basic concept of risk management in the organisational practice of risk management; we will argue that this gap and abundance is the key catalyst element behind the financial collapse of 2007. Many researchers and academic writers have argued that what actually happens when a financial risk collapses the whole financial structure of organisations. Interestingly, Risk Management

Theory argues itself that how does a financial collapse or disaster do happen. But how would it sound when the similar collapse happen due to the negligence of the risk management theory in an organisation and lack of practice by it. Theory does indicate that its not only the gap between the theory and practice of Risk Management that lead organisations towards high risk and sometimes financial collapse but at times few firms over rely and over depend on untested risk models which lead them to underestimate the risk. International Atlantic Economic Society recently published an article stating the same fact that a very similar practice to above lead a firm excessive in mortgage market and finally ended them in financial crisis (Mian, & Sufi, 2009). Although those organisations were considering many risk management models to minimize their risks but still they underestimated the potential risk in housing and mortgage market, by wrongly over relying their untested risk models. Is risk management all about quantitative approach? On the other hand the selection of either quantitative risk models or qualitative risk models measures is a major decision for organisations to take. Many of the big financial organizations in the modern times depend on quantitative risk management models in order to quantify the risk, and that is of the major reason and cause of the recent crisis that many of the organisation over relied on untested credit risk models. Figures merely explain the results and impacts of their character over risk proposition. It more need a qualitative approach to merge with only quantitative models of risk management. Many of the researchers and academic writers believe that the overreliance on numerical evaluation of the risk in organisations have led them to overlook qualitative verdicts on the artificial boom of the housing and mortgage market. And very similar to these models many organisations widely opt to apply various financial and credit risk models for their risk management. A very live example of such risk management models are the mortgage market, where the responsible have heavily relied on advanced qualitative models for the origination and the investment side of prepayment and default. Their performance of these models may be concluded as poor on the account of many reasons.

Ignoring History and Its Key elements in Risk Data Models: The very first basic reason why these models failed was the fact that these models mostly relied on comparatively short data. And interestingly these models lacked the part of the history data of severe economic crisis. Risk managers while creating risk data models have two kinds of modelling available to them. Either they have to choose to build a model covering longer period of time but with less elements of data of low quality or construct models for short period with more elements of high data quality. In usual practice, organisations elect to consider the data models for risk management, with sophisticated and high quality data but for short period. These organisations believe that the older data are not too relevant to be taken in account for future in risk management, given the shifts came in the mortgage market in last few spans. Short-Structured Data Models in Mortgage Market On the other hand, second reason for the failure of these risk models is the fact that the mortgage credit risk models are amazingly less and short structured models as compared to the conventional structure of risk data models. The term less and short structured model refer to the data model that does not take many key elements of high quality data into account i.e. changes in market behavior about supply and demand, potential fluctuations in different selection or moral hazard behavior. Although the theory suggests that an effective structural model would always consider the changes in market behavior about supply and demand, potential fluctuations in different selection or moral hazard behavior. Given the extraordinary changes in market conditions, growth of the market, launching of new products every working day, it may be argued that less and short structured data models covering short period of time, have high capability of containing errors.15 Gerardi et al. (2008) has particularly argued in their research to address the issue related to the precision of Short-form restricted estimations of mortgage models. The researcher considered a number of studies published by the firms engaged in mortgage business; before the actual crisis

started in 2007 and inquired about the accuracy of the data models that they use for their risk management. And the results were positive as these organisations responded confident about the accuracy of these models and highly appreciated them. In Particular they praised it for evaluating the risk relate to the increase in the house prices. Hence these data modelers were pretty accurate in their approach to ward less form structured models to forecast their risk towards increase in the house prices but they underestimated the downturn of the risk related to the industry and that was the decrease in the housing prices. And that is exactly why these models were failed to counter the risk of reducing price factor. Hence all resulted in a failure and a collapse.

4.4 Six Ways to Mismanage Risk Stulz M. A (2009) argues that in order to manage the risk effectively, organisations and their management have to consider how to manipulate the risk data, how to calculate and measure it, how to implement it and how to communicate its results in the organisational network. They should also have a strong sense of how these moving parts graft along. The famous article of Harvard Business Review, titled Six ways companies mismanage Risk by Stulz M. A (2009) argued that Risk managers normally make six essential mistakes that have potential of taking the organisations to the financial collapse. The six mistakes are defined and explained with the help of different examples from the financial management world. These six reasons are fairly summarized in the line below. 1. Relying on historical data. Extracting the lessons from the past experiences and interpreting them into the risk data models is known as Risk-management modelling. It involves inducing from the past, but speedy financial origination with latest experiences is deadly required. But if not updated and relied on the previous old data will lead a firm to travel on a risky path and having an imperfect guide. EXAMPLE The recent incident of fall of house prices indicated that historical data were not as effective as they are when updated with recent happening. It actually missed the part when market saw a slump while many of subprime mortgages were outstanding.

2. Focusing on narrow measures. The history has witnessed many financial institutions using daily measures to calculate the risk. Whereas this approach limited their capability to evaluate the potential risk to their organisation. It did also bound them to underestimate their organisation exposure as they did assume the assets of the firm are too liquid to be sold in a day and the losses were also limited as they were accounted on daily basis.

EXAMPLE Usually financial disasters contain an intense drawing of liquidity from security markets, which leaves organisations exposed for long period of time in situations they cannot easily unwind. 3. Overlooking knowable risks. Over estimation and underestimation of risk are two potentially dangerous actions that normally Risk managers endure. At times they oversee many types of risk and even create few of them by overestimating the risk. These two factors actually deviate the real focus of the risk managers from the actual risk data. EXAMPLE In order to face the risk of collapsing in the ruble, Russia hedged by currency positions with their domestic banks. But that leaded their domestic banks to fail and collapse, on the account of the fact that they ignored that currency positioning with bank will reduce their ability to meet the commitment in case if the banks felt a financial shock. 4. Overlooking concealed risks. Un-reported risks accumulate to bring a big and potentially dangerous risk to the organisations. People in organisations usually dont report the risk they face, sometime intentionally and at times unintentionally. And on other hand these Institutes have a propensity to increase unreported risks.

EXAMPLE It is a very general practice, not to mention the company loss to the traders and all these traders want to understand and enquire is how much profit their firm has made and how much it will make in future. For the risk they take they have an incentive, which will be a norm then to endure if their involved risk unmonitored.

5. Failing to Communicate. The better the Risk management system is communicated through the organisation better it is implemented and protects the organisation from the collapse. In multi-national organisations and large scale domestic firms can create synergy within the foreign and domestic units through communicating the risk management system through their organisation. EXAMPLE In case of Swiss bank UBS. The time they experienced the subprime and housing exposure, they failed to communicate their experience about that particular incident to the right audience and even the wrong audience was communicated in such a complex manner that they could not have clue what was communicated. 6. Not managing in real time. It is nature of risk to get more dangerous and potentially harm full to an organisation if it is not addressed in due time. Being very particular, the fluctuation in the stock market is so quick and sharp that it changes every now and then. If the risk associated with stock market related firms, that may change risk sharply and quickly.

EXAMPLE If a manager of a firm dealing its business with stock exchange and he opts to hold the barrier call option all day, the risk may increase sharply of failing to put hedges in right place. With

every single minute and passage of time the risk will increase and get sharp to accumulate the threat of loss to the organisation. 4.5 Mortgage Market and the Bust of the Boom. Although in a very precise and general statement we can conclude that the major catalyst element behind these crises was the loop of booming and then ending in a bust of housing society (Hu, J., 2007). Although as this loop begun it boosted the financial market as well. But that was potentially dangerous to the industry in its actual nature. That is the reason why, in August 2007 the loop came to the end of bursting the whole housing market, resulted in the onset of financial crisis. It did also collapse the ASSET-BACKED commercial market. The term assetbacked refers to the commercial markets with a high concentration in mortgage related securities. Whereas at the same time it is vital to know the fact that the collapse occurred due to the solvency of enormous financial organizations, threatened by huge damage in financial securities which were complexly structured on housing society. 4.6 The Practice Gap: That is the point to evaluate the difference between the theory and practice of risk management. Having considered that the collapse in housing market was part of the risk related to that industry but how is that possible in this modern world of business and in presence of concepts like financial Risk Management & corporate governance that these financial firms have such high depending on mortgage-related securities (Kirkpatrick, 2009). That is very crucial to understand how the theory of risk management has played its role to develop the true meaning of risk evaluation and risk minimisation for the modern financial firms. The concentrations in mortgage associated securities by these financial firms and institute actually violated elementary lessons of contemporary risk management. The basic principles of modern risk management clearly indicate any organisation/firm, not to accumulate the risk of highly depending on one source i.e. concentration in mortgage related securities. But the practice shows that it had never been a student of theory of risk management and has been alien to the

basic and general lessons of the theory. It is sad to evaluate and explain that how the available research and information to these firm was neglected.

Chapter 5 Financial Crisis in UK & Rest of the world

5.1 Introduction:

Corporate governance failure with respect to the financial services in UK was one of the major reasons to lead the situation towards financial crisis. Alongside few other elements cannot be neglected like liquidity matters and parameters of capital resource capability. In the lines below we will discuss some of the UK banks and financial institutions to demonstrate the practice of risk management in particular; performance, pre financial crisis. 5.2 Royal Bank of Scotland Group: Royal bank of Scotland Group is one of the two largest banking giants operating in retail banking at UK. In year 2005, RBS Group was re organised to join with other international banks (i.e. Fortis bank and Banco Santander) in order to create the Global Banking Division, a principal banking collaborator to offer collection of debt financing, risk management and loan services to its client banks. Royal Bank of Scotland group was among the leading heads of this Banking division rendering its services worldwide. In the same context this banking division offered to provide 71.1 billion Euros (64.7 billion) for the takeover of Dutch bank namely ABN AMRO. Later, the group disclosed that they have overpriced the deal with a margin of 15-20 Billion, almost equal to the 30.91% of the total bid. While on the other hand at very similar time, the big sum of debt that was organised by the group to finance the deal had depleted the groups reserves on the account of the financial crisis started 2007. The deal ended up as a complete failure of financial risk management and the corporate governance of the group. The deal resulted to secure the operations of the taken over bank by the governments of the particular countries, i.e. Dutch government nationalized the Dutch operations and the UK government provided a massive support to the operations that were allocated to RBS, on account of the economic bailout of the Scottish bank. Wall street Journal (2008) mentioned about the incidental deal which resulted in shattering of the whole group and the taken over bank and argued that one of the key reasons behind this happening was the existence of ineffectual risk management plans, which required a lot of amendments and updates. As discussed earlier that the quantitative approach towards risk management and ignoring the qualitative aspects of the risks are deadly in nature. Similarly, this

practice harmed the RBS group, given the reason that the risk of failing the deal was identified but it was computed just numerically. Later, these numerics were considered negligible as the risk managers at the group approached only the figures but not the facts behind them. The groups Chief executive accepted the fact that there were flags of concerns and alarms of risk raised by the risk management division but rather they were not communicated effectively to let this risk of failure be addressed before the disaster happened. 5.3 Nothern Rock. Nationalised bank which cannot fail One of the major causalities in UK financial institutes of the financial crisis 2007 is Northern Rock. Very similar to the previous case the Northern Rock had some significant mistakes at risk management. Northern rocks so called booming business strategy before crisis hit the market, was heavily based on inter-bank landing system in the UK and worldwide money markets. The process of funding through interbank landing system was backed by the funds raised from extending of the mortgages in the UK housing market and then reselling of these mortgages on higher prices. This process of extending the mortgages is recognised as securitisation. Before the financial crisis 2007 hit the market, Northern rock experienced a heavy profit and market growth, but to be realistic in our approach the increasing prices of the mortgages and houses were due to artificial boost in the Asset backed funds. After experiencing vary good years of profit growth and market extension, when the global call from financiers for securitised mortgages fell, the bank failed to repay the loans it had taken from the international money market (Keys et al, 2009). Actually the repayments of these loans were scheduled on the basis of money raised from the securitization (Acharya & Schnabl, 2009. But as the demand for the mortgage based funds fell, the process could not generate sufficient money to repay the loans.

In order to replace the funds for repayment of the loans borrowed from international money market, Northern Rock obtained liquidity support facility from the Bank of England in September 2007. The market witnessed that a successful and highly profitable bank like Northern rock was too shattered to be funded by the Government in order to save its existence. So, it did also left an impression on the depositors and customers of the bank that there is high possibility that they may not receive their savings from the bank as bank yet have to repay the

recovering amount to the UK government. That was the first time in the history of UK banking history, when depositors lined up to cash out their savings with bank as early as possible. This created a big sense of insecurity about the bank in the existing and potential market of the bank. That is the reason why after nationalising of the bank, it markets its first impression as Nationalised bank which cannot fail

5.4 UK Government Inquiry about the Crises and its possible Remedies: As explained above the example of two UK banks and financial institutes enduring the wounds of financial crisis, lack of corporate governance and ineffective risk management. The UK government wanted to inquire the role of corporate governance in financial institutes and banks of the Britain. For that purpose Prime Minster United Kingdom, Mr Gordon brown asked Sir David Walker to investigate the issue and present the report to the house. At the very similar time another independent financial council known as FRC (financial Reporting Council) opened a review, experiment the level Walker Recommendations to the UK financial institutes and other companies in different business areas. Sir David Walker finally presented his recommendations on the requested subject area to the house and later the Financial Reporting Council dispensed its findings on the Code, which was later known as UK Corporate Governance Code. Both of the documents had their limitation in their applications to the industry. Whereas the suggestions made by Sir Walker did not required to change any other area of the corporate governance but recommended to carry out cultural and organisational changes in corporate governance. But this has yet to be testified that either these recommended changes will bring any good for the financial market and the financial institutions of the UK market. Lets consider some of the aspects of the recommendations of the report. 5.4.1 Risk


There was a heavy emphasis on the risk element, in the framework of the Walker appraisal and the global financial crisis. The recommendations of Sir Walker suggest that the Chief risk officer should be dedicated to serve the boards of financial institutes. They should combine to make a Risk committee, which should investigate into Risk Exposure and advice the board for Risk strategy. It should also give its assistance to the board regarding the strategic acquirements or disposals. His report mostly further argued about the changes in the culture of corporate governance rather evaluating risk and approaching to eliminate it. That is the reason why the Financial Reporting Council did not further suggested the Walkers recommendations about risk to the listed financial companies. They rather emphasized the risk committees to put their hard efforts to recognise the organisations risk and discuss the strategy which can help the organisation to get equipped against this risk. And as a result UK market may not lead to such financial disaster again. 5.4.2 Institutional investors Institutional Investors have an important role to play in corporate governance of the financial institutes. Their Importance has been recognised for a long period of time, given the impact they can leave on the corporate governance of the companies. First reporter was Cadbury (1992), who mentioned and analysed the significance of Institutional Investors in the financial market. And later many other writers have elaborated the topic but there has always been absence of a direct code on these financial institutes regarding their institutional investment (i.e. RBS Institutional investment into ABN AMRO). But the theory has also identified the concern of both the companies and the investors regarding quality of the practice in institutional investment. Walkers suggestions and the Financial Reporting Centre have both identified and have stressed this issue in their reports. Walker has emphasised on the need of approved institutes to certify the commitment of a financial institute towards Stewardship Code. In the same regard Financial Institutes Centre has recently initiated its consultation services to the institutional investors and their obligation towards Stewardship Code.

Apart from the emphasis to opt and implement the stewardship code and providing consultation to attain the commitment towards it, it still remains a question that Whether the projected Stewardship Code will bring or add any value to the practice of institutional investment. In order to respond this question Financial Reporting Council has accepted the responsibility of providing separate consultation on issue of making the practice of Stewardship Code valuable.

5.5 Islamic Banking in UK and Risk Management: It was almost unidentified from the situation nearly three decades back, Islamic banking put its expansion and stable advancement to become fast growing and distinctive division of banking world and capital markets. In more than 70 countries, 200 Islamic banks are in operation right now including western and Muslim nations. A good number of people around the world have approached and took interest to experience this new mode of banking. Islamic banking method have been recognized by the Muslim community in very low level and remained mystification in much of the west because of low research and high degree of risk involved contained by the segment of Islamic banking. Islamic banks yet remain an oasis of richness and calm whereas standard leading banks have to encounter the most terrible financial disaster. Buckmaster (1996) as proposed by Islamic intellectuals that Islamic banking is a component of in-depth theory of Islamic economics which is introduction of moral philosophy and importance of Islam into financial world. Islamic banking was introduced about 40 years back mainly to offer shariah financing options and mechanisms. Controlling risks in Islamic banking excellently is one of the most critical tasks that can crop up in financial dealings. Islamic banking is different than non-Islamic bank to a certain extent. Such as investments can be performed by exercising (Murabahah) defined income methods of financing. 5.6 Risk management in Rest of the world. UK was not the only example that has experienced the financial market crash but the storm of Financial crisis took its devastation to the countries, irrespective of their geographical boundaries. United State of America, Australia, New Zealand and Canada were among the long

list of the effective countries. The crisis was majorly targeting the financial institutes all around the world most specifically those assisted by mortgage backed funds. Lets consider the case of the United States, as this country was the centre of the attraction for the financial institutes funded by the mortgage based funds.

5.6.1 United States: The United State financial crisis was mainly centred by the Mortgage crisis in the region. The reason for these crises was similar to what in UK financial market. The dramatic rise in the mortgage prices and the overnight growth in the trend of backing the financial institutes by Mortgage based funds (Gerardi et al, 2008). The typical price of a mortgage in United States during 1997 to 2006 experienced a growth of 124%. This growth attracted the rest of the market (mostly financial institutes) to invest their funds in the mortgage based funds. And on the other hand as the prices of the houses increased consumers started saving less and spending along with borrowing more and more. This was another indicator of the potential financial crises as this trend of this practice was growing as the prices of the mortgages were increasing.

In mid-2006 the prices of these mortgages started declining. Although the investors in the housing society based funds were with the view that property would keep appreciating like it was in previous 10 years. And finally the market bubble busted in 2007. In Feb 2007 HSBC (The worlds largest bank of the time) declared the loss of $10.5 Billion in the mortgage backed securities (Hu, 2007). Later this year around 100 US based mortgage companies were shattered by the crisis and were either closed down or were suspended operations. In end 2007 the CEO of Citigroup (one of the most prominent financial group) resigned due to the worst outcomes of the crisis and situation being out of control. Failure of Lehman Brothers in September 2008 was among the worst casualties, US financial market endured in result of the crisis. Many reporters and writers have reported several reasons behind these crises and situation being out of control for the economy to back it up. Few of them are named as below. I. Bust in the Housing/Mortgage society.


Borrowing/landing practice of high risk mortgage backed loans. In accurate Credit ratings and over reliance of financial institutes on it. Policies to control the Investment activities of Commercial Banks (Central Bank, Government)

The analysis has indicated the presence of a big gap between theory and practice of risk management, not bound with any particular geographical boundary like USA and UK markets. But it had been noticed in most of the examples around the world. On other hand we noticed at many occasions when financial institutes have clearly violated the basic concepts of risk management. As a result the economies around the world have experienced a destructive wave of financial collapse. Even various strong and well known financial institutes like HSBC, Citigroup, Lehman Brothers, Royal Bank of Scotland and many more had faced huge losses and few lost their existence in market, during this financial crisis times. And I conclude on my analysis of the given topic that this gap is the actual responsible for this blow.

Nowadays; risk management is growing to be a much more skilled game than in the olden days. Current experiences of financial crashes reveal that risk management must be prepared to work practically as well as hypothetically. The constant duty for bank administration and directors is to validate that those engaged in risk management activities are aware of potential operational shortfalls and act promptly to resolve any, if arises. The history has witnessed that in recent years the risk management has merely became about speculating the unexpected quantitative losses and not relating it the reality of qualitative approach and accounting the expected losses. The modern mind set might have considered the risk management as the management of unexpected and hidden quantitative losses to the organisations. And have mostly ignored the actual expected danger and threat caused by many factors in financial market.


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