A View From INSEAD

Banking Strategies and Risk Management

Professor Jean Dermine

Professor of Banking and Finance

Since 2008, banking strategies and risk management have become a hot topic for the entire world – not just bankers and professors of finance. As a leading international business school with one of the world’s top finance faculties, INSEAD has a particular interest in this issue. And one of our greatest experts is Jean Dermine, Professor of Banking and Finance. In the following interview he gives his opinions.

There have been numerous reports on banking strategies and risk management over the last few years. Have they got it right?

The Walker Report published in the United Kingdom in 2009 and, since then, guidelines proposed by international organizations (such as the Basel Committee, the OECD and the European Union) all have a common objective: never again! This much is correct. However, the focus of these governance reports is exclusively on risk avoidance, with little guidance as to how boards should define an acceptable level of risk.

You talk a lot about boards. Is corporate governance the main issue?

It’s one of the major issues. Good corporate governance in banking is essential for effective banking strategies and risk management in both small and large institutions. And, during the 2008 crisis, there were certainly several high-profile failures of banking governance.

Aren’t boards there to serve shareholders, rather than society as a whole?

The debate on governance shouldn’t be only about the boards of banks themselves. It should also be about the governance of banking supervision. I believe there should be a dual governance system based on clear objectives and accountability. On the one hand, the governance of banking supervision should insist on a clear objective (stability of the banking system) and accountability of supervisors. On the other hand, the governance of banks should concern itself with the maximization of the welfare of shareholders.

Won’t that lead to short-termism in both banking strategies and risk management?

In a world where financial markets reward short-term reported profits, it is the responsibility of a bank’s board to take care of long-term value creation, even if that means hurting reported revenue and the share price in the short term. Executives should drive the business in accordance not only with the regulations but also with the strategy and manner (that is, the ethics and culture) set and supervised by the board.

Realistically, can boards really be aware of risks taken by executives?

First of all, there are the external “stress tests”, which – especially now that they have been tightened up ­– offer non-executive directors important insights. Second, directors should be able to ask the right questions to distinguish between risk and uncertainty. In a situation of risk, the probability distribution of losses can be identified with relevant data. But in the case of a new product (such as subprime mortgages were) the distribution of losses cannot be measured, as no relevant data are available. This isn’t to say that bankers should necessarily avoid situations of uncertainty. As entrepreneurs they should look at new business opportunities. But cases of uncertainty should receive very special attention from the boards of banks and banking supervisors, and, at a minimum, the scale of exposure should be limited until more information on risk becomes available.

But what about all the cognitive biases that psychologists have discovered? Boards can’t prevent bankers from behaving in a way that’s only human.

No, but they can pay special attention to the cognitive biases that are known to exist with respect to risk. For example, we know that human beings have limited memory. They believe that the recent past describes potential future volatility, ignoring historical cases of higher volatility. We also know that success breeds complacency and over-confidence. Boards should take these – and other common biases – into account when carrying out their supervisory role.

What about the big issue of bonuses?

In the debate on compensation, it is implicitly assumed that risk-taking is driven by compensation incentives. However, I believe that, while some individuals are driven mostly by financial incentives, sometimes other factors may be at work, such as competition among large egos, the race to be in first position or a tendency for conformity and herding behaviour. Bonuses, like the other issues associated with banking strategies and risk management, are a far from simple matter.

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