HOW RISK MANAGEMENT AND CORPORATE

GOVERNANCE FAILURES INFLUENCED GLOBAL

FINANCIAL CRISIS 2008

Submitted By:

Rupak Kumar Mohanty

Roll No-17202041

MBA-II

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 CONTENTS

Sl No TOPICS Pg No
1 Abstract 3
2 Introduction 4-6
3 Analysis of the financial crisis 6-25
4 Classification of risks with a link to Financial crisis 2008 6-9
5 Dramatic Failures of Risks Management and Corporate Governance in 9-10
many systematically Important Financial Institutions
6 Excessive borrowings, Risky Investments and lack of Transparency 10-12
7 Widespread failures in financial regulations and supervision 12-13
8 Failure of credit rating agencies 16
9 Funding and market liquidity problems 18-20
10 Firms’ re-evaluation of existing practices 20-22
11 Debates on Corporate Governance Failures 22-24
12 Conclusion 25-26
13 References 26

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Abstract:
The financial crisis began with the collapse of the United States subprime mortgage
market in 2007 as housing prices continued to decline (after mid-2006) and default rates
rose. By late 2008 the crisis had spread globally to institutions overexposed to the risks
inherent in investment products that had packaged United States subprime mortgages
(mortgage-backed securities).
The Gramm-Rudman Act was the real villain. It allowed banks to engage in trading
profitable derivatives that they sold to investors. These mortgage-backed
securities needed home loans as collateral. The derivatives created an insatiable demand
for more and more mortgages.
There were some high-profile bank failures early in 2008, notably the nationalization of
Northern Rock in the United Kingdom in February 2008 and the distress sale of Bear
Stearns to JP Morgan in the United States in March 2008. However, the severity of the
crisis only really became apparent in September 2008, when the United States
government took over Freddie Mac, Fannie Mae and AIG, and Lehman Brothers filed for
bankruptcy protection.
This was followed by a series of government bailouts or government engineered
emergency acquisitions of a number of large financial institutions (Washington Mutual,
Wachovia, Citigroup, Merrill Lynch and others). Around this time the global reach of the
crisis was also becoming apparent as a number of European financial institutions
(Bradford & Bingley, Dexia, Fortis, Hypo Real Estate, UBS, RBS and HBOS) were
either bailed out or nationalized and the entire banking system of Iceland collapsed.
Failures of corporate governance and risk management at many systemically important
financial institutions are among key causes of the crisis. A hunger for larger market share,
profits, and bonuses lead important financial institutions to ignore risk exposure involved
in high-risk activities. This ignorance, coupled with lack of judgment and irresponsibility,
created a breakdown in corporate governance and risk management practices.
Risk management, even if flawlessly executed, does not guarantee that big losses will not
occur. Big losses can occur because of business decisions and bad luck. Even so, the
events of 2007 and 2008 have highlighted serious deficiencies in risk models. For some
firms, risk models failed because of known unknowns. These include model risk,
liquidity risk, and counterparty risk. In 2008, risk models largely failed due to unknown
unknowns, which include regulatory and structural changes in capital markets. Risk
management systems need to be improved and place a greater emphasis on stress tests
and scenario analysis. In practice, this can only be based on position-based risk measures
that are the basis for modern risk measurement architecture. Overall, this crisis has
reinforced the importance of risk management.

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Introduction:
 The financial crisis of 2007–2008, also known as the global financial crisis and the 2008
financial crisis, is considered by many economists to have been the most serious financial
crisis since the Great Depression of the 1930s.

 It began in 2007 with a crisis in the subprime mortgage market in the United States, and
developed into a full-blown international banking crisis with the collapse of the
investment bank Lehman Brothers on September 15, 2008. Excessive risk-taking by
banks such as Lehman Brothers helped to magnify the financial impact
globally. Massive bail-outs of financial institutions and other palliative monetary and
fiscal policies were employed to prevent a possible collapse of the world financial
system. The crisis was nonetheless followed by a global economic downturn, the Great
Recession. The European debt crisis, a crisis in the banking system of the European
countries using the euro, followed later.

 The first sign that the economy was in trouble occurred in 2006. That's when housing
prices started to fall. At first, realtors applauded. They thought the overheated housing
market would return to a more sustainable level.
 Realtors didn't realize there were too many homeowners with questionable credit. Banks
had allowed people to take out loans for 100 percent or more of the value of their new
homes. Many blamed the Community Reinvestment Act. It pushed banks to make
investments in subprime areas, but that wasn't the underlying cause.
 The Gramm-Rudman Act was the real villain. It allowed banks to engage in trading
profitable derivatives that they sold to investors. These mortgage-backed
securities needed home loans as collateral. The derivatives created an insatiable demand
for more and more mortgages.
 Hedge funds and other financial institutions around the world owned the mortgage-
backed securities. The securities were also in mutual funds, corporate assets, and pension
funds. The banks had chopped up the original mortgages and resold them in tranches.
That made the derivatives impossible to price.
 Why did stodgy pension funds buy such risky assets? They thought an insurance product
called credit default swaps protected them. A traditional insurance company known as

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 the American International Group sold these swaps. When the derivatives lost value, AIG
didn't have enough cash flow to honor all the swaps.
 The first signs of the financial crisis appeared in 2007. Banks panicked when they
realized they would have to absorb the losses. They stopped lending to each other. They
didn't want other banks giving them worthless mortgages as collateral. No one wanted to
get stuck holding the bag. As a result, interbank borrowing costs, called Libor, rose. This
mistrust within the banking community was the primary cause of the 2008 financial
crisis.
 The Federal Reserve began pumping liquidity into the banking system via the Term
Auction Facility. But that wasn't enough.
 The 2008 financial crisis timeline began in March 2008. Investors sold off their shares of
investment bank Bear Stearns because it had too many of the toxic assets. Bear
approached JP Morgan Chase to bail it out. The Fed had to sweeten the deal with a $30
billion guarantee. By 2012, the Fed had received full payment for its loan.
 After the Bear Stearns bailout, Wall Street thought the panic was over. Instead, the
situation deteriorated throughout the summer of 2008.
 Congress authorized the Treasury Secretary to take over mortgage companies Fannie
Mae and Freddie Mac. It cost $187 billion at the time. Since then, Treasury has made
enough in profits to pay off the cost.
 On September 16, 2008, the Fed loaned $85 billion to AIG as a bailout. In October and
November, the Fed and Treasury restructured the bailout. The total cost ballooned
to $182 billion. But by 2012, the government made a $22.7 billion profit when Treasury
sold its last AIG shares. The value of the company had raised that much in four years.
 On September 17, 2008, the crisis created a run on money market funds. Companies park
excess cash there to earn interest on it overnight. Banks then use those funds to make
short-term loans. During the run, companies moved a record billion out of their money
market accounts into even safer Treasury bonds. If these accounts had gone bankrupt,
business activities and the economy would have ground to a halt.
 That crisis called for a massive government intervention. Three days later, Treasury
Secretary Henry Paulson and Fed Chair Ben Bernanke submitted a $700 billion bailout
package to Congress. Their fast response stopped the run. But Republicans blocked the
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 bill for two weeks. They didn't want to bail out banks. They only approved the bill after
global stock markets almost collapsed.
 The bailout package never cost the taxpayer the full $700 billion. Treasury
disbursed $439.6 billion from the Troubled Asset Relief Program. By 2018, it had put
$442.6 billion back into the fund. It made $3 billion in profit. How did it do this? It
bought shares of the companies it bailed out when prices were low. It wisely sold them
when prices were high.
 The TARP funds helped five areas. Treasury used $245.1 billion to buy bank preferred
stocks as a way to give those cash. Another $80.7 billion bailed out auto companies. It
contributed $67.8 billion to the $182 billion bailout of insurance company AIG.
Another $19.1 billion went to shore up credit markets. The bank repaid $23.6 billion,
creating a $4.5 billion profit. The Plan disbursed $27.9 billion to modify mortgages.
 President Obama didn't use the remaining $700 billion allocated for TARP. He didn't
want to bail out any more businesses. Instead, he asked Congress for an economic
stimulus package. On February 17, 2009, he signed the American Recovery and
Reinvestment Act. It had tax cuts, stimulus checks, and public works spending. By 2011,
it put $831 billion directly into the pockets of consumers and small businesses. It was
enough to end the financial crisis by July 2009

Analysis of the crisis:

1. Classification of Risks
To analyze this point, risks can be classified into three categories: “known
knowns,” “known unknowns,” and “unknown unknowns,” corresponding to
different levels of uncertainty.
s
i) Known Knowns
 The S&P index lost 38% in 2008. As a result, this portfolio should have lost 0.5
times 38%, or around 19%. This loss is a combination of bad luck (i.e., a very large
fall in the S&P index, but not unprecedented as U.S. stocks lost 43% in 1931) and
exposure (i.e., having a high beta). If the distribution was properly measured, the

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 outcome matched the risk forecast. In this case, the risk measurement system was
flawless.

ii) Known Unknowns

 Even so, management systems do have numerous known blind spots. First, the risk
manager could have ignored important known risk factors. Second, the distribution
of risk factors, including volatilities and correlations, could be measured
inaccurately. Third, the mapping process, which consists of replacing positions
with exposures on the risk factors, could be incorrect. These fall in the broad
category of model risk.
 As an example of the first problem, many portfolios unexpected lost money on
basis trades during 2008. These involve hedged positions. For instance, a trader
could buy a corporate bond and at the same time purchase a credit default swap
(CDS) that provides protection in case of default of the same name. Normally, if
the position can be held to maturity with no extraneous risks, this should be an
arbitrage trade. Since Long- Term Capital Management, we know that arbitrage
trades are subject to mark-to-market risk. In practice, however, most risk
management systems map both the bond and CDS to the same risk factor, which
ignores the basis risk. During 2008, this basis widened sharply, leading to large
mark-to-market losses on such positions that were not captured by most risk
models.
 As an example of the second problem of incorrect distributions, assume that the risk
manager had estimated the volatility of the S&P index using a fixed 2-year period,
2005 to 2006. Because this period was unusually quiet, this would have understated
the risk during the following two years.
 Many banks experienced large losses on super senior, AAA rated, tranches of
securities backed by subprime mortgages. Investing in these tranches can be viewed
as selling out-of-the-money put options, which involve nonlinear payoffs. As long
as the real estate market continued to go up, the default rate on subprime debt was
relatively low and the super senior debt was safe, experiencing no price volatility.
As the real estate market corrected sharply, the put options moved in-the-money,
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 which led to large losses on this super senior debt. Of course, none of these
movements showed up in the historical data prior to 2007 because this period only
reflected a sustained appreciation in the housing market but also because of the
inherent nonlinearity in these securities.
 It is well known that risk management systems do not account for liquidity risk,
which involves both asset liquidity risk, which is the price impact of large asset
sales, as well as funding liquidity risk, which arises when the firm cannot meet cash
flow or collateral needs. This is why the Basel Committee did not institute formal
capital charges against liquidity risk. Yet, the BSCBS (2006) stated that “Liquidity
is crucial to the ongoing viability of any banking organization. Banks' capital
positions can have an effect on their ability to obtain liquidity, especially in a
crisis.” Liquidity risk, however, is extremely complex and difficult to reduce to
simple quantitative rules.

iii) Unknown Unknowns

 In the last category of risks are events totally outside the scope of most scenarios.
This includes regulatory risks such as the sudden restrictions on short-sales, which
played havoc with hedging strategies, or structural changes such as the conversion of
investment banks to commercial banks, which accelerated the deleveraging of the
industry. These risks affected the entire industry starting with the Lehman
bankruptcy in September 2008.
 Similarly, it is difficult to account fully for counterparty risk. It is not enough to
know your counterparty; you need to know your counterparty’s counterparties too.
In other words, these are network externalities. Understanding the full
consequences of Lehman’s failure would have required information on the entire
topology of the financial network. Such contagion effects transform traditional risks
that can be measured into Knightian “uncertainty,” a form of risk that is
immeasurable.
 Evaluating such risks will always be a challenge but their existence must be
acknowledged. This can lead to higher capital cushions than otherwise.
Management should also develop plans of actions when these risks start to develop.
 In the end, however, financial institutions cannot possibly carry enough capital to
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 withstand massive counterparty failures, or systemic risk. In such situations, the
bank regulator becomes effectively the risk manager of last resort.

7 main reasons of the financial crisis 2008

1. Dramatic failures of corporate governance and risk management at

many systemically important financial institutions were a key cause of
this crisis.
 There was a view that instincts for self-preservation inside major financial firms would
shield them from fatal risk-taking without the need for a steady regulatory hand, which,
the firms argued, would stifle innovation. Too many of these institutions acted recklessly,
taking on too much risk, with too little capital, and with too much dependence on short-
term funding
 Mental change in these institutions, particularly the large investment banks and bank
holding companies, which focused their activities increasingly on risky trading activities
that produced hefty profits. They took on enormous exposures in acquiring and
supporting subprime lenders and creating, packaging, repackaging, and selling trillions of
dollars in mortgage-related securities, including synthetic financial products. Like Icarus,
they never feared flying ever closer to the sun.
 Many of these institutions grew aggressively through poorly executed acquisition and
integration strategies that made effective management more challenging. The CEO of
Citigroup told the Commission that a $40 billion position in highly rated mortgage
securities would “not in any way have excited my attention,’ and the co- head of
Citigroup’s investment bank said he spent “a small fraction of 1%” of his time on those
securities. In this instance, too big to fail meant too big to manage.
 Financial institutions and credit rating agencies embraced mathematical models as
reliable predictors of risks, replacing judgment in too many instances. Too often, risk
management became risk justification.
 Compensation systems—designed in an environment of cheap money, intense
competition, and light regulation—too often rewarded the quick deal, the short-term

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 gain—without proper consideration of long-term consequences. Often, those systems
encouraged the big bet—where the payoff on the upside could be huge and the down-
side limited. This was the case up and down the line—from the corporate boardroom to
the mortgage broker on the street.
 It was revealed that stunning instances of governance breakdowns and irresponsibility.
Among other things, about AIG senior management's ignorance of the terms and risks of
the company’s $79 billion derivatives exposure to mortgage-related securities; Fannie
Mae's quest for bigger market share, profits, and bonuses, which led it to ramp up its
exposure to risky loans and securities as the housing market was peaking; and the costly
surprise when Merrill Lynch’s top management realized that the company held $55
billion in “super-senior” and supposedly “super-safe” mortgage-related securities that
resulted in billions of dollars in losses.

2. A combination of excessive borrowing, risky investments, and lack of

transparency put the financial system on a collision course with crisis.

 Clearly, this vulnerability was related to failures of corporate governance and regulation,
but it is significant enough by itself to warrant our attention here.
 In the years leading up to the crisis, too many financial institutions, as well as too many
households, borrowed to the hilt, leaving them vulnerable to financial distress or ruin if
the value of their investments declined even modestly. For example, as of 2007, the five
major investment banks—Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill
Lynch, and Morgan Stanley—were operating with extraordinarily thin capital.
 By one measure, their leverage ratios were as high as 40 to 1, meaning for every $40 in
assets, there was only $1 in capital to cover losses. Less than a 3% drop in asset values
could wipe out a firm. To make matters worse, much of their borrowing was short-term,
in the overnight market—meaning the borrowing had to be renewed each and every day.
For example, at the end of 2007, Bear Stearns had $11.8 billion in XX Financial crisis
inquiry report commission.
 Equity and $383.6 billion in liabilities and was borrowing as much as $70 billion in the
overnight market. It was the equivalent of a small business with $50,000 in equity
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 borrowing $1.6 million, with $296,750 of that due each and every day. One can't really
ask “What were they thinking?” when it seems that too many of them were thinking
alike.
 And the leverage was often hidden—in derivatives positions, in off-balance-sheet
entities, and through “window dressing” of financial reports available to the investing
public.
 The kings of leverage were Fannie Mae and Freddie Mac, the two behemoth government
sponsored enterprises (GSEs). For example, by the end of 2007, Fannie’s and Freddie’s
combined leverage ratio, including loans they owned and guaranteed, stood at 75 to 1.
 But financial firms were not alone in the borrowing spree: from 2001 to 2007, national
mortgage debt almost doubled, and the amount of mortgage debt per house- hold rose
more than 63% from $91,500 to $149,500, even while wages were essentially stagnant.
When the housing downturn hit, heavily indebted financial firms and families alike were
walloped.
 The heavy debt taken on by some financial institutions was exacerbated by the risky
assets they were acquiring with that debt. As the mortgage and real estate markets
churned out riskier and riskier loans and securities, many financial institutions loaded up
on them.
 By the end of 2007, Lehman had amassed $111 billion in commercial and residential real
estate holdings and securities, which was almost twice what it held just two years before,
and more than four times its total equity. And again, the risk wasn’t being taken on just
by the big financial firms, but by families, too. Nearly one in 10 mortgage borrowers in
2005 and 2006 took out “option ARM” loans, which meant they could choose to make
payments so low that their mortgage balances rose every month.
 Within the financial system, the dangers of this debt were magnified because
transparency was not required or desired. Massive, short-term borrowing, combined with
obligations unseen by others in the market, heightened the chances the system could
rapidly unravel. In the early part of the 2oth century, we erected a series of protections—
the Federal Reserve as a lender of last resort, federal deposit insurance, ample
regulations—to provide a bulwark against the panics that had regularly plagued
America’s banking system in the 19th century.
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 Yet, over the past 30-plus years, we permitted the growth of a shadow banking system—
opaque and laden with short- term debt—that rivaled the size of the traditional banking
system. Key components of the market—for example, the multitrillion-dollar repo
lending market, off-balance-sheet entities, and the use of over-the-counter derivatives—
were hidden from view, without the protections we had constructed to prevent financial
meltdowns. We had a 21st-century financial system with 19th-century safeguards.
 When the housing and mortgage markets cratered, the lack of transparency, the
extraordinary debt loads, the short-term loans, and the risky assets all came home to
roost. What resulted was panic. We had reaped what we had sown.

3. Widespread failures in financial regulation and supervision proved

devastating to the stability of the nation’s financial markets.
 The sentries were not at their posts, in no small part due to the widely accepted faith in
the self- correcting nature of the markets and the ability of financial institutions to
effectively police themselves. More than 30 years of deregulation and reliance on self-
regulation by financial institutions, championed by former Federal Reserve chairman
Alan Greenspan and others, supported by successive administrations and Congresses, and
actively pushed by the powerful financial industry at every turn, had stripped away key
safeguards, which could have helped avoid catastrophe.
 This approach had opened up gaps in oversight of critical areas with trillions of dollars at
risk, such as the shadow banking system and over-the-counter derivatives markets. In
addition, the government permitted financial firms to pick their preferred regulators in
what became a race to the weakest supervisor.
 Yet it was not acceptable that regulators lacked the power to protect the financial system.
They had ample power in many arenas and they chose not to use it. To give just three
examples: the Securities and Exchange Commission could have required more capital
and halted risky practices at the big investment banks. It did not. The Federal Reserve
Bank of New York and other regulators could have clamped down on Citigroup’s
excesses in the run-up to the crisis. They did not.
 Policy makers and regulators could have stopped the runaway mortgage securitization
train. They did not. In case after case after case, regulators continued to rate the
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 institutions they oversaw as safe and sound even in the face of mounting troubles, often
downgrading them just before their collapse. And where regulators lacked authority, they
could have sought it. Too often, they lacked the political will—in a political and
ideological environment that constrained it—as well as the fortitude to critically
challenge the institutions and the entire system they were entrusted to oversee.
 Changes in the regulatory system occurred in many instances as financial markets
evolved. But as the report will show, the financial industry itself played a key role in
weakening regulatory constraints on institutions, markets, and products. It did not
surprise the Commission that an industry of such wealth and power would exert pressure
on policy makers and regulators. From 1999 to 2008, the financial sector expended $2.7
billion in reported federal lobbying expenses; individuals and political action committees
in the sector made more than $1 billion in campaign contributions. What troubled us was
the extent to which the nation was deprived of the necessary strength and independence
of the oversight necessary to safeguard financial stability.

4. Collapsing mortgage-lending standards and the mortgage securitization

pipeline lit and spread the flame of contagion and crisis.
 When housing prices fell and mortgage borrowers defaulted, the lights began to dim on
Wall Street. This report catalogues the corrosion of mortgage-lending standards and the
securitization pipeline that transported toxic mortgages from neighborhoods across
America to investors around the globe.
 Many mortgage lenders set the bar so low that lenders simply took eager borrowers
qualifications on faith, often with a willful disregard for a borrower's ability to pay.
Nearly one-quarter of all mortgages made in the first half of 2005 were interest- only
loans. During the same year, 68% of “option ARM” loans originated by Countrywide and
Washington Mutual had low- or no-documentation requirements.
 These trends were not secret. As irresponsible lending, including predatory and
fraudulent practices, became more prevalent, the Federal Reserve and other regulators
and authorities heard warnings from many quarters. Yet the Federal Reserve neglected its
mission “to ensure the safety and soundness of the nation’s banking and financial system
and to protect the credit rights of consumers.”
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 It failed to build the retaining wall before it was too late. And the Office of the
Comptroller of the Currency and the Office of Thrift Supervision, caught up in turf wars,
preempted state regulators from reining in abuses.
 While many of these mortgages were kept on banks’ books, the bigger money came from
global investors who clamored to put their cash into newly created mortgage related
securities. It appeared to financial institutions, investors, and regulators alike that risk had
been conquered: the investors held highly rated securities they thought were sure to
perform; the banks thought they had taken the riskiest loans off their books; and
regulators saw firms making profits and borrowing costs reduced.
 But each step in the mortgage securitization pipeline depended on the next step to keep
demand going. From the speculators who flipped houses to the mortgage brokers who
scouted the loans, to the lenders who issued the mortgages, to the financial firms that
created the mortgage-backed securities, collateralized debt obligations (CDOs), CDOs
squared, and synthetic CDOs: no one in this pipeline of toxic mortgages had enough skin
in the game. They all believed they could off-load their risks on a moment's notice to the
next person in line. They were wrong. When borrowers stopped making mortgage
payments, the losses—amplified by derivatives—rushed through the pipeline. As it
turned out, these losses were concentrated in a set of systemically important financial
institutions.
 In the end, the system that created millions of mortgages so efficiently has proven to be
difficult to unwind. Its complexity has erected barriers to modifying mortgages so
families can stay in their homes and has created further uncertainty about the health of
the housing market and financial institutions.

5. Over-the-counter derivatives contributed significantly to this crisis.

 The enactment of legislation in 2000 to ban the regulation by both the federal and state
governments of over-the-counter (OTC) derivatives was a key turning point in the march
toward the financial crisis.
 From financial firms to corporations, to farmers, and to investors, derivatives have been
used to hedge against, or speculate on, changes in prices, rates, or indices or even on
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 events such as the potential defaults on debts. Yet, without any oversight, OTC
derivatives rapidly spiraled out of control and out of sight, growing to $673 trillion in
notional amount. This report explains the uncontrolled leverage; lack of transparency,
capital, and collateral requirements; speculation; interconnections among firms; and
concentrations of risk in this market.
 OTC derivatives contributed to the crisis in three significant ways. First, one type of
derivative—credit default swaps (CDS)—fueled the mortgage securitization pipeline.
CDS were sold to investors to protect against the default or decline in value of mortgage-
related securities backed by risky loans. Companies sold protection—to the tune of $79
billion, in AIG’s case—to investors in these newfangled mortgage securities, helping to
launch and expand the market and, in turn, to further fuel the housing bubble.
 Second, CDS were essential to the creation of synthetic CDOs. These synthetic CDOs
were merely bets on the performance of real mortgage-related securities. They amplified
the losses from the collapse of the housing bubble by allowing multiple bets on the same
securities and helped spread them throughout the financial system. Goldman Sachs alone
packaged and sold $73 billion in synthetic CDOs from July 1.
 2004, to May 31, 2007. Synthetic CDOs created by Goldman referenced more than 3,400
mortgage securities, and 610 of them were referenced at least twice. This is apart from
how many times these securities may have been referenced in synthetic CDOs created by
other firms.
 Finally, when the housing bubble popped and crisis followed, derivatives were in the
center of the storm. AIG, which had not been required to put aside capital re-serves as a
cushion for the protection it was selling, was bailed out when it could not meet its
obligations.
 The government ultimately committed more than $180 billion because of concerns that
AIC’s collapse would trigger cascading losses throughout the global financial system. In
addition, the existence of millions of derivatives con- tracts of all types between
systemically important financial institutions—unseen and unknown in this unregulated
market—added to uncertainty and escalated panic, helping to precipitate government
assistance to those institutions.

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6. The failures of credit rating agencies were essential cogs in the wheel of

financial destruction.

 The three credit rating agencies were key enablers of the financial meltdown. The
mortgage-related securities at the heart of the crisis could not have been marketed and
sold without their seal of approval. Investors relied on them, often blindly. In some cases,
they were obligated to use them, or regulatory capital standards were hinged on them.
This crisis could not have happened without the rating agencies. Their ratings helped the
market soar and their down- grades through 2007 and 2008 wreaked havoc across
markets and firms.
 From 2000 to 2007, Moody's rated nearly 45,000 mortgage-related securities as triple-A.
This compares with six private-sector companies in the United States that carried this
coveted rating in early 2010. In 2006 alone, Moody’s put its triple-A stamp of approval
on 30 mortgage-related securities every working day. The results were disastrous: 83% of
the mortgage securities rated triple-A that year ultimately were downgraded.
 The forces at work behind the breakdowns at Moody’s, including the flawed computer
models, the pressure from financial firms that paid for the ratings, the relentless drive for
market share, the lack of resources to do the job despite record profits, and the absence of
meaningful public oversight. Without the active participation of the rating agencies, the
market for mort- gage-related securities could not have been what it became.

7. The government was ill prepared for the crisis, and its inconsistent
response added to the uncertainty and panic in the financial markets.

 The key policy makers—the Treasury Department, the Federal Reserve Board, and the
Federal Reserve Bank of New York—who were best positioned to watch over markets
were ill prepared for the events of 2007 and 2008.
 Other agencies were also behind the curve. They were hampered because they did not
have a clear grasp of the financial system they were charged with overseeing, particularly
as it had evolved in the years leading up to the crisis. This was in no small measure due to
the lack of transparency in key markets. They thought risk had been diversified when, in
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 fact, it had been concentrated. Time and again, from the spring of 2007 on, policy makers
and regulators were caught off guard as the contagion spread, responding on an ad hoc
basis with specific programs to put fingers in the dike.
 There was no comprehensive and strategic plan for containment, because they lacked a
full understanding of the risks and interconnections in the financial markets. Some
regulators have conceded this error. They had allowed the system to race ahead of ability
to protect it.
 While there was some awareness or at least a debate about, the housing bubble, the
record reflected that senior public officials did not recognize that a bursting of the bubble
could threaten the entire financial system. Throughout the summer of 2007, both Federal
Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paul- son offered public
assurances that the turmoil in the subprime mortgage markets would be contained.
 When Bear Stearns’s hedge funds, which were heavily invested in mortgage-related
securities, imploded in June 2007, the Federal Reserve discussed the implications of the
collapse. Despite the fact that so many other funds were ex- posed to the same risks as
those hedge funds, the Bear Stearns funds were thought to be “relatively unique.” Days
before the collapse of Bear Stearns in March 2008, SEC Chairman Christopher Cox
expressed “comfort about the capital cushions” at the big investment banks.
 It was not until August 2008, just weeks before the government takeover of Fannie Mae
and Freddie Mac, that the Treasury Department understood the full measure of the dire
financial conditions of those two institutions. And just a month before Lehman’s
collapse, the Federal Reserve Bank of New York was still seeking information on the
exposures created by Lehman's more than 900,000 derivatives contracts.
 In addition, the government's inconsistent handling of major financial institutions during
the crisis—the decision to rescue Bear Stearns and then to place Fannie Mae and Freddie
Mac into conservatorship, followed by its decision not to save Lehman Brothers and then
to save AlG increased uncertainty and panic in the market.
 In making these observations, we deeply respect and appreciate the efforts made by
Secretary Paulson, Chairman Bernanke, and Timothy Geithner, formerly president of the
Federal Reserve Bank of New York and now treasury secretary.
 Many others who labored to stabilize our financial system and our economy in the most
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 chaotic and challenging of circumstances.

Funding and Market Liquidity Problems

 The events of 2007-09 demonstrated on a large scale the vulnerabilities of firms

whose business models depended heavily on uninterrupted access to secured
financing markets.
 Many firms relied on excessive short-term wholesale financing of long-term
illiquid assets, in many cases on a cross border basis—a practice that made it
difficult for the firms to with stand market stresses absent deposits and sovereign
and central bank support.
 Borrowers had taken advantage of the opportunity the market afforded to obtain
short-term (often overnight) financing for assets that should more appropriately
have been funded with long-term, stable funding. Faced with uncertainty about
the value of specific instruments and mindful of the higher volatility of assets
more generally, lenders demanded substantial cushions, or “haircuts,” on the
assets they were willing to finance.
 Firms that were least affected by market developments had the apriority discipline
to resist excessive short-term funding.
 Some larger and more diverse financial institutions were able to weather events
initially by drawing on other sources of funding, such as deposits, liquidity pools
consisting of sovereign bonds and, when available, central bank lending facilities.
 Some firms’ business models also relied on excessive leverage, which, combined with
doubts about the realizable value of the firm’s assets, heightened solvency and
business-model concerns among the firms’ creditors and counterparties.
 Firms permitted excess leverage and reliance on short-term financing to develop
over time because of a combination of risk governance weaknesses and
misaligned incentives (as explained below), incomplete risk capture in
management reports, limitations or unintended consequences of regulatory
requirements, and ineffective market discipline.

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  These structural issues affected a wide range of financial institutions, including
various U.S. investment banks, certain U.S. and U.K. mortgage banks, some
German Land banks, and some banks that had recently completed acquisitions
that strained their capital base with the assets and risks acquired. However, market
stresses affected nearly all major global financial institutions, with most requiring
some form of assistance. In this environment, exceptional official sector support
was necessary to maintain the viability of the financial system.
 The disruption of the secured financing market highlighted a number of issues
relating to the U.S. trip arty market for repurchase agreements (repos).
 Securities dealers of ten depended on the trip arty repo market to fund certain
kinds of securities increasingly, as time passed, illiquid and hard-to-price
securities and were consequently vulnerable to disruptions in that market.
 Lenders funded through trip arty arrangements significant volumes of illiquid
securities that they would be prohibited from retaining should a borrower fail.
Clearing agent banks took on significant credit risk by extending intraday credit
without fully considering whether they would be able to liquidate collateral
should then rise.
 Borrowers failed to anticipate the collateral amounts that their clearing agents
would require when faced with providing intraday funding for a weak borrower
with a deteriorating collateral pool.
 Similarly, the bankruptcy of Lehman Brothers International (Europe) LBIE
highlighted the risks of relying on the hypothecation of clients’ securities as a source
of funding.
 Many counter parties of LBIE elected to have accounts that allowed Lehman to
hypothecate securities positions to obtain funding. After LBIE declared
bankruptcy, prime brokerage clients sought to withdraw from arrangements.
However these clients were deemed to unsecured creditors of the estate and
found themselves without access to their positions.
 The failure of Lehman Brothers generated concern among hedge fund customers
relating to the fact that, in certain instances, their prime brokerage free credit
balances and other assets in the United Kingdom were not subject to
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 segregation; in many cases, customers decided to withdraw from these
arrangements.
 Firms whose U.K. dealer subsidiaries relied on hypothecating clients’ securities
to obtain funding did not recognize that this source of funding would be lost
when Lehman Brothers declared bankruptcy.
 Firms also failed to realize that two important sources of funding, securities
lending and money market funds, could impose further demands on firm liquidity
during periods of stress.
 Traditional sources of funding, especially for European banks, such as securities
lending reinvestment pools and money market mutual funds, faced significant
and immediate pressures to reduce their investment positions. These pressures
became apparent following the announcement of losses in the Primary Fund
series of the Reserve Fund in the United States.

Firms’ Re-evaluation of Existing Practices

The global financial firms participating in the liquidity and self-assessment exercises
began reevaluating existing practices at the corporate and business line level.
 Many firms acknowledged that, if robust funds transfer pricing practices had been
in place earlier, they would not have carried on their trading books the
significant levels of illiquid assets that ultimately led to large losses and would
not have built up significant contingency illiquidity risks associated with off-
balance-sheet exposures.
 Firms reported that substantial efforts are underway to implement or enhance
funds transfer pricing practices, including both broadening the scope of
business activities subject to transfer pricing and integrating transfer pricing
more deeply with firm processes.
 In addition, many firms reevaluated how they measure their future needs for
funding. Before the crisis, most firms relied heavily on a “months of [contractual]
coverage” metric that did not adequately reflect the contractual and behavioral
demands triggered in a stressful market environment.

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  For example, the coverage metric did not capture many of the stresses that
developed during the crisis, such as meeting demands for collateral from
clearing agents and counterparties, accepting credited fault swap (CDS)
novation’s and—even when not contractually required to do so—supporting
instruments and vehicles such as sponsored funds, structured investment
vehicles, and money market and similar funds.
 Recognizing the weakness of their existing measures of funding needs, firms
are now enhancing their calculations of “stress needs.”

 A key weakness in governance stemmed from what several senior managers

admitted was a disparity between the risks that their firms took and those that
their boards of directors perceived the firms to be taking.
 In addition, supervisors saw insufficient evidence of active board involvement
in setting the risk appetite for firms in a way that recognizes the implications of
that risk taking. Specifically only, rarely did supervisors see firms share with
their boards and senior management a) robust measures of risk exposures (and
related limits), b) the level of capital that the firm would need to maintain after
sustaining a loss of the magnitude of the risk measure, and c) the actions that
management could take to restore capital after sustaining such a loss.
Supervisors believe that active board involvement in determining the risk
tolerance of the firm is critical to ensuring that discipline is sustained in the face
of future market pressures for excessive risk taking.
 Within firms, the stature and influence of revenue producers clearly exceeded
those of risk management and control functions.
 Belatedly responding to this imbalance, virtually all firms have strengthened
the authority of the risk management function and increased the resources
devoted to it. Nevertheless, firms face considerable challenges in developing
the needed infrastructure and management information systems (MIS).
 Some of the imbalance we noted between risk and rewards can be seen in the
approaches to remuneration. There was broad recognition that industry
compensation practices were driven by the need to attract and retain talent and were
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 often not integrated with the firms’ control environments. Among the critical
weaknesses that the firms cited are the following:
 Historical compensation arrangements evidenced both in sensitivity to risk
and skewed incentives to maximize revenues.

 The accrual of compensation pools historically did not reflect all

appropriate costs.

 Schemes for measuring individual performance often failed to take into account
true economic profits, adjusted for all costs and uncertainty.
 Firms considered changes to their compensation regimes—including
modifications to the accrual of bonus pools, the allocation of pools to business
units and individuals.

 Overall, the crisis highlighted the inadequacy of many firms’ IT infrastructures in

supporting the broad management of financial risks.
 In some cases, the obstacle to improving risk management systems had been the
poor integration of data that has resulted from firms’ multiple mergers and
acquisitions. This problem has been seen as affecting firms’ ability to implement
effective transfer pricing, consistently value complex products throughout an
organization estimate counterparty credit risk (CCR) levels credit aggregate
exposures quickly, and perform forward-looking stress tests. Building more robust
infrastructure systems requires a significant commitment of financial and human
resources on the part of firms, but is viewed as critical to the long-term
sustainability of improvements in risk management.

Debates on Corporate Governance Failures:

 The main problems with banks and the entire financial industry in developed countries
that caused the 2008 financial crisis not resolved. For example, the culture of short-term
profit maximization, excessive bonuses for CEOs and senior managers (even with
taxpayers’ money), and banks routinely exploiting their millions of customers and
believing in a ‘too-big-to-fail’ world were still there. For this reason, in March 2011, the
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 Governor of the Bank of England Sir Mervin King warned that, without reform of the
banks, Britain risks suffering another financial crisis.
 However, not everyone had agreed that the governance of banks and other financial
institutions has been malfunctioned and resulted in the recent financial crisis. There were
three different views in the debate on the relationship between corporate governance and
the financial crisis. The first view was that corporate governance was unrelated or little
related to the financial crisis.
 It was claimed that since the 1970s corporate governance in the United States and other
developed countries has improved significantly. Publicly held corporations were, in
general, governed satisfactorily before and during the financial crisis with no significant
correlation between corporate governance and the financial crisis. Drawing on his
empirical study of 37 firms removed from the S&P 500 index during 2008, concluded
that corporate governance in those firms functioned tolerably well and did not fail in the
financial crisis.
 Using a large sample of data on financial and non-financial firms from 1996 to 2007,
Adams (2009) showed that the governance of financial firms was on average not worse
than that of non-financial firms. Boards of banks receiving bailout money were more
independent than the boards of other banks, and bank directors received far less
compensation than directors in non-financial firms.
 The second view was that the financial crisis was closely associated with the insufficient
implementation of corporate governance codes and principles while current corporate
governance frameworks were not wrong in general (OECD, 2009). OECD identifies four
weak areas in corporate governance that contributed to the financial crisis: executive
remuneration, risk management, board practices and the exercise of shareholder rights.
Yet, it argues that the principles of corporate governance had adequately addressed those
key governance concerns and the “major failures among policy makers and corporations
appear to be due to lack of implementation” of those principles.
 The UK Financial Reporting Council shared a similar view that there were no major
problems with corporate governance codes prior to the financial crisis and the only
problem remained with the implementation of the codes.

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 The systemic failure of corporate governance was particularly associated with
the Anglo-American corporate governance model that has enabled, permitted or
tolerated excess power and wealth at the hands of CEOs and cultivated a ‘greed-
is-good’ culture in banks.
 The third view was that the financial crisis was at least in part caused by a systemic
failure of corporate governance. The failure of corporate governance was not purely an
implementation issue, but more a systemic failure of institutional arrangements that were
underpinned by increasingly popular paradigms or paradigmatic assumptions like market
fundamentalism, self-regulation, self-interest human behavior and shareholder primacy.
Points out that ‘The financial crisis was both a failure of the invisible hand of market and
a failure of the visible hand of management’. Corporate governance and management was
hijacked by the ideology of ‘Reagonomics’:
 ‘The company’s job was to make money for shareholders; the individual’s job was to
pursue self-interest, allowing the invisible hand to work its magic; and the job of
governance was to align “agents” (managers) with “principals” (shareholders) by
incentives and sanctions. The carrot was pay linked to stock price, often in the form of
stock options. The stick: high levels of debt and a vigorous market for corporate control,
which ensured that underperforming assets could readily pass into the hands of sharper
managers at hungrier companies.’
 The systemic failure of corporate governance was particularly associated with the Anglo-
American corporate governance model that has enabled, permitted or tolerated excess
power and wealth at the hands of CEOs, cultivated a ‘greed-is-good’ culture in banks,
corporations, financial markets and financial capitalism, and incentivized investment
bank executives to pursue vast securitization and high leveraging to enrich themselves at
the severe cost of shareholders, investors and other stakeholders.

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Conclusion:

 Risk management, even if flawlessly executed, does not guarantee that big losses
will not occur. Big losses can occur because of business decisions and bad luck.
Even so, the events of 2007 and 2008 have highlighted serious deficiencies in risk
models. For some firms, risk models failed because of known unknowns. These
include model risk and liquidity risk. In 2008, risk models largely failed due to
unknown unknowns, which include regulatory and structural changes in capital
markets and contagion risks. Such risks, admittedly, are not amenable to formal
measurement.
 There are a variety of immediately implementable enhancements for risk
management systems, however. This includes the overweighting of recent data in
risk models, the use of stress tests and broader scenario analysis. All of these require
position- based risk measures. In other words, this crisis has reinforced the
importance of risk management. There is simply no alternative. Risk management
will not go away as a core function of financial institutions
 In the end, a risk management system simply cannot--and is not designed to--take
the place of the judgment and business expertise of the users of the system. We will
surely see substantial improvements in risk systems as a result of the credit crisis.
As stated previously, “formal risk management models cannot substitute for
judgment and experience.”
 A good corporate governance system in a free market economy is a systemic
integration of regulatory governance, market governance, stakeholder governance
and internal governance, with sufficient flexibility for dynamic variations of
governing modes and mechanisms in different times and contexts.
 It is obvious that a basic legal and regulatory framework is needed for maintaining
the order of free market competition and for good governance. The financial crisis
indicates that stricter regulations are particularly needed in the finance industry. But
we also need to be aware of the limits of regulations, as regulations are often
reactive rather than proactive to corporate activities, and inappropriate regulations
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 may also lead to corporate governance failure or business failure. Hence, a balance
between regulatory governance and other governance modes and mechanisms needs
to be carefully considered.

References
 https://en.wikipedia.org/wiki/Financial_crisis_of_2007-2008
 https://en.wikipedia.org/wiki/Global_financial_crisis_in_September_2008
 Risk Management Lessons from the Global Banking Crisis of 2008
 GPO-FCIC.pdf
 Financial crisis report findings.pdf

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