LESSONS FROM THE FINANCIAL CRISIS FOR RISK MANAGEMENT

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1 LESSONS FROM THE FINANCIAL CRISIS FOR RISK MANAGEMENT Gabriela PAVAL Alexandru Ioan Cuza University of Iasi Iasi, Romania Abstract Lately, in the literature in the field there have been encountered concepts like crisis management, which are suggesting a constant unification of all the efforts made to minimize conflictual situations of any kind, a more complex and researched approach on the situations that are causing them, but especially on finding solutions. Across the financial services industry were registered significant weaknesses in risk management practices in the context of the current financial crisis. Having this in mind, from the current financial crisis, we can identify some important lessons that can be drawn, in order to improve the financial risk management. Keywords: risk management, lessons, financial crisis JEL Classification: K10, F52, H12 1. CRISIS MANAGEMENT CONCEPT In general, management means the scientific area that study, fundaments and forms principles, rules, norms, relations, structures, methods and ways of leadership, all for creating perfect systems and for increasing leadership efficiency. It can be stated that, despite the fact that it can be called the oldest human activity, management represents in the same time, one of the youngest scientific domains, being the result of the generalization of practice, taking shape by forming a continuously growing knowledge area. Crisis management it is a specialized action of big complexity, sustained on many levels (politic, diplomatic, military, economic, social, religious, etc.), for minimizing and keeping the negative effects under control. The main character of crisis management is the quick and adequate reaction of the Government when the events threatens or affects directly the national security, or, in case of disasters, the normal conditions. Starting from this, it can be said that the crisis management gathers all the measures and the actions that the Government establishes to guarantee order and national security. 2. CRISIS MANAGEMENT OBJECTIVES Contributes on reducing tensions with the purpose of avoiding transforming them in crisis - Handling real crisis, and avoiding transforming

2 them in conflicts - Organize civil and military actions for all kinds of crisis - Control reactions, and in the case of conflicts, prevent their growth. From a short analyse, there are the main components of crisis management: - Methods and procedures of collecting, transmission and evaluation of information - Analysing the existing situation - Analysing the factors that were involved in the process - Analysing ways and purposes - Defining answers options corresponding political, military, economic and social purposes - Implementing the best solution The effective handling of any type of crisis depends on the efficiency of the established links in the interior of the system, and also on its exterior. 3. CRISIS MANAGEMENT PRINCIPLES: -Forming decisions -Providing real information -Controlling activities -Controlling managerial activities -Informing the audience -Assuming responsibility Crisis management is realized by national authorities in charge, which have decisional attributions and responsibilities concerning conceiving, planning, organizing and controlling the adopted measures. To solution a crisis an assembly of measures and actions is needed, applied individually or combined, depending on how the crisis wants to be solved. Romanian government controls all; military actions need to be the last one that has to be approached. When handling crisis situations, Romania makes sure that every solution concerning engaging armed forced will be a constitutional one. 4. STEPS ON CRISIS MANAGEMENT A very important aspect is making decisions operatively. This is a very complex process, based on knowing the generator causes of crisis situations, handling legislative procedures, preparing established forces, adapting concrete action modalities, so the damages will be as small as possible. It assumes the existence of a managerial team on different fields, one that can establish strategies on crisis times. Planning has to be based on real experiences lived by certified specialists, on the capacity of anticipation and preparing for upcoming events. Moreover, highly importance for crisis management has the research field. Plans drawn up in advance are good in the preparation process, in training management teams and participating forces, but to be viable in crisis situations they must be adapted according to the new information. The coordination of the activities is another requirement in crisis management. This assumes the distribution of relevant information to all factors interested in the crisis situation, so they could fulfil their duties properly. However, in crisis situations, there are people who want to do more, case where they will involve themselves

3 in the management process, but also in the execution, causing conflicts of competence and, ultimately, providing the failure or difficulties in solving the crisis. Therefore, the activities must ensure that tasks and missions are fulfilled by the persons and bodies entitled by law or by documents prepared in advance. Informing the audience it s another managerial task with extraordinary effects on crises dynamics. With no doubt, informing the audience is managerial team s task, but they have to make a clear distinction between the information that can be seen by a certain category of people and the information that are offered to the wide audience. Another equally important requirement is assuming responsibilities. Legitimacy of actions in crisis situation consists from democratic accountability of the measures which were taken by the management team. This should be understood as solving a crisis with a firm attitude, responsibility, understanding that national interests, the Constitution and other laws prevails, even if a small number of individuals will be subject to restrictions, including the right to liberty. Depending on the causes can occur different types of crises, economic, political, diplomatic, military, circumstantial, social, religious, environmental, etc. Very often, we find out that crises are a combination of several types, but with a main "theme. Concerned interests will be vital or important and will almost always be directly or indirectly related to the extension or protection of the power or influence of state. An economic crisis, for example, can have social and political issues that lead to disorders or to use of military instruments to restore order. The first step is the scientific work which was carried out, the embodiment of reform in each area, for the transition to the new company, with acceptable costs. This means studying all existing or potential contradictions, the internal and international conditions that may contribute to the chronicity of their setting bodies and the adoption of necessary legislative framework for solving the problem before or after triggering the crisis. The second step is the one that begins immediately after the crisis. In this situation, measures are required for grouping the specialists from the management teams, monitoring carefully and continuously the evolution of the crisis and searching for the most appropriate ways and means to counter the negative trends. Third step is the firm political, diplomatic, economic, and military actions, to deter the escalation of violent demonstrations or to fight them and to take care of the reconciliation of all political and social forces involved. Is possible to exist another step in which it is pursued the fulfilment of legal measures established by the management teams to return to normality. Sure, we can talk about this stage in case of finding appropriate solutions, this step not being necessary when the crisis peaked and reached the armed conflict. Solving crisis represents the process of taking a series of political, diplomatic, economic, informational, military or other actions, applied individually or combined, depending on the concept; measures that can be applied at the stage of escalation and in the regression of the crisis, leading to flexible actions. Romania, the Romanian state, and the decisional parts, established, for the prevention and resolution of threats to

4 national defence, national security and public order and to prevent, limit and remove the consequences of disasters, state of emergency or state of siege. These are set by the President with the approval of Parliament, obtained within 5 days. If The Parliament is not in session, it shall be convened as within 48 hours of the imposition of a state of emergency or a state of siege. The state of emergency is an exceptional measure that is established for the removal of public dangers that threaten the order, health and morals of people or to limit the consequences of calamities or of a particularly serious disaster. During the state of emergency, coordinating implementation of measures rests with the Ministry of Interior and the use of the forces of the Ministry of Defence to solve the crisis and to restore the order are last resort measures, which are used on a mandate from the Supreme Council of Defence. The state of siege is an exceptional measure that can be set for the removal of imminent public dangers, which consist of force actions which seriously damage national security and cannot be removed by the intervention of state institutions provided for by the Constitution and law, respectively forces of public order. State of siege is set by presidential decree, countersigned by the Prime Minister. During the state of emergency or state of siege, the use of firearms is permitted by following the law and constitutes an extreme measure. The financial crisis is by definition a very dynamic one, suffering changes with every step of its evolution, and because of that, everybody it is aware that there cannot be drawn any final lesson, because we constantly need more information and analysis. In time, this very dynamic makes the crisis change and gain a series of new variables. On the international financial market, the implications of the current financial crisis are multiple. One of them is the fact that financial innovations can present unknown risks. These results of innovations led to transparency reduction and an increase of the markets interconnectivity. The complexity of the process has generated a gap between money offer and demand. Investors aren t now able to properly identify and asses the risks implied by their investments, due to the low transparency and to the complexity of these instruments. In this case, risks were perceived with a negative connotation, and the liquidity level has fallen. As a result, it is very difficult to predict the evolution of price and risks during financial turmoil. Another highly important lesson is that standard models that measure quantity for risk management assessment/evaluation and its users analysts have the tendency to underestimate the systematic nature of risks. One cause that could increase systematic risk is the similarity between the strategies of risk management that the banks have. This similarity functions as a chain reaction: using the same Value-at-Risk models, the investor came to the same conclusion, at the same time, adopting similar decisions, and increasing systematic risk. To avoid this situation, there should be used more stress testing and analysis scenario for measuring and managing risks.

5 All the market participants and their supervisors in the areas of systematic risk confronted some new challenges in the context of innovations in credit risk transfer markets. The most important feature is that the development of the risk management, processing and settlement infrastructure can be outpaced by the rapid increase in new products and changes in the structure of the markets. In a particular sector, the credit derivatives one, the difference between the infrastructure and the risk management systems are believed to be more conspicuous. All the environment is suddenly involving uncertainty due to the complexity degree of some financial innovations and to the relative immaturity of some of the various approaches that are used to measure the risks. One of the most notable innovations for the credit risk management is the credit derivatives (example: Collateralized Debt Obligations and ABS-CDO). Their main purpose is to separate the origination, the funding, the holding and the management of credit risk. The impact is that banks are now changing their business model, replacing them with the originate-and-distribution model. The differences are now lying in all the aspects of the credit process. The new one supposes, on one hand, the separation between origination and funding of credit, and on the other hand, holding and management of credit risk. As a final conclusion, the banks should improve their risk management models. There is also the term of counterparty risk, measured by losses resulting from the OTC derivative contract to the financial system from the default of the broker dealers. Looking forward to short-term gains, the managers oriented the compensation culture towards to assuming growing risks that they don t understand. The risk management is also not appropriately correlated with the incentive and compensation policies. The market, being occupied by a small number of dealer banks, has been exposed to a systemic risk. The biggest investment bank had to collapse for the investors to ask themselves if too big is to fail. Knowing that prudential regulation has to be kept in mind, we can avoid increasing risks. Some international rating agencies, have given very easily most of the prime ratings for the first tranche, increasing the lack of transparency. Lately, they have recognized that passing the time they have been overwhelmed by the complexity and the volume of financial instruments. In the current financial crises context appeared new elements that do not match with the classical risks models. The performance of CDO is influenced mostly by the macroeconomic cycle, while the performance of the corporate bonds depends on the macroeconomic conditions and on the condition of the issuing company. Estimations of CDO are made on the basis of historical data from good times. That is so since these financial innovations never suffered serious market turbulences.

6 Because of the lack of experience in the risks management sector, many financial institutions had difficulties in identifying or assessing the risks faced by the company, and also failed in communicating them to board directors. There is the risk that the management systems will fail, if proper or complete information is not offered in reports. The full catalogue of risk reports runs against a simple presentation of the risk. It has to be managed and identified the actions that need to be taken. Another important thing to remember from the current financial crisis is that financial institutions have to respect the rules of corporate governance. In the core of risk management infrastructure has to stay a strengthened risk governance regime. 5. CONCLUSION Having a bigger ability to manage risks gives a bigger advantage and the best way to increase the shareholder value for non-financial and financial corporations. In the view of recent year s financial crisis, we can observe that there is an urging need to improvise the wide risk management procedures. Testing the techniques and rethinking the compensation plan could also be an alternative. The preview of the new systemic risks is forcing the upgrade of the actual settlement and regulation system, for receiving a response that can assure the financial stability, and also that can contribute to the global financial governance. References [1] Anton, S.G., (2009). Gestiunea riscurilor financiare. Iasi: Al. I. Cuza University of Iaşi Publishing House. [2] Dăianu, D., Lungu, L., (2008). Why is this financial crisis occurring? How to respond to it?. Romanian Journal of Economic Forecasting, 9(4), [3] Jorion, P., (2009). Risk Management Lessons from the Credit Crisis. European Financial Management. [4] [5] ic.pdf