The Role of Financial Institutions
&
Risk Management in Subprime Crisis

Vikrant Joshi

The Role of Financial Institutions & Risk Management in The Subprime Crisis
This paper discusses the role of financial institutions & their risk management strategies in the subprime mortgage crisis. The downturn in the housing and mortgage markets precipitated the first phase of the financial crisis in August 2007 when the solvency of a number of large financial firms was threatened by huge losses in complex structured financial securities. Why did these firms have such high concentrations in mortgage-related securities? Given the information available to firms at the time, these high concentrations in mortgage-related securities violated basic principles of modern risk management.

Introduction:
This paper analyzes the role of financial institutions in the light of risk management and corporate governance in the events leading to the subprime crisis. This paper explores the following question: Given the tremendous advances in financial risk measurement and management, why was the solvency of large and complex financial firms threatened by large losses in the mortgage market?
First, the subprime mortgage market was about $1.3 trillion. Even a very high percentage loss in this market seemed manageable, given the overall size of U.S. and world debt markets. Commonly cited reasons such as high mortgage defaults in 2006 and 2007 do not provide a sufficient explanation for why this particular shock led to a financial crisis and created doubts over the solvency of a number of major financial institutions. Some explanations emphasize the role of ‘irrational exuberance’ in the housing market, which led to a bubble that unexpectedly burst. Others cite the ‘originate-to-distribute’ model as distorting incentives for risk taking, since lenders no