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Financial Institution Risk Management

Paper Session

Friday, Jan. 6, 2017 3:15 PM – 5:15 PM

Sheraton Grand Chicago, Chicago Ballroom IX
Hosted By: American Finance Association
  • Chair: Michael Faulkender, University of Maryland

Bank Complexity and Risk Management: Evidence From Operational Risk Events in United States Bank Holding Companies

Anna Chernobai
,
Syracuse University
Ali Ozdagli
,
Federal Reserve Bank of Boston
Jianlin Wang
,
Federal Reserve Bank of Boston

Abstract

Recent regulatory proposals tie the systemic importance of a financial institution to its complexity. However, we know little about how complexity affects a bank's behavior, including its risk management. Using the gradual deregulation of banks' nonbank activities during 1996-1999 as a natural experiment, we show that the frequency and magnitude of operational risk events in U.S. bank holding companies have increased significantly with their business complexity. This trend is particularly strong for banks that were bound by regulations beforehand, especially for those with an existing Section 20 subsidiary, and weaker for the other banks that were not bound and for nonbank financial institutions that were not subject to the same regulations to begin with. These results reveal the darker side of post-deregulation diversification, which in earlier studies has been shown to lead to improved earnings performance. We use operational risk events as a risk management measure because (i) the timing of the origin of each event is well identified, whereas actual balance sheet losses can take years to materialize, and (ii) the risk events can serve as a direct measure of materialized failures in risk management without being influenced by the confounding factors that drive asset prices, such as implicit government guarantees. Our findings have important implications for the regulation of financial institutions deemed 'systemically important,' a designation tied closely to their complexity by the Bank for International Settlements and the Federal Reserve.

Risk Management in Financial Institutions

Adriano Rampini
,
Duke University
S. Viswanathan
,
Duke University
Guillaume Vuillemey
,
HEC Paris

Abstract

We study risk management in financial institutions using data on hedging of interest rate risk by U.S. banks and bank holding companies. Theory predicts that more financially constrained institutions hedge less and that institutions whose net worth declines due to adverse shocks reduce hedging. We find strong evidence consistent with the theory both in the cross-section and within institutions over time. For identification, we exploit net worth shocks resulting from loan losses due to drops in house prices. Institutions which sustain such losses reduce hedging substantially relative to otherwise similar institutions. We find no evidence that risk shifting, changes in interest rate risk exposures, or regulatory capital explain hedging behavior.

Do Bank Boards Focus Adequately On Risk?

Samanvaya Agarwal
,
Indian School of Business
Saipriya Kamath
,
Indian School of Business
Krishnamurthy Subramanian
,
Indian School of Business and Northwestern University
Prasanna Tantri
,
Indian School of Business

Abstract

Prior academic research on bank governance has concentrated on the role of board
structure. However, board conduct and its relationship to bank governance has not
received attention. In this paper, we fill this gap by analyzing the minutes of board
and risk management committee meetings of 29 banks in India. We manually classify
the issues into different categories, and code whether each issue has been deliberated
at length. Risk accounts for only 10% of the board's attention with regulation and
compliance accounting for the most (41%) followed by business strategy (31%). Only
20% of the issues are deliberated at length. The risk management committee meets
infrequently and deliberates only 28% of the issues. Only 25% of the issues tabled in the
risk management committee are forward-looking in nature. Using a simple framework
to discipline our analysis and to enable the interpretation of our results, we infer that
bank boards are under-investing in matters relating to risk and over-investing in matters
pertaining to compliance.
Discussant(s)
Elena Loutskina
,
University of Virginia
Mark Flannery
,
U.S. Securities and Exchange Commission
Miriam Schwartz-Ziv
,
Michigan State University
JEL Classifications
  • G3 - Corporate Finance and Governance