BANKING INDUSTRY MELTDOWNS

Banking Industry Meltdowns

Banking Industry Meltdowns

Cases

Barings Bank was one of the oldest banks in England. The company “ceased to exist on February 26, 1995. The bank failure was because of a futures trader named Nick Lesson. Lesson lost approximately $1.4 billion in the company assets. Lesson loses started in the first two months of 1995, but instead of getting the help, he tried to cover these loses by investing in more risky investments. These investments only yielded greater losses.

United Bank of Switzerland (UBS) is a financial services company that is headquartered in Switzerland. Recently UBS has been investigated by the IRS for helping some of its American clients to hide money if offshore accounts to avoid taxes. In 2008, UBS asked the Swiss government for aid, because of the bank's dependant on derivatives and mortgage related securities. In exchange for the aid, UBS agreed to not pay its top 3 executive $27.7 million in pay.

Bear Sterns was founded in 1923. In 2002, the firm started focusing on the housing industry, which would be the cause of the company's doom five years later.

Derivatives

Derivatives are financial instruments that were created to reduce risk, and their use on Wall Street is known as hedging. In recent years, however, as their prevalence and complexity ballooned, they created new kinds of risk and played a vital role in the meltdown of the world's banking system. The financial regulatory overhaul passed in July 2010 will turn trading in derivatives from a highly profitable niche to a more regulated, general business focused on volume.

The name "derivative'' comes from the fact that their value "derives" from underlying assets like stocks, bonds and commodities (Dodd, 2008).

The Risks of Derivatives

Derivatives increase volatility in underlying markets and the potential for manipulation. Their effects are amplified by herd behavior, generating instability (especially if they are coupled to the self-fulfilling nature of expectations. As for taking positions in highly leveraged derivatives markets multiply the risks of speculation, the point to destabilize markets.

Derivatives have become extremely complex making it particularly difficult to assess the risks they were supposed to reduce the spread as risk prevents traceability and they are then given a concentration of relatively small number of hedge funds that make the majority of transactions, with a new concentration in the banks. The result is a threat of systemic risk (Dubina, 1995).

An indicator of instability is the volatility. Volatility is the standard deviation of price changes. The volatility of the assets does not give a measure of high risk, which correspond to the nonlinearity of the markets, the unusual nature of the market (Mandelbrot) or uncertainty (as opposed to risk) or systemic risk.

The risks resulting from the use of derivatives can not be eliminated by the internal control and supervision. Product complexity, speed and frequency of transactions by traders are not able to prevent losses, while massive losses can be generated in a few days, if not within hours.

It is misleading to claim a scientific assessment of the value of ...