Lehman Brothers filed for bankruptcy on 15 th September 2008. As at the date, the firm had $639 billion worth of assets and was $619 billion in debt. Since its assets surpassed those of companies that had filed for bankruptcy previously, Lehman’s filing for bankruptcy was acknowledged to be the largest historically (Kershaw & Moorhead, 2013; Jones & Presley, 2013; Johnson & Mamun, 2012 ; Sieczka et al., 2011). Moreover, at the time of filing, the firm was the fourth-largest investment bank in the United States (U.S) with a global workforce of 25,000 employees. Companies that had been declared bankrupt previously included Enron and WorldCom. Lehman was a culprit of the financial crisis that affected financial markets globally in 2008, and which was fuelled by subprime mortgages . However, the collapse of Lehman intensified the crisis, contributing to the loss of up to $10 trillion market capitalization from equity markets globally in October the same year. The collapse of Lehman Brothers exemplified risk management negligence within the U.S financial services industry.
Factors that contributed to the financial failure of Lehman’s Brothers
The collapse of Lehman can be blamed on several factors. The first key factor is that the firm took on too much risk in a booming financial market. In this regard, the management allowed the institution’s leverage ratio to skyrocket irrespective of the booming market. It is believed that the company’s leverage ratio stood at 44 to 1 at the time of the collapse . Thus, the management failed to control the rising leverage ratio. On the other hand, d ue to the hard economic times that characterized the period , no single financial institution was willing to buy help Lehman Brothers. Prominent financial institution s in the U.S such as Bear Sterns, Merrill Lynch, Washington Mutual and Wachovia were all troubled . Thus, they could not take the risk of bailing out Lehman Brothers . Interestingly, notable institutions such as the Federal National Mortgage Association (Fannie Mae), the Federal Home Mortgage Corporation (Freddie Mac), Bear Stearns and American International Group (AIG) received financial assistance from the U . S Treasury Department and the Federal Reserve . However, Lehman Brothers did not benefit from this bailout (Johnson & Mamun, 2012).
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The second factor that contributed to the collapse of Lehman Brothers wa s the wanting nature of the firm ’s balance sheet . T he bank had made such huge losses that it did not have sufficient ly high collateral to procure an emergency loan ( Jones & Presley, 2013 ). Subsequently , the Federal Reserve was unable to offer the firm an emergency loan . Moreover , the institution’s financial state implied that the central bank could have incurred massive lo s ses in its efforts to bail out the bank. This is based on the fact that Lehman Brothers was bound to collapse either way ( Johnson & Mamun , 2012). T he collapse of Lehman Brothers can thus be attributed to the management ’s fail ure to m aintai n liquidity. This is despite the fact that the firm had a massive asset base. The low liquidity meant that there was the absence of ready cash as well as readily disposable assets ( Johnson & Mamun , 2012). The lack of political palatability for bailouts is also another factor that led to the failure of Lehman Brothers. For instance, the general public had increasingly grown impatient with the financial industry and wouldn’t accept another burden worth millions of dollars in the form of taxes to bail out the firm .
Several strategies would have been used as risk management measures to avoid the imminent collapse of Lehman Brothers. These can also be recommended so as to deal with similar risks in the future. The first strategy is that Lehman Brother’s management ought to have maintained average leverage levels even amidst the booming business. Low or average leverage levels can adequately cushion a company against massive losses in that should the number of defaulters increase , the net loss made by the firm is not magnified (Hull, 2012) . Hence, in periods when a firm is experienc ing booming business, the best strategy is to borrow money and invest in assets . Care should be taken to ensure that the assets invested in are rising in value so as to ensure that the returns are magnif ied when interest rates are low.
Another recommendation is that compa nies ought to maintain a high liquidity level besides a firm asset base. In this case , Lehman Brothers could have quickly turned the situation around i f it had sufficient liquid cash and other disposable assets. Other firms declined to trade with Lehman Brothers because the bank lacked adequate liquidity. Similarly, when other banks became worried over the financial performance of Lehman Brothers, they promptly pulled off Lehman’s lines of credit so as to protect their businesses. The inability to trade meant that Lehman and its financial business ceased to exist to other banks and hence th e collapse.
Assess ing the sufficiency of risk management techniques used by financial institutions today
In financial systems management, the essence of r isk analysis is not to solely eliminate the risk. Rather, it is aimed at understand ing the effect of identified risks on the performance of a particular financial institution. Thus , most h igh-risk investments such as mortgage-backed securities use four primary risk management techniques to alleviate the impacts and effects of risks on their performance (Hull, 2012; Belmont, 2004) . The first risk management technique is risk mitigation. Under risk mitigation , investment firms carry out an exhaustive analysis to identify the various potential risks and their probable effects on the firm . Once the risks are identified, and their effects established , the focus is then shifted to developing policies that would prevent the occurrence of such risk s in the future. Likewise, the emphasis is placed on the significant reduction of such risks to negligible levels should they eventually occur.
The second risk management technique involves the transfer of risks. Risk transfer implies that another institution is paid to take up the burden of a potential risk . In this regard, investment institutions transfer the risks from their institutions by entering into agreement s with insurance companie s that then offer protection against any substantial financial loss. With respect to risk transfer, there are various insurance policies and covers that provide protection against different risks . Another risk management technique is the acceptance of risk. In essence, a financial institution cannot acquire protection against all forms of risks. Similarly, some risks can go unseen regardless of having undergone exhaustive risk identification and analysis. Thus , risk management can be done through the acceptance of risk once it has occurred. Moreover, f inancial institutions accept risks up to a certain level . This is especially the case if the anticipated profit generat ion from the business activity is far greater than its potential risk ( Sieczka et al., 2011 ).
My take is that risk cannot be entirely alleviated . This is because i n some cases, risks may be unseen . Nevertheless, t he three techniques are sufficient in managing risks. For instance, mitigation ensures that the potential effects of various identified risks are minimized . On the other hand , transfer of risks ensures that financial institutions do not get overwhelmed by the risks but instead transfer the responsibility to other firms wh ich o ffer protection against any probable risks . Finally, acceptance of risks implies a sense of responsibility and business goodwill. Thus, a combination of the three techniques provides better protection a nd overall risk management that can help most institutions to avoid the effects of risks and uncertainties.
M anagement’s role in establishing proper risk management procedures for high-risk investments and the appropriate level of accountability for portfolio performance
A firm’s management plays a very significant role in the analysis, mitigation and management of risks and uncertainties. For instance, it is the responsibility of the management to devise a precise methodology for use in identif ying and analyz ing the financial impact of loss to the institution . Likewise, the management is charged with the responsibility of identifying r ealistic and cost-effective opportunities to balance retention programs with commercial insurance. Moreover, t he managers are expected to provide direction in cooperation with the g eneral c ounsel . Also, they ought to maintain control over the claims process so as to assure that claims are settled fairly, consistently and in the best interest of the particular entity (Belmont, 2004).
While managers are charged with the responsibility of develop ing and oversee ing the risk management policies of financial institutions, the occurrence of risks is inevitable sometimes. Hence, if risks eventually occur or in the case th at Financial Firm Management fails to perform their fiduciary obligation to investors and the investor’s resources are at stake, the most important consequence to be enacted is th at of ensuring that the investor s get back their investment (Belmont , 2004). Lehman Brothers ’ bankruptcy is a typical example of the failure of management to mitigate financial risks . The efforts by Lehman Brothers ’ management to reverse the situation were aimed at ensur ing that the losses were not transferred to its stakeholders and investors. Hence, in the event of such unfortunate events as the collapse of Lehman Brothers, managers are expected to ensure that they find ways o f securing the payment for all investors whose investment could be at stake.
The procedure for paying back investors may differ depending on the financial status of a particular firm a t the time of occurrence of the risks. Nevertheless, the standard practice is that the insti t ution seeks a bailout from the Federal R eserve or an acquisition by another financial institution so as to raise sufficien t finances to inject into the business so as to either reignite the business or pay back the investors.
T he impact of recent debt crisis within the EURO zone of Europe to the performance of foreign markets and how financial firms can minimize investment risk in these markets
The recent debt crisis, which started in the U . S had wide-spread effects on all the financial markets in the world. One crucial impact of the crisis on the foreign markets is that it led to massive regression in economic growth . This was evident in the sinking per capita income, especially in developing countries. Regarding macro-economies, the crisis was depicted in the increased deficits in trade and payment balances . It also led to dwindling currency reserves, currency devaluations , increas ed rates of inflation , increased indebtedness and soaring public budget deficits (Lapavitsas, 2012). In the U.S, the crisis revealed an overreliance on the Federal Reserve for a bailout in the event of a financial crisis. One approach to minimizing risks in the affected markets is for the financial firms to promote financial independence. This can be attained through various ways. F irstly , financial institutions should maintain high liquidity levels apart from consolidating their investment bases . H igh liquidity will ensure that the firms have access to read y cash in case of a financial crisis . Likewise , despite the booming business at the g lobal level , financial institutions should maintain a keen eye on their leverage levels. O perating at high leverage levels could easily result i n increased losses in case of a crisis in the financial market .
The role of the Federal government in the regulation of investments by financial institutions
The federal government plays a vital role in regulating investments by financial institutions. For instance, the f ederal government, through the Federal Reserve, is responsible for regula ting the U . S monetary system. In this regard, t he Federal Reserve regulates the amount of money printed as well as its distribution. It also c ontrol s the circulation of money and the lending taxes by banks and other financial institutions. Moreover, t he Federal Reserve monitors the operations of holding companies, including traditional banks and banking groups (Hull, 2012). T he advantage of th e Federal Bank’s r egulat ory role is that banks and other financial institutions are incapable of using their preferred lending rates. Hence, the regulation is aimed at protecting the citizen ry from exploitation by the financial institutions. One consequence of the regulation is that financial institutions are forced to operate within certain limits wh ile their actual ability gives them a n upper hand in the market . In this regard, the regulation is limiting.
The Federal Reserve's approach to the regulation of the country’s monetary policy has significantly changed since the financial crisis . This is especially the case since late 2008 when the Federal Open Market Committee ( FOMC ) came up with a near-zero target range for the federal fund's rate. In the next five years, it is highly likely that the Federal Reserve w ill have significantly grown its holding of longer-term securities through open market purchases with the aim of reducing the current pressure on longer-term interest rates . Consequently, it will be in a better position to support economic activity and job creation due to the presence of more accommodative financial conditions (Hull, 2012) .
References
Belmont, D. P. (2004). Value added risk management in financial institutions: Leveraging Basel II & risk adjusted performance measurement (Vol. 255). Wiley.
Hull, J. (2012). Risk management and financial institutions,+ Web Site (Vol. 733). John Wiley & Sons.
Johnson, M. A., & Mamun, A. (2012). The failure of Lehman Brothers and its impact on other financial institutions. Applied Financial Economics , 22 (5), 375-385.
Jones, B., & Presley, T. (2013). Law and Accounting: Did Lehman Brothers Use of Repo 105 Transactions Violate Accounting and Legal Rules?. Journal of Legal, Ethical and Regulatory Issues , 16 (2), 55.
Kershaw, D., & Moorhead, R. (2013). Consequential responsibility for client wrongs: Lehman B rothers and the regulation of the legal profession. The Modern Law Review , 76 (1), 26-61.
Lapavitsas, C. (2012). Crisis in the Eurozone . Verso Books.
Sieczka, P., Sornette, D., & Holyst, J. A. (2011). The Lehman Brothers effect and bankruptcy cascades. The European Physical Journal B , 82 (3-4), 257.
