On the Role of the Chief Risk Officer and the Risk Committee in Insuring Financial Institutions Against Litigation

Abstract

Purpose: In most financial institutions, chief risk officers (CROs) and their risk management staff fulfill a role in managing risk exposures, yet their lack of involvement in the governance has been cited as an influential factor that contributed to the financial crisis of 2007-2008. Various legislative and regulatory bodies have pressured financial firms to improve their risk governance structures to better weather potential future crises. Assuming that CROs and risk committees are given sufficient power to influence the corporate governance of financial institutions, can CROs and risk committees protect financial institutions from violating litigable securities law? Can they improve bank performance?

Design/methodology: We employ a principal component analysis to construct a single measure that captures various aspects of risk management in a firm. We compare the risk governance characteristics of sued firms with their non-sued peers and consider one of the final outcomes of risky behavior: shareholder litigation. We compute ROA and buy-and-hold abnormal returns to capture operating and stock performance and examine whether risk governance improves bank performance by reducing litigation risk.

Findings: Proper risk governance reduces a firm’s litigation probability. The addition of our risk management factor to models that have been previously proposed in the literature improves the accuracy of those models in identifying companies that are most susceptible to class action lawsuits. Better risk management improves the financial and stock price performance of financial institutions.

Research limitations/implications: The data collection is laborious as the information about CRO governance has to be hand-collected from the 10K report. A broader sample employing, e.g., non-U.S. banks may provide additional insights into the relationship between risk management practices, shareholder litigation, and bank performance.

Practical implications: Our study shows that a bank’s risk management functions play a critical role in improving bank and operating performance and in reducing shareholder litigation. Banks should emphasize the risk management function.

Originality/value: This is the first study to examine the mechanism behind the positive association between risk management and bank performance. The study shows that better risk management improves overall bank performance by decreasing litigation risk.

Keywords: Litigation, chief risk officer, corporate governance

JEL Classification: G30, G32, G34, G38