FERM CH 20 Case Studies

Question 1

List Causes of 2008 Financial Crisis

Answer 1

1. The role of China
   * China invested a large proportion of its income from exports into US treasury bonds, resulting in lower yields
2. Role of housing markets
   * Low mortgage rates increased demand to buy houses
3. The role of regulation

• The Gramm-Leach-Bliley Act of 1999 allowed commercial and retail banks to carry out investment banking activities
• Basel I system of capital requirements gave incentive for banks to securitize loans

4. The Role of Incentives

• Securitization led to decline in credit quality of loans
• Incentive to take large risks to earn bonuses

5. The Role of Models
   * Models used to price CDOs were not sufficiently accurate
6. Organizational Issues
   * Many managers did not recognize the risks in MBS

Question 2

Lessons of the Financial Crisis

Answer 2

1. Organizational Structure of Banks

• ERM should have a much higher status, and CROs should have much higher power
• Those who design and work with complex models should be given a greater say in the use of those models

2. Capital Structure: Banks should hold more liquid capital
3. Bank bonuses: Should reflect the term of the instruments being traded
4. Models: Do not blindly trust the output of models

Question 3

Reasons for Barings Bank Collapse

Answer 3

• Nick Leeson was responsible for both trading and accounting, making it easier to hide trading losses
• Insufficient scrutiny from London, as large profits from a low-risk arbitrage strategy should have been a warning sign
• Insufficient analysis on the size of transfers requested by Leeson to fund his trading
• Leeson had two separate reporting lines (one to London and one to Tokyo)
• Bonus structure was based on performance over a very short period

Question 4

Lessons from Barings Bank Collapse

Answer 4

1. Internal and external auditors should carry out their jobs more rigorously
2. A clearer and more direct reporting line should be in place
3. Separate parties responsible for trading and for back office work
4. Need more robust analysis of the consistency of profits being made from a strategy
5. The bonus structure should take into account profits over a longer period

Question 5

Reasons for Equitable Life Collapse

Answer 5

• Equitable Life had insufficient capital backing its liabilities
• Failed to predict that interest rates would decrease
• A cultural attitude of arrogance
• Insufficient scrutiny of its own business model
• The appointed actuary was also the CEO of the company

Question 6

Reasons for Korean Air Accident

Answer 6

The hierarchical nature of Korean society

Question 7

Lessons from the Korean Air Accident

Answer 7

Make the only language allowed in a Korean Airlines jet be English

• Reduces risk of communication problems
• Korean flight crew will be more willing to challenge decisions

Question 8

Lessons from LTCM Collapse

Answer 8

• LTCM was caught off guard by large, unexpected movements in the markets
• Over-reliance on models
• Investors were star-struck by the presence of two Nobel Prize winners in LTCM’s management team