LO 5: Understand the Control and Management of Operational and Financial Risk in a Business Assessment Answers

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Financial Risk Manager [FRM] Assignment Answers

Question 5: Answer the following questions.

a] In your chosen organization, explain what are the different types of businesses and financial risks faced by it in the conduct of normal business operations and the decisions involved in it?

b] What is meant by internal risk environment in an organization? Analyze the given situation below and provide your opinion as to what led to the failure of the said institution.

Case Study 1: Washington Mutual

  • 2004 :Embarked upon a lending strategy to pursue higher profits by emphasizing high risk loans
  • 2006 :High risk loans began incurring high rates of delinquency and default,
  • 2007 :Mortgage backed securities began incurring ratings downgrades and began incurring losses due to a portfolio that contained poor quality and questionable customers. (Source: Wall Street and the Financial Crisis: Anatomy of a financial collapse began incurring losses due to a portfolio that contained poor quality and fraudulent loans and securities. Its stock price dropped as shareholders lost confidence and depositors began withdrawing funds, eventually causing a liquidity crisis at the bank)
  • 2008: Seized by its regulator, the Office of Thrift Supervision (OTS) Placed in receivership with the Federal Deposit Insurance Corporation (FDIC) Sold to JPMorgan Chase for $1.9 billion.

Case Study 2 – Barings Bank

On February 26, 1995, Barings Bank (Barings) – the United Kingdom’s (UK) oldest and one of its most reputed banks – declared it was bankrupt. The bank with a total net worth of $900 mn had suffered losses in excess of $1 bn.

These losses were result of the gross mismanagement of the bank’s derivatives trading operations by Nicholas William Leeson (Leeson), the General Manager of Barings Future in Singapore (BFS).

BFS had been established to look after the bank’s Singapore International Monetary Exchange (SIMEX) trading operations. Leeson’s job was to make arbitrage profits by taking the advantage of price differences of similar contracts on the SIMEX (Singapore) and Osaka stock exchanges.      In spite of not having the authority, he traded in options and maintained un-hedged   position.   He acted beyond the scope of his job and was able to conceal his   unauthorized derivatives trading activities.

Due to the senior management’s carelessness and lack of knowledge of derivatives trading, the bank landed up in a major financial mess.

When Barings finally went into receivership on February 27, 1995, it had an outstanding notional futures position on Japanese equities and bonds of US$ 27 bn (US$ 7 bn on Nikkei 225 equity contracts and US$ 20 bn on Japanese government bond (JGB) and Euro yen contracts).

Analysts said that the situation demanded that banks the world over must tighten their internal control procedures.

c] Based on the above case study explain in your opinion the risk management instruments that could have been applied for avoiding a financial risk situation.

 [Total-30 marks]

 

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