Good Governance Curbs Excessive Bank Risks

IMF Blog, October 16, 2014

Source details

Study authors: Luis Brandão-Marques, Gaston Gelos, Erik Oppers.
Publication date: October 16, 2014.
Data and methods:
- Sample of 830 banks from 72 countries.
- Several definitions of risk and four different empirical methods were used.
Core finding: Aligning compensation practices with long-term performance is associated with lower levels of bank risk taking.

Compensation linked to long-term performance (for example, paying bonuses with restricted stock) is associated with lower bank risk taking.
Capital impact: An increase in the Tier 1 Capital of 2 percentage points generally leads to a decrease in risk taking of about 5 percent.
Governance and compensation reforms can produce decreases in risk of similar magnitude to the effect of higher capital, although they should be treated as complements rather than substitutes.
CEO background and risk culture:
- Banks where the CEO has a professional background in retail banking or risk management show lower levels of risk.
- Banks where the CEO comes from investment banking show higher levels of risk, even after controlling for bank specialization and other firm-level characteristics.
- Figure 3.5 in the report provides more detail on these findings.

Align compensation with long-term bank performance:
- Pay bonuses with instruments tied to long-term performance (for example, restricted stock).
- Consider paying managers partly with long-term bank bonds to tie compensation to the bank’s default risk.
Adjust timing and clawbacks for variable pay:
- Make variable compensation available to executives only with a lag.
- Include clawback provisions forcing managers to return past bonuses if decisions cause longer-term losses.
Strengthen board independence and oversight:
- Ensure boards of directors are independent of bank management.
- Require boards to establish risk committees.
Improve representation of creditor interests:
- Consider measures to ensure boards represent not only shareholders but also creditors.
- For instance, consider granting board representation to certain types of bond holders to improve creditor monitoring of managers.
Enhance supervisory assessment of risk culture:
- Supervisors should complement evaluation of risk management functions with qualitative evaluation of a bank’s culture.
- Supervisory inquiries could include whether managers set the right “tone at the top,” whether that tone trickles down, whether the organization rewards responsible behavior, whether staff understand core values, and whether employees (including senior management) are held accountable.

Governance and compensation reforms can materially contribute to prudent risk taking and financial stability, with impacts comparable to increases in capital.
Capital requirements and governance/compensation improvements are complements and are best implemented together.
Risk culture matters, but the mechanisms are not fully understood; further academic and policy research on why and how risk culture affects behavior is a priority.

Source: Good Governance Curbs Excessive Bank Risks (IMF blog, October 16, 2014).