Research Handbook on International Banking and Governance
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Research Handbook on International Banking and Governance

Edited by James R. Barth, Chen Lin and Clas Wihlborg

The contributors – top international scholars from finance, law and business – explore the role of governance, both internal and external, in explaining risk-taking and other aspects of the behavior of financial institutions. Additionally, they discuss market and policy features affecting objectives and quality of governance. The chapters provide in-depth analysis of factors such as: ownership, efficiency and stability; market discipline; compensation and performance; social responsibility; and governance in non-bank financial institutions. Only through this kind of rigorous examination can one hope to implement the financial reforms necessary and sufficient to reduce the likelihood and severity of future crises.
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Chapter 16: Incentives to Improve the Corporate Governance of Risk in Financial Institutions

Richard J. Herring


Richard J. Herring 16.1 INTRODUCTION Although debates still rage over the causes of the financial crisis of 2007–2009, most analysts agree that faulty corporate governance of risk was a major contributing factor, if not the principal cause. Examples of failures in the governance of risk abound. An apparent lack of effective firm-wide oversight plagued many of the institutions that failed or required massive government intervention. Chief executive officers (CEOs) and boards appeared to have lacked an effective framework for imposing a consistent riskappetite to constrain aggregate risk within acceptable limits. This defect took many forms: an over-reliance on risk decisions taken at a low level in many product lines and trading desks without consideration of how such exposures might interact under various macroeconomic conditions; a failure to question the risks of particular strategies and, instead, a tendency to follow the herd in an attempt to grow revenues and market share with minimal attention to risk; a reluctance to question fundamental assumptions about basis risks and hedges; an astonishing disregard for the centuries-old challenge of funding long-term assets with short-term liabilities and for liquidity risk more generally; a tendency to override limits when they conflicted with revenue goals; an astonishing inability to track aggregate exposures over complex legal structures and product silos; and a failure to risk-adjust the price of internal transfers of funds and compensation more generally. As a result, the bonuses and compensation were real, but the profits were not. Examples of these problems may be found in...

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