The IMF’s latest Global Stability Financial Report published on 1 October 2014 identifies excessive risk taking by banks and lapses in the regulatory framework that failed to prevent such risk taking as contributors to the global financial crisis. 

 

In an empirical investigation, the IMF has related various measures of bank performance and risks to bank characteristics of governance, risk management, pay practices, and ownership structures.  Although much public discussion has focused on the level of compensation, the analysis did not find a consistent relationship between the total amount of executive compensation (adjusted for firm size) and risk taking.  However, to the extent that compensation structures are designed to align incentives between managers and shareholders (e.g. by the use of equity-based pay), they increase the risk-taking appetite of managers when the bank is close to default—against the interests of bondholders, who would prefer less risk.

 

Other results show that banks with board members who are independent of bank management tend to take less risk. More pay that is related to longer-term job performance is associated with less risk. Moreover, banks that have large institutional ownership tend to take less risk. As expected, periods of severe financial stress alter some of these effects because incentives change when a bank gets closer to default.

 

Recommended policy reforms to limit risk include:

 

·         Ensuring that executive compensation of bankers is sufficiently risk sensitive through mandatory deferral of compensation, provision for clawback and a link to default risk (e.g. by paying managers partly with long-term bank bonds)

·         Requiring that bank boards are independent of management

·         Requiring banks to establish board risk committees to improve board oversight and internal risk controls

·         Encouraging financial supervisors to ensure that boards conduct effective oversight of risk taking in banks and that a bank’s culture is consistent with financial stability

·         Encouraging policymakers to consider measures to ensure that boards take into account not only the interests of shareholders but also those of debt holders (e.g. by having debt holders represented on bank boards)

·         Requiring banks to be transparent to foster accountability and strengthen market discipline.

 

The IMF report is available HERE.

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