Article Detail

Strategic Risk Management: Practice in Systemically Important Banks

Journal 36: Global Finance and Regulation

This paper describes the results of a study into the practice and governance of strategic risk management in 18 of the world’s largest banks, all SIBs. The study found that these banks do not appear to pay sufficient attention to this critical area, despite banking regulators identifying strategic risk as warranting additional and intrusive supervision. Far from having clear strategies for the future against which management can be measured and remunerated, most banks in the study still appear to be on “auto-pilot”, merely doing today what they did yesterday which generally happens to be what the rest of the industry is also doing. The majority of these banks are acting as if they are part of a “herd”, betting on the same business model.

In light of the systemic failures that occurred during the GFC as a result of banks loading up on the same risks, regulators should consider whether more diversity, or at the very least a clearer understanding of exactly where important banks are headed, might improve the overall stability of the financial system.

During the global financial crisis (GFC), several large banks failed, or had to be rescued by governments, including Lehman Brothers [Valukas (2010)], Anglo Irish Bank [Honahan (2010)], Washington Mutual [Levin and Coburn (2011)], and Royal Bank of Scotland [FSA (2011)]. Much has been written about the events surrounding these failures but less about the strategies that these banks were pursuing which eventually lead to their demise. In several cases, the seeds of failure had been sown years before the banks’ failures as their boards and management embarked on ultimately ruinous high-risk strategies. In short, official inquiries concluded that these banks did not manage the execution of their strategies and the resulting strategic risks properly and failed as a result.

Following the GFC, banking regulators identified the importance of large “systemically important banks” (SIBs) in the stability of the international banking system and made proposals for such banks to hold more capital against losses and to be more closely supervised [Basel III (2010), Dodd Franks (2010), FSB (2010), ICB (2011)]. The reason for addressing issues of corporate governance in these “too big to fail” banks is put forward by the U.K. Independent Commission on Banking [ICB (2011), 19]:

“The failure of a systemically important bank which provides critical financial services and which is heavily connected to the rest of the financial system and the wider economy has particularly high costs. Because not all of the costs of a bank’s failure are borne by its owners, creditors and managers, banks are likely to take on more risk than is good for society as a whole, unless their structure and conduct is carefully regulated.”

Many of the regulators’ proposals relate to measures that could be activated in future economic and market crises to prevent, or at least lessen the impact of, a bank becoming insolvent. Such measures to reduce systemic risk are designed to ensure that contagion does not spread to other banks and the financial system as a whole [Dodd Franks (2010)]. Proposed measures include ring fencing of retail businesses from trading businesses and so-called recovery and resolution plans (RRPs), sometimes known as “living wills” [ICB (2011)]. However, less attention has been paid to the root causes of potential failures, in particular, whether a bank’s long-term strategy may be overly risky, almost guaranteeing failure, or at least severe disruption, at some time in the future.

The first part of this paper describes the proposals made by regulators and industry bodies concerning the governance of strategy and strategic risk. Such proposals are, however, somewhat theoretical in that what firms should do is important but what they actually do can be ruinous. The paper, therefore, goes on to describe the official disclosures of selected banks to determine how the development of strategy is publicly disclosed and how strategic risks are, reportedly, managed in these SIBs [McConnell (2012c)]. At various levels of detail, most of the firms studied do disclose “strategies”, except that the disclosed strategies tend to be vague and aspirational, rather than concrete and measurable. The paper assumes that public disclosures, in particular annual reports, accurately reflect a board’s commitment to the firm’s strategy and concludes that the disclosures show that there are major deficiencies in the governance of strategy and strategic risk in many of these firms. The paper concludes by considering whether these failings add to systemic risk.