INTRODUCTIONThe run-up to the global financialcrisis was marked by excessive risk taking in financial sector and once thecrisis hit, the accumulated risks led to systemic problems and the failure ofmany individual financial institutions.
The causes of such risk taking by bankswere many and complex. This paper aims to contribute to the academicunderstanding of what drives risk taking by banks. There are few main factorsthat are related to risk in bank system such as characteristics of governance,risk management, pay practices and ownership structures. To tackle the issue ofrisk taking by banks, there are some solutions to improve the regulation ofcorporate governance and regulating bank’s compensation. Furthermore, some adjustmentsshould be added to enhance board oversight of bank risk and to ensure thatexecutive pay imparts the appropriate incentive to absorb the risk (Marques andOppers (2014) page number missing). In addition,some policy initiatives recommended by IMF will be mentioned to control therisk taking by banks.
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SECTION 1: The main factors involve creating risk taking by banksThis section would be focused onexplain some important factors which are connected to risk taking by banks.These are including board characteristic, compensation, ownership structure andrisk management and culture.1.1.
Bankgovernance and risk taking by banksBoard independencies connectedwith lower risk. A board that is more independent of management may be betterplaced to supervise and control risk taking. This is especially crucial whenexecutive compensation (designed to counteract the managers’ naturalrisk-aversion) gives managers incentives to take too much risk. The CEO chairsthe board variable (English?) alsoappears to be associated with higher risk taking in banks, reinforcing theimportant role of board independence in curbing risk taking. Board financialexperience is associated with increased risk in banks. This suggests that boardmembers with financial experience are generally more comfortable with the banktaking more risk. However, the regression (where?) using2008 data shows the opposite effect, suggesting that more financial experience onthe board may guard banks against tail risks or enable boards to better managethe consequences if these risks materialize. (International Monetary Fund(2014) page?).
1.2. Pay practices and risk taking by banks A higher share of salary(fixed pay) is associated with higher risk, but only for small banks (with lessthan $10 billion in assets) (Marques and Oppers (2014)). This may illustratedifferent compensation practices, reverse causality. For instance, smallerbanks have a low charter value, which tends to lead them to take on more risk.Taking on more risk, in turn, means that their managers will require higherfixed pay.
In terms of larger banks, however, higher risk is usually associatedwith higher complexity, which demands delegation of responsibilities tomanagers, but also a higher share of variable compensation. In line with theexisting empirical literature, the relationship between cash bonuses and riskis vague. There is generally no relationship using cash bonus as a proportionof total compensation, but an alternative measure (bonus as a share of salary)shows a positive association with risk during the crisis (Marques and Oppers(2014)).Equity-linked and long-termincentive pay is associated with less risk in general. The same holds forrestricted stock awards. Restricted equity awards can lead to enlarged risktaking if the bank is close to default but the opposite is true if the default probability is low because ofmanagers’ incapability to diversify personal risk (related to their job tenureand personal wealth invested in the firm). The impact of equity awards on risktaking during the global financial crisis was much higher and significant for bankscloser to default, which suggests that extending the horizon of compensation reducesthe incentive for managers to favour short-term risks.
The level of compensation(fixed plus variable) is not consistently related to risk taking. The level of compensation(adjusted for bank size) was related to higher risk taking during the globalfinancial crisis (Cheng, Hong, and Scheinkman (2007)), but the other approachesshow that it is either negatively or not significantly related to bank risk.1.3. Ownership structure and bank’s riskIn general, institutionalownership is associated with less risk taking, and insider ownership is notcorrelated with risk. However, the presence of institutional investors and oflarge insider ownership correlates with more measured risk (Marques and Oppers(2014)). Corporate insiders (managers) or institutional investors hold a higherfraction of the ownership of the company should show less risk taking if thebank is financially strong, because they have a lot to lose. When the firm isclose to defaulting on its debt, managers have less to lose by taking morerisk.
In fact, the latter result can be seen as indicative of a significantgambling-for-resurrection problem, captured by the 2008 crisis regression (Marquesand Oppers (2014)) . 1.4. The relationship between riskmanagement and culture with risk taking by banksThe signal on the effectof risk controls is mixed. It suggests that although risk controls may supportmanage risks in general, they may not shelter the bank from tail risks.
Theexistence of a board risk committee is related with lower risk in banks but therelationship is weak. Only when simultaneously controlling for all governancevariables does the analysis find that a risk committee is significantly relatedto less risk. The professional backgroundof the CEO (an imperfect proxy for different risk cultures) is connected to thebank’s risk taking. When the CEO comes from retail banking or has previousexperience in the risk function of a financial institution, banks tend to takeon less risk, with the opposite being generally true for bankers with abackground in investment banking.
These results are interpreted as indirectevidence that risk culture is an important determinant of bank risk taking.As expected, theimportance of board oversight and risk management is greater in countries with strongerlegal frameworks and government effectiveness However, the association between riskmanagement indicators and risk taking is not consistently stronger in countrieswith strong supervisors.In sum, the section proposesthat the importance between risk taking in bank with board independence, theexistence of a risk committee, the share of equity-linked compensation in totalcompensation, and the share of ownership by institutional investors