Financial Disasters - Pitfalls in Risk Managements

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Financial Disasters

Financial Risk Manager (FRM®), Part I of the FRM Exam covers the fundamental tools and techniques used in risk management and the theories that underlie their use.

 

RISK MANAGEMENT FAILURES

This section on Financial Disasters can best be illustrated using cases which have already occurred in the past. Several of these cases are described in this presentation which pays close attention to their causes, and also the preventive steps in order to avoid a similar situation. In many cases there is a desire to mislead, in order to earn higher profits. Poor controls and lack of proper risk management measures are the main causes for such failures. If you have already gone through the lectures in Financial Markets, there will be a better understanding of the cases presented here. Even if you have not gone through them, I have briefly explained the required concepts, so you need not worry.

AGENDA

First, we will discuss cases in which there was fraud or misrepresentation from the company’s officials, such as the case of Drysdale Securities, Kidder Peabody, Barings and Allied Irish Bank. In the second type of case, we will discuss about the failures due to large market movement, as in LTCM and Metallgesellschaft. Lastly, we will discuss about the failure due to improper conduct towards customers, as in the case of Banker’s Trust.
 
Drysdale Securities and Chase Manhattan
 
Let us discuss the first case study of a financial disaster involving Drysdale Securities and Chase Manhattan. In 1976, Drysdale Securities managed to borrow $300million through the broker, Chase Manhattan. This size of the loan was way beyond the financial capacity of Drysdale Securities. It could manage to get a loan of this size because it took advantage of a minor flaw in the calculation of bond values. At that time, bonds were valued without considering the accrued interest. Drysdale Securities purchased these bonds and showed the value of the bonds to be higher than what they could be sold for in the cash market, after considering the accrued interest. Chase Manhattan also missed the contract terms that stated that it would be responsible for payments due. When these bonds declined in value, Drysdale could not pay the borrowed funds and was forced into bankruptcy. Chase Manhattan had to bear most of the losses. If we reflect on the reasons for the disaster, it was mainly due to the misrepresentation by Drysdale Securities. Chase Manhattan was also to be blamed as it neither investigated the use of borrowed funds, nor did it notice that the contract required it to bear the losses in the event of default. This event led others to have better risk control. Also, a more precise method for calculating bond values was introduced.

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