Shadow Banking System And Repo Market Finance Essay - Free Essay Example

Sample details Pages: 30 Words: 8955 Downloads: 4 Date added: 2017/06/26 Category Finance Essay Type Research paper Did you like this example? The shadow banking system played a crucial role in the 2007-2009 financial crisis that, in which one of the most important role is the creation of systemic risk. Since repurchase agreements are the major component of the shadow banking system, it is necessary to focus on the role of repo in the shadow banking system as well as in the 2007-2009 financial crisis, then discuss for effective regulation on repo market. In addition, for the repo markets systemic nature and structural weaknesses, regulatory exercise on repo market should focus more on systemic risk of financial institutions, rather than individual, as the current regulations. Key Words: shadow banking system, repurchase agreement, systemic risk, regulation. Acknowledgements Table of Content Chapter 1. Introduction The shadow banking system played a critical role in the 2007-2009 financial crisis. The FSB (2011b) report has defined shadow banking as credit intermediation which occurs outsid e or partially outside the banking system, but which involves leverage and maturity transformation, and the shadow banking system as the system of credit intermediation that involves entities and activities outside the regular banking system. It provides a cheaper and more efficient way for corporations to meet their needs on funding, and was emerge as a complement to regular banking. However, the financial crisis shown that the shadow banking system can also create a number of risks, in which the most important one is systemic risk. A repurchase agreement is a financial contract that market participants used it as a financing method to meet short and long term liquidity needs, in which one participant borrows cash from the other by pledging a financial security as collateral. In U.S. repo market, a series of regulatory changes in the 1980s made the repo market an attractive source of short-term financing for primary dealers to finance their positions in the debt of the U.S. gove rnment, federal agencies, corporations, and federal agency mortgage-backed securities. Moreover, another significant change in 2005 makes repo transactions eligible for bankruptcy safe harbor protection based on any stock, bond, or security. In addition, the rapid growth of money holding by institutional investors, pension funds, mutual funds, states and municipalities, and non-financial firms is another main driver for increasing use of repos. Unfortunately, there is no official data of the overall size of the repo market in U.S.. Since repos are the major component of the shadow banking system, and shadow banking is seen to rely on wholesale funding such as repo as the deposits issued by traditional banks, and even seen as more dependent on these sources of funding than traditional banks are on deposits, it is necessary to focus on the role of repo in the shadow banking system as well as in the 2007-2009 financial crisis, and discuss the effective regulation on repo market. 1.1 Aim and Research Objectives The primary aim of this research is: Shadow Banking System and Repo Market during 2007-2009 Financial Crisis: the Implications for Repo Regulation In particular, the research will address the following research aspects: Study the classical researches on shadow banking system, repo market and regulations. Discuss the critical role of repo in 2007-2009 financial crisis and the necessity of repo regulation. Summarize and discuss recent financial regulation, and give the implications for the future. 1.2 The Structures of Dissertation There are 6 chapters in this dissertation, the first chapter is the introduction which introduces the reasons for writing, research aim and objectives. The second chapter briefly introduce the background of the dissertation. First give a definition on shadow banking system, discuss its role in financial system, and point out its differences compared to traditional banking system. Then provide the definition of repurchase agreement, explaining how it works, outlining a profile of the U.S. repo market, and describing how it came to play such an important role in the shadow banking system. The third chapter overview classic literatures related to the shadow banking system, repo market and financial regulations. The fourth chapter using data to help understand the changes in financial crisis, and then discuss the critical role that repos play in the current financial crisis. The fifth chapter focus on repo regulation, which overview the regulatory framework of repo market, summarize current regulatory exercises in several countries, and then articulate the implications for future repo market regulation. The last chapter is the conclusion of the research, which summary the main ideas in the paper. Chapter 2. Background of Dissertation 2.1 Shadow Banking System FSB (2011a) mentions that the emergence of the term shadow banking system reflected a recognitio n of the increased importance of entities and activities structured outside the regular banking system that perform bank-like functions. The recent financial crisis demonstrated that shadow banking is highly interrelated with the regular banking system and can have an significant impact on financial stability. In the later report, FSB (2011b) defined shadow banking as credit intermediation which occurs outside or partially outside the banking system, but which involves leverage and maturity transformation, and the shadow banking system as the system of credit intermediation that involves entities and activities outside the regular banking system. The traditional banking system based on making and holding loans with insured savings as the main source of funds, it borrowing short-term from other banks and lending long-term to the retail consumer. The shadow banking system based on the business of packaging and reselling loans, it provides a cheaper and more efficient way for cor porations to meet their needs on short-term funding, in which repos and asset-backed commercial paper (ABCP) are the main source of funds. These banks provide credit both directly and indirectly through three different processes of financial transformation: Credit transformation, which means they enhance the credit quality to offer a range of seniority and duration, and a corresponding range of risk and return, from short-term AAA down to equity; Maturity transformation, by which they finance long-term assets with short-term liabilities, it makes the term of their liabilities much shorter than their assets, and exposes short-term investors to market liquidity and duration risks; Liquidity transformation, by which they fund illiquid assets with liquid liabilities, it causes the same result as maturity transformation through different techniques. According to one measure of the size of the shadow banking system from FSB (2011), it grew rapidly before the financial crisis, from an estimated $27 trillion in 2002 to $60 trillion in 2007, and remained at around the same level in 2010. Gorton and Metrick (2010a) argue that the force from both supply and demand side cause the rapid development of shadow banking system before the current crisis: a series of changes in innovations and regulations eroded the banks competitive advantage; and demand for collateral for financial transactions of bank promote the development of securitization and increase the use of repos as a money-like instrument. On the one hand, it should be recognised that intermediating credit through shadow banking can offer advantages to the financial system. First, shadow banking system provide an alternative source of funding for market participants to bank deposits. Second, since some non-bank entities increased specialization, it provide more efficiently credit resource to meet the specific needs in the economy and reduce the cost the investors. Third, it constitute an alternative s ource to diversify risk other than traditional banking system. On the other hand, however, as the financial crisis has shown, the shadow banking system can also create a number of risks, in which the most important one is systemic risk. First, shadow banking business exposed to the similar risks as traditional banks, it financed by short-term deposit-like funding of non-bank entities, which my lead to runs in the market if confidence is lost. Second, the operation of non-deposit sources of collateral funding in shadow banking can be highly leveraged without being limited by regulator, especially when asset prices are rise and haircuts on secured financing are low. Highly leveraged transactions can increase the fragility of the financial system and become a source of systemic risk. Third, the risks in the shadow banking system can easily transmitted to the regular banking system since shadow banking businesses are often closely linked to the traditional banking sector. Which means that any failures in shadow banking can lead to important contagion due to the fact that banks often take part in the shadow banking credit intermediation chain or even provide support to the shadow banking entities. In addition, shadow banking system operations provide tools that banks can use it to avoid regulation or supervision applied to traditional bank system. Banks can break the traditional credit intermediation process under legally independent structures dealing with each other. As well known, the operations that banks circumventing capital and accounting rules, transferring risks out the control of banking regulation is the main cause of the recent crisis. 2.2 The Repurchase Agreement (Repo) Market 2.2.1 The Repurchase Agreement (Repo) The most important component in shadow banking is securitized debt, such as U.S. Treasuries, commercial paper, mortgage-backed securities (MBSs), equities, and so on. Acharya and ÃÆ'Æ’-ncà ¼ (2010) mention that, by the fourth quarter of 2009, the amount of outstanding securitized debt in the United States totaled $11.6 trillion, about one-third of the entire U.S. debt market, and much of this securitized debt is in the form of repurchase agreements. As mentioned before, shadow banking is seen to rely on wholesale funding such as repo as the deposits issued by traditional banks, and even seen as more dependent on these sources of funding than traditional banks are on deposits. A repurchase agreement is a financial contract that market participants used it as a financing method to meet short and long term liquidity needs, in which one participant borrows cash from the other by pledging a financial security as collateral. It also known as a sale and repurchase agreement for a two part transaction, originally the bank or borrower, and the depositor or lender. In case that repo is negotiated and executed privately between a borrower and a lender, it is referred to as a bilateral agreement. And when both p articipants to a repo share a common custodian to hold collateral and to transfer cash, the arrangement is referred to as a tri-party repo. The depositor deposits money and earns interest, whereas the bank provides bonds as collateral to back the deposit in exchange for the cash. Regulatory changes in the 1980s made the repo market an attractive source of short-term, often overnight, financing for primary dealers to finance their positions in the debt of the U.S. government, federal agencies, corporations, and federal agency mortgage-backed securities. Later, it also became a funding source for investors to lend and invest in relatively illiquid mortgage-backed securities. When a repo transaction is agreed, cash will exchange for collateral on both the settlement and the maturity. The sale price for the establishment of securities equals to the amount of cash lent to the borrower, and the repurchase price is equivalent to the sale price plus interest charged by lender. Typical ly, the loan amount is equivalent to the market value of the collateral minus a haircut, in which the haircut is a percentage that calculated to protect the lender in the case of default by the borrower. Figure 2.1 shows the cash exchanges in an overnight bilateral repo that settles on the day after the trade and matures on the day after settlement, and Figure 2.2 illustrates the role of a tri-party agent in holding the borrowers collateral and transferring the lenders cash. Repo is an over-the-counter (OTC) contract that shares many key features with derivatives, such as the reliance on its counterparts to meet obligations over time. Similar as all OTC products, the life cycle of repo contains several standard processes: documentation, execution, clearing, settlement, and custody. Figure 2.3 shows the life cycle of repo. The step of clearing is the match of trade notices generated by the two participants and the initiation of settlement instructions for the movement of cas h and securities. Clearing happens several times during the life cycle of a trade: dealers match trades between themselves and their clients, and depositories match the resulting settlement instructions. Settlement of repo is the exchange of cash and collateral. Custody is the maintenance of the cash and collateral in two separate accounts for both the lender and the borrower, which are held by broker-dealers themselves, by custody banks representing either party to the transaction, or by a single bank serving as custodian for both parties simultaneously. 2.2.2 Repo Market in the U.S. In 1917, the repurchase agreements were first introduced to the U.S. financial market by the Federal Reserve. As Acharya and ÃÆ'Æ’-ncà ¼ (2010) mention, the Fed used repos secured with bankers acceptances to extend credit to dealers to encourage the development of a liquid secondary market for acceptances. Early repos in the U.S. had two distinguishing features. First, accrued interest wa s excluded from the price of the repo securities. Second, even though the creditor could sell or deliver the repo securities to settle a prior sale at prices that included the accrued interest during the term of the repo, ownership of the repo securities rested with the debtor. Figure 2.4 lists the main changes in the U.S. repo market history, the last significant change before the current crisis is that Congress enacted the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), which expanded the definition of repurchase agreements to include mortgage loans, mortgage-related securities, and interest from mortgage loans or mortgage-related securities, which make repo transactions eligible for bankruptcy safe harbor protection based on any stock, bond, or other security . In the U.S. repo market, loans are mostly extended overnight, which constitute about half of all repo transactions, and most of them are open, which means that they roll over automatically u ntil either party chooses to exit. Other repo transactions called term repos, have terms longer than one day but shorter than one year, while most maturity of them three months or less. Participants in the repo market include commercial banks, investment banks, hedge funds, mutual funds, pension funds, money market funds, municipalities, corporations, and other owners of large amounts of idle cash, as well as the Fed and primary securities dealers. The Fed participates in the repo market mostly to implement its monetary policy, while primary securities dealers participate mainly to finance their market-making and risk management activities. Owners of large amounts of cash in the repo market mainly engage for two reasons: First, get better interest rates in the repo market compared with deposits at commercial banks. Second, for insurance purposes. Large deposits at commercial banks are not insured, whereas deposits at repo banks are secured by debt used as collateral. The rapid growth of money holding by institutional investors, pension funds, mutual funds, states and municipalities, and non-financial firms is one of the main drivers of increasing use of repos. They are seeking for a safe investment which can earn interest and simultaneously have strong liquidity. Under the U.S. Bankruptcy Code, especially since the change in 2005, repos have a special status: repo contract allows either participant to enforce the termination provisions of the agreement unilaterally if a bankruptcy filing by the other participant. Figure 2.5 shows the institutional investors financial assets in the United State from 1980 to 2008. Unfortunately, there is no official statistics of the overall size of the repo market in US, the Fed only counted the repo contracts that completed by the primary security dealers trade with the Fed. Figure 2.6 indicates annual average of Daily financing by U.S. government primary dealers from 1996 to 2011, and it can be seen that there is an exponential growth in repo market. Hà ¶rdahl and King (2008) report that repo markets doubled in size from 2002 to 2007, the paper indicate that with gross amounts outstanding at year-end 2007 of roughly $10 trillion in each of the US and euro repo markets, and another $1 trillion in the UK repo market. They also point out that the U.S. repo market exceeded $10 trillion in mid-2008, including double counting both repo and reverse repo in the same transaction. Gorton (2010) illustrate that the size of repo market in US is likely to be about $12 trillion as of 2009, compared with the total assets in the U.S. banking system of $10 trillion. In addition, the tri-party repo is predominantly part in the US repo market, anecdotal evidence suggests that tri-party repo activity may account for between 65% and 80% of the overall US repo market. Figure 2.7 shows the growth of tri-party repo transactions from May 2002 to May 2010. The value of securities financed by tri-party repos grow smoothly since 2002, reached the peak to about $2.8 trillion in early 2008, then the size of the market has declined notably to $1.7 trillion during first-quarter in 2010. Chapter 3. Literature Review The term shadow banking system was first coined by former Pacific Investment Management Company (PIMCO) executive Paul McCulley at Federal Reserve Bank of Kansas Citys Economic Symposium in Jackson Hole Wyoming in 2007. McCulley (2010) said that the shadow banking system appeared with the development of money market funds in the 1970s, the money market accounts function similar as bank deposits, but money market funds not regulated as banks. Gertler and Boyd (1993) and Corrigan (2000) are early discussions of the role of commercial banks and the market based financial system in financial intermediation. Paul Krugman (2008) of the New York Times trace the cause of the economic meltdown to a run on shadow banks when credit dried up. He argued that the shadow banking system rely on complex financial design, avoid the conventional financial regulation and take part in more commercial banking business. Because of not regulated, shadow banks are easier to expand business areas than traditional banks, the financial crisis leads people to transfer their money from the shadow banking system to government bonds, suddenly the shadow Banks liquidity exhaustion. 3.1 Literature on Shadow Banking System After the panic of 2007, there are a number of academic studies focus on the shadow banking system, and point out that the shadow banking system is at the heart of the credit crisis. Pozsar (2008) cataloguizes different types of shadow banks and describes the asset and funding flows within the shadow banking system. The paper clearly presents how the collateralized debt obligations (CDOs) changed from tools to manage credit risk to a source of credit risk. Adrian and Shin (2009) focus on the role of security brokers and dealers in the shadow banking system, and discuss the implications for financial regulation. The paper illustrates that securitization was initially intended to be a way to transfer credit risk to something better able to absorb losses, but instead it increased the fragility of the financial system. It allows banks and other intermediaries to leverage up by buying each others securities. They point out that it is important to prevent excessive leverage and maturity mismatch, which can undermine the stability of entire financial system. Pozsar, Adrian, Ashcraft, and Boesky (2010) provide a overview of shadow banking institutions and activities, focus on funding flows in a somewhat mechanical manner. The paper outline the economic role of shadow banking and show that there is a deep connection between shadow banking system and traditional banking system. The authors expect the shadow banking to be a significant part in the financial system in the future, but in a different form. Gorton and Metrick (2010a) present a goo d description of the shadow banking system and discuss its risks to financial stability. The analysis focus on three major institutions: money-market mutual funds (MMMFs), securitization and repurchase agreements (repos). They argue that the change that makes repo a bankruptcy safe harbor was crucial to the growth and efficiency of shadow banking, regulators can make use of the admittance to this bankruptcy safe harbor as the breach to enforce new regulations. Gennaioli, Shleifer and Vishny (2011) develop a model of shadow banking where intermediaries originate, securitize and trade loans, financed externally with riskless debt. As a result, maturity transformation and leverage are excessive, and lead to credit booms and busts when investors and intermediaries neglect tail risks. Therefore, the paper argued that regulators should continuously monitor intermediaries exposures and financial innovations and intervene when necessary. 3.2 Literature on Repurchase Agreements (Repo) There are increasing number of literatures on markets for repurchase agreements (repo) since the panic of 2007 broke out. Before that, studies on repo mainly focus on the asset pricing field, e.g. Duffie (1996) and Buraschi and Menini (2002). After the 2007 financial crisis, the researchers started to discuss the role of repo in shadow banking system, and its contribution to recent financial crisis. Most of the researches are based on the evidence of the U.S. repo market. Many theoretical studies have shown that pro-cyclical margins and haircuts have strong negative impact on the stability of financial markets. Brunnermeier and Pederson (2009) develop a model where margins can increase in illiquidity given uncertainty over the nature of price shocks. Once the speculators are subject to capital constraints, they will reduce their positions and market liquidity fall, which will then lead to higher margins and a so-called liquidity spiral. They argued that regulators should impro ve market liquidity by boosting speculator funding conditions during a liquidity crisis. Jurek and Stafford (2010) provide financing terms in collateralized lending markets with a theoretical model. The paper shows that securities which have quickly declining recovery values are financed at higher haircuts, will respond much more strongly to market fluctuations. They argue that the risk profile of the underlying collateral alone can explain why the repo haircuts shift massively during the recent financial crisis. Acharya, Gale and Yorulmazer (2011) present a model of market freezes and haircuts in secured borrowing, which explain a main feature of the crisis of 2007-2009: a sudden freeze in the market for short-term and asset-backed financing. The model contains three essential features: the term of debts is much shorter than the assets and needs to rolled over frequently; if the borrower default the contract, the collateral will be sold by the creditors and there is a small liquida tion cost; and a significant part of potential buyers of the collateral also relies on short-term debt finance. Under these conditions, the debt capacity of the assets can be much less than the fundamental value, and in fact, equal the minimum possible value of the asset. The paper argued that it is true even if the fundamental value of the assets is currently high. In particular, a small change in the fundamental value of the assets can be associated with a sudden collapse in the debt capacity. Other papers on this topic include Valderrama (2010), Rytchkov (2009), Geanakoplos (2010). Predictably, a great number of empirical literatures based on evidence from the US repo market have turned up to confirm the pro-cyclicality of margins and haircuts. The conclusion from these empirical studies strongly show that changes in margins and haircuts has a signally negative effect on financial system. Adrian and Shin (2010) showed that marked-to-market leverage is strongly procyclical, repo transactions have accounted for most of the pro-cyclical adjustment of the leverage of investment banks. In this paper, they argued that aggregate liquidity can be understood as the rate of growth of the aggregate financial sector balance sheet. Financial intermediaries balance sheets generally become stronger when asset prices increase, their leverage tends to be too low, and then they hold surplus capital. In this case, the intermediaries will attempt to find ways to employ their surplus capital. And for such surplus capacity to be utilized, they must expand their balance sheets, which means that they should take on more short-term debt on the liability side and search for potential borrowers on the asset side. From the evidence of repo market in the U.S., it can be seen that when balance sheets are expanding fast enough, borrowers are granted credit even they do not have the means to repay, since the urge to employ surplus capital is so intense. They point out that this is t he fundamental cause for the subsequent decline in the credit cycle. Gorton and Metrick (2010b) present direct evidence on the haircuts in the repo market and illustrate that withdrawals from securitized banks is the main cause of increase in repo haircuts, which means that it is a bank run. The paper said that when all investors involve in the run and the haircuts rise high enough, the securitized banking system cannot finance itself and is forced to sell assets. These changes in the constraints on funding liquidity can have a fast effect on asset prices and market dynamics. As a result, the assets become information sensitive and the liquidity dries up, and finally the system is insolvent. Gorton and Metrick (2011) argued that one of the major cause of the 2007-2009 financial crisis was changes in repo haircuts.The paper study a segment of the bilateral repo market and use a novel data set that includes credit spreads for hundreds of securitized bonds to trace the path of cr isis from sub-prime-housing related assets into markets that had no connection to housing. They find that changes in the LIB-OIS spread, a proxy for counter-party risk, was strongly correlated with changes in credit spreads and repo rates for securitized bonds, which implied higher uncertainty about bank solvency and lower values for repo collateral. Moreover, they draw a figure showing the haircuts index, which can be seen as an average haircut for collateral used in repo transactions but not including U.S. Treasury securities, In the US repo market, average haircut rising from zero before July 2007 to nearly 50 percent at the peak of the financial crisis in late 2008. With decreasing asset values and increasing haircuts, the U.S. banking system was finally insolvent for the first time since the Great Depression. However, Richard Comotto (2012) argued that there is a serious flaw in this haircut index, as well as the thesis that much of the crisis was driven by run on repo. The paper point out that Gorton and Metrick (2011)s data based their conclusions was only for collateral in the form of structured securities (ABS, RMBS, CMBS, CLO and CDO). Moreover, the paper claim that Gorton and Metrick (2011) offer no data on US Treasuries, which constitutes the largest pool of repo collateral in the US, and ignore the tri-party segment of the repo market, which may have accounted for 50-60% of outstanding U.S. repo and is largely collateralized by U.S. Treasuries, Agencies and MBS, for which haircuts are much lower and asset values were not impacted by the crisis to anything like the degree as structured securities. The paper also indicate that the Fed sponsored Task Force on Tri-party Repo Infrastructure (2009) reported that the available data suggested that haircuts in the tri-party repo market did not change much during the 2007-2009. In conclusion, Richard Comotto (2012) thought that Gorton and Metrick (2011) are unwise to assume that repo funding is by virtue of the dynamics of haircuts is an inherently unstable source of funding without sufficient empirical data. Copeland, Martin and Walker (2011) find that there are significant differences between haircut changes in bilateral and tri-party segment of the repo market. During the 2007-2009 financial crisis, haircuts and funding in the bilateral repo market changed dramatically which is similar with the result of Gorton and Metrick (2011)s work. However, haircuts in the tri-party repo market did not change much, and that funding was very stable for dealers, and the only exception is Lehman Brothers, whose tri-party repo book decreased sharply in the days leading up to its bankruptcy. The author provide three possible explanations as to why haircuts in the tri-party repo market almost keep unchanged. First one is that some cash investors prefer to withdraw funding rather than take possession of the collateral when they think a dealer is not creditworthy. Secondly, since money funds are very intolerant of liquidity and credit risk, major categories of tri-party repo investors have to worry about withdrawal pressures from their own investors. Thirdly, due to tri-party repos were mainly overnight and the clearing bank would unwind repos every morning, cash investors may feel that they can always pull away from troubled dealer, which makes the management of haircuts less important. Since tri-party repo market and the bilateral repo market were both at the heart of the current financial crisis, to recognise the different use of haircuts across these two repo markets is important to regulators in considering policies designed to prevent runs on securities dealers. A further study from Martin, Skeie and von Thadden (2011), develop a dynamic equilibrium model to study how the fragility of short-term funding markets depends upon the particular microstructures, liquidity, and collateral arrangements that may lead to runs at various types of financial institutions. The p aper shows that market microstructure can explain the different changes of haircuts between bilateral and tri-party repo markets. The haircut for each collateral class is included in the custodial undertaking agreement between the three parties and takes much more time to change than bilateral contracts, which make the tri-party repo market more susceptible to runs. The model can actually explain why haircuts may not adjust sufficiently to protect the investors in case of Lehman Brothers. Although several studies believe that the run on the repo market play a crucial role during the financial crisis, some empirical papers argue that the impact of repo contraction on the shadow banking system is relatively limited. For example, Krishnamurthy, Nagel and Orlov (2012) measure the repo funding extended by money market funds (MMF) and securities lenders to the shadow banking system, including quantities, haircuts, and repo rates by type of underlying collateral. They suggest that repo only played a very small role in funding private sector assets prior to the crisis, only 3% of outstanding non-Agency mortgage-backed securities (MBS) and asset-backed(ABS) securities was financed by repos from MMFs or securities lenders, and 22% was financed by asset-backed commercial paper (ABCP). However, they also find that the contraction in repo particularly have systematical impact on key dealer banks with large exposures to private sector securities, which then had knock-on effects on security markets. 3.3 Literature on Repo Market Regulation Gai, Haldane and Kapadia (2011) develop a network model of interbank lending in which unsecured claims, repo activity and shocks to the haircuts applied to collateral assume center stage. The model shows that how the complexity and concentration in financial system may amplify its fragility. The analysis not only points out that minimum margin requirements can be used as a macro-prudential tool in regulation, it also suggests that how a range of policy measures including liquidity regulation and capital surcharges for systemically important financial institutions could make the financial system more resilient. Goodhart, Charles, Kashyap, Tsmocos and Varoulavis (2011) introduce a model that includes both a banking system and a shadow banking system that each help households finance their expenditures, and explore how different types of financial regulation could combat many of the phenomena that were observed in the financial crisis of 2007 to 2009. The paper analyses the effects of increasing margin requirements on repo transactions, and show that margin restrictions may partially constrain risk taking and raise the cost of mortgage borrowing. Gorton and Metrick (2010b) suggest that repos should be regulated because they are, in effect, new forms of banking, it is similar to bank deposits but have the same vulnerabilities as bank-created money. The authors proposals are aimed to create a sufficient amo unt of high quality collateral which can safely be used in repo transactions. Acharya and ÃÆ'Æ’-ncà ¼ (2012) point out one of the regulatory failures behind the recent financial crisis started in 2007 has been that the regulatory exercise focus on individual, rather than systemic, risk of financial institutions. Therefore, they provide a set of resolution mechanisms which is not only capable of addressing the issues of inducing market discipline and mitigating moral hazard, but also capable of addressing the systemic risk associated with the systemically important assets and liabilities (SIALs). Specifically, in order to control the risk of the run on repo market, the authors propose to create a Repo Resolution Authority (RRA) in jurisdictions with significant repo activities, which can address the externality of systemic risk of repo contracts on risky and potentially illiquid collaterals. Chapter 4. Repo in 2007-2009 Financial Crisis 4.1 The Crisis of 2007-2009 Du e to the fact that the majority of leveraged positions in shadow banking was based on repo financing, it effectively observed that a run on repos play a significant role in the financial crisis. Gorton and Metrick (2010) use two main variables to help review the timeline of the crisis: the ABX index, and LIB-OIS. The ABX index provides publicly observable market that prices sub-prime risk, can be seen as a proxy for fundamentals in the sub-prime mortgage market. The LIB-OIS, which is the spread between the three-month London Interbank Offered Rate (LIBOR) and the three-month overnight index swap (OIS) rate, can be seen as a proxy for counter-party risk in repo transactions. Figure 4.1 shows the ABX and LIB-OIS spreads, in which the ABX spread is the CDS spread on the BBB-rated ABX tranche of the first vintage of the ABX in 2006. According to the ABX index in figure, the sub-prime market start to deteriorate since the beginning of 2007, which had a direct impact on banks whoes balance sheets had lots of securitized assets and pre-securitized mortgages. Creditors started to ask the two Bear Stearns funds to provide more collateral to back the repos, and when the funds unable to meet the calls, creditors led by Merrill Lynch threatened to declare the funds in default of repos and to seize the investments. In fact, according to Acharya et al. (2009), Merrill seized $850 million of the CDOs and tried to auction them on June 19, 2007. However, when Merrill was only able to sell approximately $100 million worth of CDOs, sub-prime assets illiquid nature and the declining value emerged. The rapid increase of the ABX spread during July 2007 appears to be a response of the sub-prime market to this run on the shadow banks in the repo market. The importance of the exemption of repos from the application of automatic stay becomes to emerge. The Bear Stearns funds can have filed for bankruptcy and avoid the forced fire sale of their assets since their repo securitie s was subject to automatic stay, and the sub-prime mortgage decline became systemic eventually. After keeping unchanged in the first 6 months in 2007, LIB-OIS first signals danger with the first major jump in August, for the real deterioration in bank balance sheets in the interbank market. In period during July to September LIB-OIS reached and past its historical record 3 times, which is also the period that the initial shock for a wide range of the securitization markets, particularly in high-grade parts that commonly used as collateral in the repo market.In early August 2007, a run ensued on the assets of three structured investment vehicles (SIVs) of BNP Paribas. On August 9, BNP Paribas suspended redemptions from these SIVs. BNP Paribass SIVs were bankruptcy-remote entities financing their sub-prime holdings through the issuance of ABCPs that had essentially lost their liquidity and become non-tradable. The announcement of the suspension of redemptions by BNP Paribas gave ri se to counter-party risk concerns and caused the ABCP market to freeze, and This freeze coincided in the LIB-OIS spread. Fears of counter-party risk spread through markets, all short-term debt markets-including the repo market-froze, only to open after central banks injected massive amounts of liquidity into the system. The LIB-OIS spread remained in a historically high until September 2008, when the events at Fannie Mae, Freddie Mac, Lehman, and AIG cause a rapid regression in interbank markets and sustained increase in the LIB-OIS until the end of 2008. 4.2 Repo Haircuts A haircut of repo is a percentage discount deducted from the market value of a security which is being offered as a collateral in a repo in order to calculate the purchase price. The formula for a haircut is as follow: It counts to addresses the risk that if the depositor of the bond in repo must sell a bond in the market to get the withdrawal, the trader to whom the bond is sold may be better informed and resulting in a loss, which means that the price may not adjust to address this risk. In this case, a haircut tranching the collateral to recreate an information insensitive security and thereby improve its liquidity. Gorton and Metrick (2010) suggest that the increasing haircuts in the interdealer repo market may be seen as a run on shadow banks, it tantamount to a withdrawal from the issuing bank. Figure 4.2 shows the haircuts for the non-sub-prime-related group, sub-prime-related groups, and the average of all the categories from 2007 to 2009. The data Gorton and Metrick (2010) examine are the interdealer repo haircuts for the following asset classes ¼Ãƒâ€¦Ã‚ ¡(1) A-AAA ABS (auto/credit cards/student loans); (2) AA-AAA RMBS/CMBS; (3) below-A RMBS/CMBS; (4) AA-AAA CLO; (5) unpriced ABS/MBS/all sub-prime; (6) AA-AAA CDOs; (7) unpriced CLOs/ CDOs. Of these classes, (1) through (4) are not sub-prime related since they do not contain sub-prime mortgages. The RMBS in cate gories (2) and (3) are prime mortgages, not sub-prime. Categories (5) through (7) are either directly sub-prime or contain sub-prime mortgages. in particular, CDOs contain some sub-prime mortgages. Gorton and Metrick (2010) use all seven categories to construct an equally weighted average repo haircut index for structured bonds. Figure 4.2 illustrates that in the period of 2007 to 2009, the repo haircuts increased from zero in early 2007 to nearly 50 percent in late 2008 on average. Haircuts were higher on sub-prime-related asset classes, it eventually went to 100 percent haircuts, which means these assets were not acceptable in repo as collateral, whereas the non-sub-prime-related asset classes reached a peak at 20 percent. In order to help understand the impact of run on repo, for instance, take total size of the repo market to be $10 trillion. Then, if the average haircut goes from zero to 20 percent during the crisis, which means that the securitized banking system must rise $2 trillion from other sources to fund its assets. In this case, the only available way for banks to make up the difference was sale the asset, which caused a further decline in the prices of these asset classes, making them less usable as collateral, then further sales, and so on. Moreover, Figure 4.2 also shows a loss of confidence through the haircut growth in the non-sub-prime-related group even though it had nothing to do with sub-prime mortgages. It is worth noticing that Gorton and Metrick (2010)s data ignore the tri-party segment of the repo market, and according to the Task Force on Tri-party Repo Infrastructure White Paper (2010), the available data suggested that haircuts in the tri-party repo market almost remain unchanged during 2007 and 2009. However, it does not mean tri-party repo had nothing to do with the crisis. FRBNY White Paper (2010) claims that (a)t several points during the financial crisis of 2007-2009, the tri-party repo market took on particular import ance in relation to the failures and near-failures of Countrywide Securities, Bear Stearns, and Lehman Brothers. The potential for the tri-party repo market to cease functioning, with impacts to securities firms, money market mutual funds, major banks involved in payment and settlements globally, and even to the liquidity of the U.S. Treasury and Agency securities, has been cited by policy makers as a key concern behind aggressive interventions to contain the financial crisis. 4.3 The Transparency of Repo Security financing market is complicated, evolved rapidly and sometime can be opaquely for some market participants and regulators. The transparency may, as well, be lacking due to the bilateral nature of securities financing transactions. During the financial crisis, the lack of transparency is embodied in several levels: Market data on macro level: previous to the current crisis, some authorities faced difficulties in valuating and supervising the risks on certain angles of the markets. There are only some available data from data vendors that collect information from intermediaries for commercial purposes, or based on surveys presented by the authorities or trade associations. Especially in bilateral and synthetic transactions, the lack of transparency is much more severe since there is no market data available and authorities have to rely on market intelligence. Market data on micro level: due to the fact that securities lending and repo are constructed in various ways, without exact data on transaction level, it might be difficult to seize the real risks that individual market participants pose to the system, especially for the bilateral transactions. Corporate disclosure by market participants: in most authorities, cash-versus-securities transactions are usually reported on-balance sheet. However, according to the accounting standards used in some cases, repos can be reported off-balance sheet, or even disclosure is provided in financial accounts of securities-versus-securities transactions, that are typically looked through for the purpose of financial report. The engagement of financial institutions in off-balance sheet transactions without sufficient disclosure may contribute to their risk-taking incentives and eventually increase the fragility of the entire financial system. Risk reporting by intermediaries to their clients: previous to the current crisis, a number of prime brokers had not provide adequate disclosure on re-hypothecation activities to their hedge fund clients. After the collapse of Lehman Brothers International, for instance, many hedge funds turned into unsecured general creditors unexpectedly since they did not realized that the extent to which it had been re-hypothecating client securities. Moreover, some securities lenders, particularly some less sophisticated lenders who have claimed that they were not adequately informed by the agent lenders about the counter-party risk and cash collater al reinvestment risk of their securities lending activities. 4.4 Role of Repo during the Crisis Repo played a crucial role in each stage of the financial crisis, from investor distress in early 2007 to the collapse of major financial institutions at the peak of the crisis in October of 2008. ICMAs Europe European Repo Council (2012) outline and discuss several possible roles that repo played during the current crisis: 4.4.1 Excessive Leverage In theory, repo can allow infinite leverage. For example, a firm finance the purchase of an asset with its own funds initially, then it could repo out the assets to borrow cash and use the cash to buy more assets, and it repos out for more cash and so on. However, the risk of collateralized financing encouraging excessive leverage is somewhat mitigated by the real world constraints on over-borrowing, which apply to both unsecured and secured instruments. This is why Lehman Brothers perpetrated Repo 105 and why MF Global employed rep o-to-maturity. And although borrowing levels are only disclosed periodically with a lag and imperfectly, participants in both the unsecured and secured money markets conduct real-time scrutiny of each others borrowing in order to detect patterns of behavior that suggest an unusual hunger for liquidity. It is a gross misunderstanding of the nature of repo that collateral makes lenders indifferent to counter-party credit risk. Some banks have over-leveraged, using both unsecured and secured financing. So, some sort of constraint can be justified. But a mandatory haircut to act as a type of fractional reserve is undesirable, as it would distort the relative pricing of secured versus unsecured instruments. It would also be a very blunt tool, which would reduce liquidity across the entire market, to deal with what should be seen as a problem of risk management specific to individual institutions. General instrument-based approaches are more likely to have unexpected consequences. And, as a matter of principle, concerns about institutions taking excessive leverage should be addressed directly using institution-specific tools such as leverage limits and capital ratios. 4.4.2 Encumber Assets Traditionally, encumbrance is a problem arising from the pledging of collateral, which may be caused when assets are provided as collateral by a borrower. Although those assets still appearing on the borrowers balance sheet, they are no longer available to help meet the claims of unsecured creditors in the event of the insolvency of the borrower. Now repos such as collateral swaps have started to be seen as a source of encumbrance. Encumbrance might arise where repo collateral is subject to an haircut. In this case, it can be argued that the assets represented by the haircut are encumbered, as their sale is not compensated by cash. Hence, it would appear that haircuts structurally subordinate the claims of unsecured creditors over assets given as collateral. However, i t should to be remembered that haircuts are not universally applied nor are they are significant in size. The problem can arise where haircuts are deep, for example, in long-term repo and collateral swaps, over-collateralization could be seen as giving rise to encumbrance. However, the giving of the haircut in such transactions is typically compensated by the buyer pledging the haircut back to the seller, which eliminates any encumbrance. Therefore, the issue of the encumbrance of assets by repos is largely illusory. 4.4.3 Amplify Pro-cyclicality Regulatory concerns that market practices in setting haircuts help to amplify financial market pro-cyclicality envisage a haircut-asset valuation spiral as the amplification mechanism. In an up-cycle, ample liquidity, low volatility, rising asset values, high credit ratings and strong competition for business erode haircuts, contributing to the growth in leverage. When an aggregate shock triggers the start of a down-cycle, haircuts are increased in response to the initial loss of confidence. In the manner of a credit multiplier in reverse, this reduces the liquidity of market users who sell assets in response. Asset sales reduce the value of collateral, causing haircuts to be increased again. And so on. Each market user is behaving rationally from its point of view but, in aggregate, their individual actions create a negative systemic externality. This type of scenario has given rise to the broader claim that the market crisis of 2007-09 was essentially, if not entirely, a run on repo and that repo is an inherent, unstable source of funding. However, the regulatory debate has been taking place largely in the absence of sufficient empirical data on haircuts use or potential impact. Estimates of the likely impact of changes in haircuts on the liquidity of the European repo market between 2007 and 2009, using available data on market size and composition, suggest that their systemic impact may be relatively i nsignificant in terms of the de-leveraging that took place over this period, which seriously undermines the argument that repo is, by virtue of haircuts, an inherently unstable source of funding. Chapter 5. Regulations in Repo Market 5.1 Current Regulatory Framework of Repo Market FSB (2012) provides a high-level summary of the results of a survey in autumn 2011, conducted by the FSB Workstream on Securities Lending and Repos and the International Organization of Commissions (IOSCO) Standing Committee on Risk and Research, which maps the current regulatory frameworks based on the responses from 12 member authorities (Australia, Brazil, Canada, France, Germany, Japan, Mexico, the Netherlands, Switzerland, Turkey, U.K. and U.S.), the European Commission, and the European Central Bank (ECB). Figure 5.1 outline the main regulatory changes in 12 jurisdictions on different aspects: 5.1.1 Requirements on Financial Intermediations Typically, risk exposures arising from securi ties lending and repo transactions are taken into account in the regulatory capital regimes for banks and broker-dealers. Under the Basel capital regime, for instance, banks are requested to hold capital against any counter-party exposures net of the collateral from repo or securities loan associated with an add-on for potential future exposure. Net of the collateral, however, is allowed only when the legal agreement is enforceable under appropriate laws. As well, capital requirements must be held against lent or repoed securities continuously. Furthermore, some other requirements that subject to banks and securities broker dealers are designed in order to improve risk management and strengthen protection on investors. Unlike consistent regulatory capital requirements that has been applied across authorities, there are a variety of tools and details each authority has adopted according to the risks that they need to deal with. 5.1.2 Requirements on Investors Due to the fact that risk exposures arising when investment funds and insurance companies involved in the securities lending and repo markets as investors, it is necessary to design relevant regulatory requirements and activity restrictions to regulate such financial institutions, as well as protect individual investors. Counter-party credit risk, which arising from securities lending and repo transactions, can be alleviated by restrictions on eligible counter-parties and counter-party concentration limits. Concretely, it can be regulated from two aspects: first, restricting eligible counter-parties for securities lending and repo transactions; second, using counter-party concentration limits to alleviate the effect of a large counter-partys default. Liquidity risk, arising from securities lending and repo transactions for insurance companies and MMFs. Some authorities restrict the maturity of securities loans and repos in order to alleviate the liquidity risk. Such maturity limits range fro m 30 days to around one year. Collateral guidelines, some jurisdictions have introduced collateral guidelines that apply either generally or specifically to securities lending and repos, which include various regulatory tools such as minimum margins and haircuts, eligibility criteria for collateral, restrictions on re-use of collateral and re-hypothecation, and restrictions on cash collateral reinvestment. Transparency, which are similar to the general requirements for public disclosures and regulatory reporting. One exception is that U.S. request insurers who involved in securities lending program to file additional disclosure in reinvested collateral by specific asset categories and stress testing. These disclosures will emphasis the duration mismatch and force the company to explain how they would manage the unexpected liquidity demands. 5.2 Implications for Further Regulation on Repo Market Currently, financial regulation mainly focus on two distinct activities: moni tor individual institutions impact on system stability, and the protection of investors. For repo markets systemic nature and structural weaknesses, however, regulatory exercise on repo market should focus more on systemic risk of financial institutions, rather than individuals. Acharya and ÃÆ'Æ’-ncà ¼ (2012) mention that unless the systemic liquidity risk of repo market is resolved, the risk of a run on the repo market will still remain. They point out that unlike the unsecured liquidity risk that financing may become unavailable to a firm, the secured liquidity risk that repo financing may become unavailable to a firm is inherently a systemic risk. In other words, markets for the repo securities may be illiquid when most part of financial sector is undergoing undercapitalization or funding stress. In good times, financial firms may not fully internalize the costs imposed on the system by being excessively financed through short-term repo markets, whereas in bad times, they charge excessively high haircuts on repo financing and do not internalize the pecuniary externalities imposed on other firms through the resulting fire sales of assets. In this case, it should be concern that whether to support financial firms facing a repo freeze or to support the assets directly. On one hand, it can subject repo-financed risky securities to a effectively regulatory haircut, which takes into account the securitys systemic risk and maturity mismatch relative to the repo tenor. On the other hand, it can choose a better design of the bankruptcy of a repo-financed debtor than simply granting its repo financier the full right to seize the collateral and liquidate it at will in an illiquid market. Haircuts are widely seen among regulators and academics as contributing to the instability of the repo financing. There is a debate as to whether larger and more stable haircuts should be imposed on the repo market in order to dampen valuation-induced pro-cyclicality in str essed market conditions, particularly for collateral assets that are prone to valuation uncertainties. This could be done directly or by the imposition of a countercyclical add-on to capital charges on secured lending to boost haircuts during up-cycles. As the paper of ICMA (2012) mentions, even if haircuts are mandated to remain stable over the business cycle, there are other lending terms that could be used to increase the availability of credit during periods of optimism and constrain credit during periods of de-leveraging, with potentially some of the same pro-cyclical effects on financial markets as that of variable haircuts Moreover, regulators also need to consider that whether mandated minimum haircuts can be sufficiently flexible to efficiently encompass the wide range of combinations of collateral, contract and counter-party that are possible in repo. A policy of one-size-fits-all mandatory haircuts risks distorting the market and creating rigidities that will foster ar tificial arbitrages. As a matter of principle, concerns about excessive leverage would best be addressed at firm rather than transaction level, by the direct regulation of leverage without concern its source. In addition, the proposal that encourage of more frequent and efficient margin maintenance to smooth out collateral calls seems more helpful than mandated minimum haircuts. Chapter 6. Conclusion This paper mainly focus on two aspects: discuss the role of repo in the current financial crisis, and outline the implications on repo market regulation. As the former comprehensive literature survey on this topic shows that there is no exact answer on what is the main cause for the current crisis and the regulators are still . In this paper, the study just devote to provide a visual understanding on repo market in the 2007-2009 financial crisis. As mentioned above, repo is the crucial part of the shadow banking system, as well played an important role in the current crisis. Ho wever, since the lack of official statistics, there still remains debate on whether run on repo is the main cause of the crisis. Moreover, repo has been viewed as a source of asset encumbrance, has the propensity of collateralized financing to encourage excessive leverage, and the possibility in amplify pro-cyclicality. On the aspect of regulation, after a brief overview of the regulatory framework in repo market, it can be seen that current financial regulation mainly focus on individual, rather than systemic risk. A effectively regulatory haircut, which takes into account the securitys systemic risk and maturity mismatch relative to the repo tenor, might be a good choice to manage the risk in repo-financed securities. However, regulators need to consider that whether mandated minimum haircuts can be sufficiently flexible to efficiently encompass the wide range of combinations of collateral, contract and counter-party that are possible in repo. As a matter of principle, concerns about excessive leverage would best be addressed at firm rather than transaction level, by the direct regulation of leverage without concern its source. Don’t waste time! Our writers will create an original "Shadow Banking System And Repo Market Finance Essay" essay for you Create order

Humanities’ Irrational and its Effects on a Utopian Society

The human psyche is divided into rational and irrational drives. Courtesy of Sigmund Freud, it is divided into the id, ego, and super-ego. According to Freud, although the super-ego controls the other two to present ourselves in a rational state within society, the id often tends to be out of complete control by the conscious, making it an unconscious action. For Freud, it’s the recognition that the irrational is there, that it must be controlled to take over. Man’s aggressive nature does tend to overpower the mind, leading to irrational actions. Both Freud’s Civilization and its Discontents and Dostoyevsky’s Notes from Underground show how humans are controlled by their irrational drives and that, as a result, the attempts to create a†¦show more content†¦The Reavers represent Freud’s mentioned id, or irrational and aggressive drives. Due to groups such as the Reavers and the Alliance, civilization trying to improve and create a perfect so ciety will fail due to human’s inevitable ways of acting through their irrational psyche. A utopian society isn’t possible because of this and Freud suggests accepting such a reality with imperfections in its inhabitants. Underestimated are the â€Å"powerful forces or irrationalism†¦ [which] would erupt with devastating fury in twentieth-century political life†¦extolling violence† (Perry 701-2).Those civilizations that attempt to create a utopian society create the illusion of civilization, the illusion that humans are, in fact, civilized. Enter Dostoyevsky, an anti-government, anti-socialist thinker and writer who offers a strong theory on man’s irrational and failures to create a â€Å"Crystal Palace† society. Being exposed to violence, death, and government suppression through his life, Dostoyevsky was able to write a notable anti-utopian novel. Moving to the discussion of the rational versus irrational thoughts supported by Freud, rather than viewing humanity as being â€Å"innately good,† Dostoyevsky viewed humans â€Å"as being innately depraved, irrational, and rebellious† (Perry 682). Like Freud, Dostoyevsky opposed Enlightenment philosophies of rationality, and believed irrationality was a dominantShow MoreRelatedAnalysis Of Aldous Huxley s Brave New World Essay2257 Words   |  10 Pagesessential to prioritize individual happiness, emotion, and humanity in order for your life to have value. OVERALL TONE: Satirical Novel Cover Art Analysis The novel Brave New World by Aldous Huxley, is set in a â€Å"utopian† society where individuals are born into a strict social destiny and given recreational sex and drugs to maintain universal happiness and social stability. The major theme exhibited is individual happiness, emotion and humanity* are essential in order for your life to have value. 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Information Technology Control and Audit Accounting

Question: Describe about the Information Technology Control and Audit Accounting. Answer: Many definitions have been developed about the audit procedure. According to Mancini et al (2016) he perceives auditing is an official examination and verification of the provided accounts and records. Gallegos (2004) states that the inspection or the examination of business financial record is mostly aimed at evaluating or improving the appropriateness, efficiency and safety of a business. Hence, based on the above definition one can easily answer our question which on responsibility of management and auditors based on laws and regulations. Since, auditing involves following of laws and regulations some tend to have the direct effect on the financial statements because they determine report amounts disclosure needed in financial statements. Hence, the non compliance with laws results to fines, litigation or it could lead to consequences that have material effect on financial statements (Mancini et al, 2016). Therefore, the responsibility for compliance with laws and regulations among management and auditors include: Responsibility of management Management responsibility tends to involve the oversight of those individuals charged with governance, thus they ensure that firms operations are conducted in accordance with the laws and regulations provided (Senft Gallegos, 2009). There is also inclusion of compliance with laws and regulations which determines the amounts reported and disclosed in business financial statements. The responsibility of auditors Requirements as pertained by the SAS is designed for assisting auditors in the identification of material misstatements in financial statements, this is in due to the noncompliance with laws and regulations. Hence, auditors arent responsible in prevention of noncompliance and cant be expected to detect any form of noncompliance with laws and regulations. As an auditor one is responsible in the obtaining of a reasonable assurance which involves financial statements as whole and free from the material statements, whether brought up by fraud instances or error (Pathak, 2005). Therefore, auditors are responsible in taking account of the applicable legal and regulation framework when planning and executing some of the audit procedures. In context of laws and regulations, the existence of potential effect of inherent limitations on auditors ability aims at detecting material misstatements because of the following reasons: Many laws and regulations which typically dont affect financial statements and isnt captured by a business information system relevant to the financial reports. Noncompliance may act as designs that work on concealing it due to forgery, collusion and failure to records transactions (Mancini et al, 2016). Therefore, based on the above discussion auditors are required to remain vigilant of the possibilities that other the audit procedures are being applied for the purpose of opinion forming on the financial statements. 2. Information technology has a critical role in the control of auditing procedure because of the critical mechanisms that maintain integrity of information systems. Therefore, IT in the current world of auditing procedure works on reporting organization finances for purpose of avoidance and hopeful creation of preventive financial fiascos (Wood, 2013). Since, global economies are independent than ever in geopolitical risks affect everyone. Therefore, it has been realised by auditors that IT has impacted their capability of performance in terms of attestation function. Organizations and associations have realised the need of IT in control and maintaining of a credible audit procedure through the use of technology. IT tends to be an important part of the audit integral function because it support the judgement of auditors based on the quality of information being processed in the computer systems. IT is also an integral part of auditing procedure because it easily enhances capability, aims and quality that characterizes worldwide technical standards (Pathak, 2005). IT also tends to improve research and education which provides auditors with better understanding of theoretical and empirical knowledge because of enhancement through information technology. IT has effectively evolved auditors practice from traditional auditors setting to technological audit procedures which involves the use of technology in carrying out audit procedures. The advantage of using IT in audit procedure is it improves auditors job quality; it escalates the levels of efficiency and effectiveness of the audit process as well as improving the viability of detecting error or fraud in financial statements (Wood, 2013). The only disadvantage of using these systems is that they are prone to hacking and such an incident may lead to information loss or mislead data. Based on the above discussion, it is certain that IT has a critical role in the auditing world today. This is because many firms are keeping their records electronically. Hence, this means that for purpose of evaluation on must be able to scrutinize data via electronic systems. Thus, having this in mind as an auditor you need to understand and use technology so as to be able to detect instances of fraud or error (Hall et al, 2005). As an auditor technology also tends to improve your levels of audit quality. References Senft, S., Gallegos, F. (2009).Information technology control and audit. Boca Raton, CRC Press/Auerbach Publications. https://ftp.factor.lg.ua/books/Information_Security_Management_Handbook__Sixth_Edition__Volume_7.pdf Mancini, D., Dameri, R. P., Bonollo, E. (2016).Strengthening Information and Control Systems The Synergy Between Information Technology and Accounting Models. Pathak, J. (2005).Information technology auditing: an evolving agenda. Berlin, Springer. https://download.springer.com/static/pdf/470/bfm%253A978-3-540-27486-5%252F1.pdf?originUrl=http%3A%2F%2Flink.springer.com%2Fbook%2Fbfm%3A978-3-540-27486 5%2F1token2=exp=1476160830~acl=%2Fstatic%2Fpdf%2F470%2Fbfm%25253A978-3-540-27486 5%25252F1.pdf%3ForiginUrl%3Dhttp%253A%252F%252Flink.springer.com%252Fbook%252Fbfm%253A978-3-540-27486 5%252F1*~hmac=263abce58c7935918b09ac8b14be28140a9691479daef6ce6b613a8d1f168a9f Wood, J., Brown, W. C., Howe, H. (2013).Information technology auditing and application controls for small and mid-sized businesses: revenue, expenditure, inventory, payroll, and more. Gallegos, F. (2004).Information technology control and audit. Boca Raton, Fla, Auerbach Publications.https://www.usfsp.edu/gkearns/Articles_Fraud/auditing%20with%20compute rs.doc Hall, J. A., Singleton, T., Hall, J. A. (2005).Information technology auditing and assurance. Mason, Ohio, Thomson/South-Western. https://iacis.org/iis/2006/Merhout_Havelka.pdf

Competitive Advantage in Global Economy

Question: Discuss about the Competitive Advantage in Global Economy. Answer: Introduction As opined by Norbck and Persson, (2014) some firms are born to be global firms, like Google and Facebook. However, other firms sell themselves and their innovations to incumbent firms. The authors argue that both strategies can be beneficial, depending upon the market. The aim of this assignment is to analyze Pengs five entrepreneurial strategies and its alignment with the global competitive strategies. The assignment also compares the assertions made by Norback and Persson with assertion made by Peng and its implications for small, new, innovative firms. Global firms are the ones that seek to achieve competitive advantage by optimally utilizing the resources and sale of the finished products in various countries all over the world. It is essential for the firms to be innovative in nature. The firms that cannot survive the competition sell their strategies and innovations to the other global firms (Norbck Persson, 2012). In order to achieve globalization it is essential for the firms to be innovative in their thinking. Most of the organizations use the strategy of innovation to achieve success in business in the global world. It is also very essential for the firms to develop the entrepreneurial skills in order to achieve competitive advantage and globalization. Entrepreneur skill is very essential for big and middle firms to become global. Entrepreneurs are people who are ready to take risks. The firms innovation strategies depend on the entrepreneurs. This in turn leads to higher growth in business and expansion (Norbck et al., 2014). Developing entrepreneurship skills also helps in developing leadership skills that can be used to effectively manage the firms. The authors findings can be aligned with Pengs five entrepreneurial strategies. This is so because Peng has concentrated on the entrepreneurship skills and its importance in achieving competitive advantage. Pengs five entrepreneurial strategies are: Growth Innovation Network Financing/governance Harvest/exit (Peng, 2013). The aim of the entrepreneurs is to create wealth by using proper growth strategies. Entrepreneurship not only exists in small firms but also in large and middle firms. The growth strategies of entrepreneurial skills focus on utilization of resources in such a way so that they are able to achieve competitive advantage. The strategies formed by entrepreneurs are flexible so that it can be used in any circumstances and situations. The entrepreneurs formulate such growth strategies that are risk free in order to avoid over aggressiveness. The second entrepreneurial skill is innovation (Haufler et al., 2014). According to Peng, innovation strategy helps in increasing the profit of the organization and creates sustainable competitive advantage. The aim of entrepreneurs is to create a wide range of network in order to add value to the organization. The global strategies presented by Norbck and Persson comply with Pengs five entrepreneurship skills as both the theories concentrates on growth, innovation and globalization. Globalization is achieved through properly utilizing the resources and being innovative in thinking. The CEO of facebook that is Mark Zuckerburg has helped the firm achieve competitive advantage through proper utilization of entrepreneurial skills. The entrepreneurial strategies presented by Peng are not only helpful for small firms but also large firms. The small firms struggle in the competitive world to achieve competitive advantage and enter the global world (Drucker, 2014). The small firms are exposed to risk and face competition from the large and middle firms. The cost of production in small firms is higher than large and middle firms due to economies of scale. The small firms also face risk from the competitive market. Hence, it is essential for the small firms to have a leader in form of entrepreneur w ho is able to convert the risks into opportunities. Entrepreneurs in small firms help in managing the cost of production and formulating strategies so that they are able to provide the products that are competitive in global market. Innovation of the existing and new products is also very important for the small firms. This is essential to fight over its competitors. Small firms face difficulty in innovating the products as they have less availability of resources and less experience and knowledge in the global world. Hence, developing efficient entrepreneurial skills will help the small firms develop by optimally utilizing the products that is new and innovative in the global market. Born to be global firms are the organizations that from its inception seek to achieved globalization and competitive advantage by properly utilizing the resources and selling the finished products all over the country (Shan et al., 2016). Many companies go global but this does not make born global. The difference between born global firms and global firms are that initial concept from its inception aim at internationalizing the business by committing their resources to international ventures (Muju, 2015). On contrary the globalised firms operate domestically in home country that slowly expand to international countries. The born global firms develops and strategies to expand themselves in the global firms from the beginning and start of its operations. Born global firms export its products to the international market. In order to indulge in extensive export it is essential for the firms to manufacture new products so that they are able to achieve competitive advantage in global world. Conclusion Hence, from the above analysis it can be concluded that developing entrepreneurial skill is essential to achieve globalization. Pengs five entrepreneurial skills comply with Norbck and Persson assertion because both the assertions concentrate on globalization and innovation. Born global firms are firms that from its inception aim at achieving globalization and selling its products to the international market. Innovation is essential factor as the competition for the firms are rising. Hence, it is essential for the firms to have leaders that are able to develop strategies that focus on growth, innovation and globalization. Developing entrepreneurial skills is not only important for small firms but also large firms. References Drucker, P. (2014).Innovation and entrepreneurship. Routledge. Haufler, A., Norbck, P.J. Persson, L., (2014). Entrepreneurial innovations and taxation.Journal of Public Economics,113, pp.13-31. Muju, S. S. (2015). Entrepreneurship and Innovation. 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