The Journal of Financial Perspectives: Risk edition

Published February, 2018 |

Cross-financial services Print

Welcome to Volume 5 of the Journal of Financial Perspectives, the academic publication of EY.

This edition is devoted to risk. Risk taking is the essence of banking. Banks add value because they bear the credit, liquidity, interest rate, foreign-exchange and operating risks that individuals and institutions wish to avoid. This issue of the Journal of Financial Perspectives deals with risk – how banks measure and manage it, as well as how supervisors monitor and, if need be, admonish banks.

Ostrom game theory applied to financial services bonuses and policy improvements addresses risk culture. Although banks’ remuneration practices have been subject to extensive reforms, Walsh et al. argue that further steps are required in order to bring incentives into line with effective risk management.

In Risk accountability and risk appetite: enhancing risk culture, Jackson emphasises that a bank’s risk culture is rooted in its risk management framework and its risk appetite statement. These effectively set the overall script that the bank should follow. To ensure that the bank does so, roles need to be clearly defined, and the senior executives need to be accountable as individuals for the performance of the units for which they are responsible. 

German banks in financial centres: how risky is their business? uses the premise that banks take risk in specific legal vehicles, and the risk of a particular liability depends on the risk of the vehicle’s assets as well as on the position of the liability within the creditor hierarchy. Theoretically, it is therefore possible to reduce the risk of a bank’s deposit by ring fencing the bank issuing it from the rest of the group and restricting the ring-fenced bank to less risky activities. In contrast, as Kerl explains, conducting risky activities in branches does little to protect the parent bank and failure of the branch would cause the bank as a whole to fail.

Ring-fencing cross-border banks: an effective supervisory response? explains that conducting the activities in separate legal vehicles may be more effective. In practice, as D’Hulster and Otker-Robe explain, it is difficult to distinguish between “good” risk and “bad” risk, especially where supervisors as well as the bank itself are monitoring the risk of the bank’s assets.

Good and bad risk - regulation and loan monitoring deals with risk and regulation. Valuation is the foundation on which risk measurement and risk management are built, but valuation depends on how the asset is expected to generate value, and that in turn depends on the business model and the state of the business. Supervisory monitoring may induce banks to cut back on their own monitoring efforts.

In the same theme, Stress testing banks: whence and whither? outlines how stress testing could be further improved. Stress testing attempts to ensure that a bank has enough actual capital in place now to absorb the losses that could arise in the future, if the economic environment were to deteriorate. The stress test has become the cutting edge of capital regulation: it is both forward looking and institution-specific. Moreover, it effectively sets capital requirements at a far higher level than the minimum required under the Basel Accord, for a bank must pass its stress test before it can pay dividends or make distributions to its shareholders. This context is also the basis for How to capture macro-financial spillover effects in stress tests.

Why small portfolios are preferable and how to choose them illustrates how “small” can be beautiful, with respect to insurance portfolios. Capital surcharges on systemically important institutions help offset the risk to the taxpayer that could arise, if these institutions are in fact “too big to fail (TBTF)”. Such surcharges potentially depress the return on equity that a TBTF institution can achieve.

Sometimes firms find it in their interest to assume responsibility for certain risks, even though they are not legally required to do so. Over time, market participants may come to expect that they will do so. This can create systemic risk. If a firm does not act in the manner that the market expects, this will cause market participants to revise their expectation of how firms generally will react. A case in point is the support that sponsors provide to money market mutual funds. The broken buck stops here: embracing sponsor support in money market fund reform argues that such support should be explicit rather than implicit, and that sponsors should be required to maintain capital so that they can provide support, if the need to do so arises.

Finally, regulators do not only control the risk of banks. They can also pose a risk to banks. A case in point is central bank digital currencies. If central banks were to introduce such an instrument, it would not only replace cash. It could very well also displace deposits and quite possibly the banks that issue them. For details, see Are banks still special?

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