Risk governance: Examining its impact upon bank performance and risk‐taking

• Published date: 01 December 2018
• Date: 01 December 2018
• DOI: http://doi.org/10.1111/fmii.12103
• Author: Yacine Belghitar,Walter Gontarek

DOI: 10.1111/fmii.12103

ORIGINAL ARTICLE

Risk governance: Examining its impact upon bank

performance and risk-taking

Walter Gontarek Yacine Belghitar

CranfieldUniversity, Cranfield, MK43 0AL, UK

Correspondence

WalterGontarek, Cranfield University,College

Rd.,Wharley End, Cranfield, Bedford MK43 0AL,

UK.

Email:walter.gontarek@cranfield.ac.uk.

Abstract

As policy-makers in the United States contemplate a relaxation of

financial regulation, our study contributes to this dialogue by testing

the veracity of heightened standards of risk governance activi-

ties for US bank holding companies (BHCs). Our study examines

evidencerelating to the adoption of these standards by BHCs follow-

ing regulatory intervention. We find that board-level risk appetite

practices have a profound association upon BHC performance and

tail risk. Our estimates show that BHCs which adopt risk appetite

practices exhibit a significant improvementin headline performance

andreduced tail risk measures. Our research is relevant to academics

by identifying the significance of this risk governance practicewhich

hasbeen introduced by global regulators. For practitioners (including

board members, risk managers, policy-makers and regulators), our

study validates the efficacy of risk appetite frameworksas the future

shape of financial regulation is being actively debated in the US.

KEYWORDS

bank regulation, BHCs, boards of directors, financial institutions, risk

appetite, risk governance

1INTRODUCTION

Ineffectiveoversight contributed to the financial crisis, that plagued the global economy from 2007 to 2009.1Excessive

risk-takingwas a leading cause of the financial crisis, resulting in significant losses (Conyon, Judge, & Useem, 2011; Gao,

Liao, & Wang,2013; Luttrell, Atkinson, & Rosenblum, 2013). Since the financial crisis, global debt levels have increased

by a sum of $70 trillion to $237 trillion (Bloomberg, 2018), which includes government borrowings to fund bailouts. In

the US, there were 387 bank failures over the three years ending 2011, up from 28 failures overthe preceding three

years(FDIC, 2018). Investors in certain banks saw the value of their holdings nearly destroyed (Beltratti & Stulz, 2012).

Beyond these economic costs, the social impact of financial crises is great, including a reduction in life expectancy,an

increase in HIV-related health issues, a decline in the availability of education and increased poverty levels (van Dijk,

2013). The financial crisis was the most severe economic eventin the US since the Great Depression (Bolton, 2009).

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Financial Markets,Inst. & Inst. 2018;27:187–224. wileyonlinelibrary.com/journal/fmii 187

188 GONTAREKAND BELGHITAR

Shortfalls in risk management are characterized by a failure to identify, measure, monitor and communicate risk

exposures; it is the purview of top management and the board of directors to set the level and types of risks to be

undertaken (Stulz, 2008). Improved corporate governance depends upon the board of directors and senior manage-

ment to determine the firm's risk appetite (Basel, 2015; Dermine, 2013). Risk profiles can be undertaken by managers

and traders whom may underweight low probability events that lead to tail risk related losses (Ellul, 2015; Kashyap,

Rajan, & Stein, 2008). Tailrisk cannot be fully mitigated by external supervision or market discipline alone, given short-

comings in measurement systems and the levelof opacity exhibited in financial institutions (Ellul, 2015). Banks that fail

to embrace robust internal risk monitoring are at risk being exposedto greater tail risk levels (Ellul & Yerramilli, 2013).

Risk appetite is top management's assessment of the expected effect upon the bank's risk profile and valuation of tak-

ing on risky investments and activities (Stulz, 2015). Thus, risk appetite practices provide a framework for the board

and senior management to improve internal monitoring activities in the post financial crisis environment (Gontarek &

Bender,2018).

In the years following the financial crisis, policy attention shifted from capital and liquidity metrics to risk-taking

oversight and conduct arenas (Basel, 2015; G30, 2015; IMF,2014). Supervisors introduced enhanced risk governance

measures to address perceived lapses in internal monitoring, including the adoption of risk appetite frameworks(Jack-

son, 2014; Yoost, 2014). We examineseveral risk governance features, including the board-level articulation of risk

appetite, the role of the risk committee and the chief risk officer (CRO). Our study exploitsa significant research gap,

which is timely giventhe potential relaxation of bank regulation currently under discussion in the US. The results of our

study can be summarised as follows: BHCs that adopt board-level approvedrisk appetite frameworks exhibit a robust

positive association to a suite of performance measures and a negative relation to tail risk, when controlling for other

performance and risk-taking determinants.2Upon examination through the lens of agency theory,our study suggests

that this practice is consistent with robust internal board-level monitoring activity, which augments direct external

monitoring and market discipline as externalcorporate governance mechanisms.

The study makesseveral contributions to the understanding of risk governance.3First, from a practitioner perspec-

tive, it disseminates evidenceregarding the impact of risk appetite upon performance and risk-taking, relevant to bank

directors and senior management giventhe demands to balance competing risk and return objectives. Next,for regula-

tors, this research validates the adoption by BHCs of risk appetite practices as a robust internal monitoring tool. From

an academic perspective, our study probes the literature on bank corporate governance and identifies a gap relating

to risk appetite and BHC outcomes. It also provides evidence of a significant association between the adoption of risk

appetite arrangements and an array of performance measures and tail risk. We assert that risk appetite has thus far

received limited attention and should be considered as a potential explanatoryvariable in future empirical research.

This article is structured as follows: Following the introduction, we describe the regulatory intervention, present a

review of the literatureand develop our hypotheses for testing. Afterwards, we discuss the data collected and method-

ology employed. Wethen examine the empirical relationship between risk governance mechanisms and a suite of out-

come measures. Our conclusions follow presentation of the research findings.

2INTERVENTON

Bank boards failed to exercise adequate oversight of risk-taking prior to the financial crisis.The de Larosière Report

(2009) and Walker(2009) state that ineffective risk monitoring contributed to the severity of the crisis. Ellis, Haldane,

and Moshirian (2014) argue that the financial crisis unveiledbank governance failures at multiple levels, including inef-

fectivebank risk monitoring. Weaknesses included the failure of board directors to establish and adhere to concise risk

appetite profiles (IIF,2011; McConnell, 2016; SSG, 2009, 2010; Walker,2009).4

Following the financial crisis, policy-makers such as CEBs (2010), EBA (2011), IIF (2011) and the G30 (2012)

embraced heightened risk governance and proposed the adoption of risk appetite practices. Bank regulators fol-

lowed with new requirements for risk appetite arrangements in the UK, Europe, USA, Singapore and Canada (BOE,

2015a and 2015b; CRD IV,2014; Thornton, 2014; MAS, 2013; OSFI, 2013).5The Federal Register (2014a and 2014b)

GONTAREKAND BELGHITAR 189

disseminated formal US risk governance guidance relating to the Dodd-FrankAct. These US standards impose signif-

icant new duties upon BHC boards of directors. US BHCs with assets of more than $50 billion are required to estab-

lish and monitor compliance to risk appetite frameworks at the board level (FederalRegister, 2014a), establish a risk

committee (with adequate levels of expertise), and ensure CROindependence and expertise levels (Federal Register,

2014b).

The risk appetite statement is the articulation by the board of directors of the aggregate leveland types of risk that

the firm is willing to assume or avoid in order to achieve its business objectives (Basel, 2015; FSB, 2013; IIF, 2011).6

The Basel (2015) guidance cites over 40 references to risk appetite, up from zero in its 2006 version. The current Basel

corporate governance guidelines were re-issued in part to emphasize the role of risk appetite at the risk committee

level (Basel, 2015).

Basel (2015) expects the responsibilities of the board of directors to include:

▪Establishing (along with the CRO)the bank's risk appetite taking into account its ability to manage risk effectively,

▪Overseeing firm adherence to the risk appetite statement and risk limits,

▪Monitoring the firm's compensation approach and assess its alignment to its risk appetite,

▪Ensure the risk appetite statement includes both qualitative and quantitative considerations,and

▪Communicating the firm's risk appetite effectively throughout the bank and linking it to daily decision-making.

The Senior Supervisors Group (SSG)7sought to ensure a demonstrable improvement in articulating their risk

appetite (SSG, 2010). In Europe, supervisors have indicated that banks face economic, financial, regulatory and other

business headwinds, thereby underscoring the importance of an effective risk appetite framework as a means to miti-

gate excessiverisk-taking (EBA, 2016). Consultants advise banks of the importance of risk appetite practices, arguing

that it will lead to timely risk-aware decision-making, align resources, and facilitate satisfying performance manage-

ment targets (Deloitte, 2014; Nestor, 2010; Wyman, 2013). The ECB (2016) recently performed an in-depth assess-

ment of boards and their risk appetite frameworks for all significant financial institutions in Europe and found room

for improvement remains, especially during the earlier stages of its adoption as well as inclusion of the interests of key

stakeholders.

Seminal conceptual studies posit that a well-governed bank identifies, measures and aggregates risk to ensure that

its actual risk profile is consistent with its risk appetite; but taking-on no risk at all is not a realistic outcome (Stulz,

2015). Dermine (2013) argues that the board should protect the legitimate interests of all relevant stakeholderswhile

establishing its risk appetite and tolerances.Effective articulation of risk appetite should lead to improved asset quality

and bank performance levels (Alix, 2012; Jackson, 2014; Mollah & Liljeblom, 2016). Surprisingly however,little empir-

ical research has been disseminated to date regarding its impact upon BHC performance and risk-taking, exposing the

research gap we seek to exploit.

3LITERATURE REVIEW

3.1 Risk governance

Practically speaking, a long-standing board-level responsibility is to provide effective internal risk monitoring

(Claessens & Kodres, 2014; Fleischer,Hazard, & Klipper, 1988; Macey & O'Hara, 2003; Macey & O'Hara, 2016). Risk

governance is a keyinternal monitoring activity of the board (Aebi, Sabato, & Schmid, 2012; Basel, 2015a; de Andres &

Vallelado,2008; Ellul, 2015; Iqbal, Strobl, & Vähämaa, 2015).

Banks exhibit unique structural features from non-financial firms (Becht, Bolton, & Roëll, 2011; Fama, 1980;

Laeven, 2013; Levine, 2004; Mülbert, 2010; Sarra, 2012). Banks are highly leveragedcompared to non-financial enti-

ties, amplifying potential gains and losses and resulting in risk-shifting and potentially moral hazards (Bolton, 2010;