READING 5: RISK MANAGEMENT, GOVERNANCE, CULTURE, AND RISK TAKING IN BANKS

Methods to Determine the Optimal Level of Risk Exposure

        Methods to determine the optimal level of risk exposure include targeting a certain default probability or credit rating and sensitivity or scenario analysis. In targeting a certain default probability or credit rating, a bank should not always aim to earn the highest credit rating possible because the rating would likely involve a large opportunity cost as the bank would have to forego risky projects that could otherwise provide high profits. Sensitivity or scenario analysis involves a bank determining its optimal level of risk exposure by the impact of specific shocks. There would be an analysis of the adverse impacts on the value of a bank due to changes in interest rates, foreign exchange rates, inflation, et cetera.

How the Optimal Level of Risk Can Differ Across Banks

        The optimal level of risk depends on the specific focus of the bank’s activities (e.g., lending, deposits, derivatives), so it will differ among banks.

        Banks need to take on an optimal amount of risk in order to maximize shareholder value while satisfying the constraints imposed by bank regulators. If a bank takes on too little risk compared to its optimal level, it may not generate sufficient returns for its shareholders, which could decrease the value of the bank. Taking on too much risk may also decrease the value of a bank.

Risk-Taking Implications

        Investing in risk management might not be worth its cost if incremental changes in risk taken do not result in much change in the value of a bank. On the other hand, risk management may add value if taking on incremental risk would otherwise result in excessive total risk and a significant decrease in the value of a bank.

         If a bank adopts an inflexible risk management process in order to manage the bank’s risk below a set acceptable threshold level, it may not allow for any value creation. In contrast, a more flexible risk management system may allow the bank to take on profitable risks and take advantage of investment opportunities that could increase its value.

        The risk management function of a bank can add value by requiring business units to take the perspective of the entire bank when making decisions regarding risks.

Limitations of Hedging

        Risk management through hedging alone will not result in risk management becoming a passive activity due to (1) risk measurement technology limitations, (2) hedging limitations, and (3) risk taker incentive limitations.

Role of Risk Management Within the Bank 

       Ideally, the risk management function within a bank would be independent of the activities of the business lines. However, risk management involves both a verification function and advising on whether to accept or reject a risky project based on established risk limits. Therefore, such independence is difficult to achieve in practice. In addition, if the risk management process is viewed as a form of internal policing, then the necessary dialogue between risk managers and business unit managers will not exist.

Value at Risk

        All individual banking units must consider their ability to adjust their VaR by trading efficiently to ensure that, overall, the bank is making optimal use of its ability to take risk and maximizing its profits. Firmwide VaR is not likely to account for all of the bank’s risks, especially operational risks. The aggregation of market, credit, and operational risks in arriving at a firmwide risk measure needs to consider the correlation estimates between such risks, although in practice, there is usually insufficient data available to make such estimates accurately. Different types of risk will lead to differing statistical distributions. For example, market risk can be approximated by a normal distribution, but credit and operational risks follow a non-normal distribution, which makes them more challenging to quantify.

Governance Impact

        It is difficult to demonstrate that a bank’s governance has a significant impact on its risk profile and performance for three main reasons. First, very limited data exists on how the risk function operates in banks. Second, risk function characteristics are also affected by the bank’s risk appetite (in addition to governance). Third, it is possible that at the firm level, poor performance will occur even in the presence of strong governance. Incentives must be designed so that they do not merely reward managers for performance
based on their respective business units alone. Incentives should reward managers for taking risks that create value for the overall bank while at the same time penalize them for taking risks that destroy value.

Incentive Structure Impact & Risk Culture Impact

        Two studies examined the impact of culture. One of these studies concluded that companies where managers were perceived as honest and trustworthy were more profitable and were given higher valuations. The other study concluded that shareholder governance improvements would change a firm’s culture from focusing on employee integrity and customer service to focusing on end results.