Better risk management for banks

A new approach to punishing offenders and rewarding the best

The recent financial crisis was exacerbated by several failures, one of which was poor risk management by banks. Previous attempts to coerce management into being more responsible have failed. How about this approach?

In principle, fining companies for risk management failures is not very effective. A fine is a one-off that can be explained as such and the magnitude is of minor importance because financial accounts can be presented excluding the effects of the fine.

However, an alternative approach would be that the capital adequecy requirements of companies are affected by the results of risk management failures. The Basel requirements calculation could be modified to include factors to compensate for poor risk management (evidenced either through the identification of weaknesses during an audit or through the manifestation of a failure).

By forcing banks with poor risk management to hold more capital, this introduces a market adjustment and puts such banks at a competitive disadvantage, thereby encouraging better risk management.

Furthermore, this approach would embody the “prevention is better than cure” principle by improving risk management before banks got into serious difficulties rather than adopting some of the ring-fencing techniques (such as the currently fashionable contingent capital approaches) to prevent contagion and systemic failures.

There would be some pre-requisites for this approach, including:

  • improvements in regulatory competence – the failure of the regulators being another reason for the magnitude of the financial crisis
  • clear guidelines for assessing the severity of risks to make sure that the capital surcharge penalty was appropriate for the crime
  • detailed modelling to ensure that banks cannot game the rules and continue to allow weaknesses because fixing them costs more than the cost of holding the additional capital

So how does this proposal differ from (UK Financial Services Authority Chairman) Lord Turner’s capital surcharge for risky banks proposal?

Well firstly, I should say that the approaches can work together. In fact, they should work together.

The emphasis of the UK regulator’s proposal is a bank’s strategy – additional capital is required in order to engage in risky activities. What Lord Turner’s approach does not cover is banks’ capabilities to manage the risks in these activities. In effect it assumes that all banks are equally competent at risk management.

However, this is clearly not the case.

So the Vox Sapiens proposal suggests that risk management competence is also measured and used to compute an appropriate capital requirement.

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