Governance, Risk Management, and Risk-Taking in Banks

39 Pages Posted: 24 Jun 2014 Last revised: 27 Jun 2014

See all articles by René M. Stulz

René M. Stulz

Ohio State University (OSU) - Department of Finance; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Multiple version iconThere are 2 versions of this paper

Date Written: June 23, 2014

Abstract

This paper examines how governance and risk management affect risk-taking in banks. It distinguishes between good risks, which are risks that have an ex ante private reward for the bank on a stand-alone basis, and bad risks, which do not have such a reward. A well-governed bank takes the amount of risk that maximizes shareholder wealth subject to constraints imposed by laws and regulators. In general, this involves eliminating or mitigating all bad risks to the extent that it is cost effective to do so. The role of risk management in such a bank is not to reduce the bank’s total risk per se. It is to identify and measure the risks the bank is taking, aggregate these risks in a measure of the bank’s total risk, enable the bank to eliminate, mitigate and avoid bad risks, and ensure that its risk level is consistent with its risk appetite. Organizing the risk management function so that it plays that role is challenging because there are limitations in measuring risk and because, while more detailed rules can prevent destructive risk-taking, they also limit the flexibility of an institution in taking advantage of opportunities that increase firm value. Limitations of risk measurement and the decentralized nature of risk-taking imply that setting appropriate incentives for risk-takers and promoting an appropriate risk culture are essential to the success of risk management in performing its function.

Keywords: Risk-taking, bank, governance, risk management, culture, incentives

JEL Classification: G21, G32

Suggested Citation

Stulz, Rene M., Governance, Risk Management, and Risk-Taking in Banks (June 23, 2014). European Corporate Governance Institute (ECGI) - Finance Working Paper No. 427/2014, Charles A. Dice Center Working Paper No. 2014-10, Fisher College of Business Working Paper No. 2014-03-10, Available at SSRN: https://ssrn.com/abstract=2457947 or http://dx.doi.org/10.2139/ssrn.2457947

Rene M. Stulz (Contact Author)

Ohio State University (OSU) - Department of Finance ( email )

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