Structural Reforms 'Not a Solution' to Excessive Risk Taking

Reform proposals for the UK banking sector, which are due to be announced in September, are unlikely to stop some banks taking excessive risks in future, according to Simon Ashby, associate professor in financial services at Plymouth Business School.

“You can force a separation between retail and investment banking but without cultural change, it’s just a sticking plaster. We will be storing up problems for the future,” said Ashby.

The official investigation into the financial crisis commissioned by the government and chaired by Sir John Vickers of the Independent Commission on Banking (ICB) is expected to concentrate on structural reforms and capital requirements for banks when it releases its final report on 12 September.

Asby’s recent paper for the Financial Services Knowledge Transfer Network (FS KTN) entitled ‘Picking up the Pieces’ challenges the view that greater regulatory prescription and capital requirements are what is needed to improve long-term stability in the banking sector, or that simple solutions, such as caps on bonus payments, will prove effective. Instead, it recommends a series of measures to enhance risk management and governance practices in financial institutions and their regulators and mechanisms to support cultural change.

Ashby’s project for the FS KTN started from the premise that most reports into the financial crisis came from outsiders looking in, but that insiders could have a different perspective and many financial institutions had not got involved in excessive risk taking. Twenty senior risk professionals from the banking industry took part in the study and concluded that ultimately the crisis was the result of management weaknesses within both financial institutions and their regulators.

Respondents placed much less emphasis on economic and market factors, such as low interest rates or the growth in securitisation, and much more on human and social aspects of the crisis within the institutions and the regulatory machinery, than did the external experts. Instead, they saw inappropriate risk cultures, poor risk communication and an over-reliance on mechanistic (model-driven) approaches to risk assessment and control.

The group also concluded that financial firms’ risk managers should have training in business and management as well as risk assessment and modelling so their role was seen as supporting business decisions rather than as costly red tape imposed by regulators.

The core recommendations of the report are:

For financial institutions

• Improve risk cultures to promote risk awareness and open communication without unnecessary conflict.
• Rethink the design of compensation arrangements, to promote long run goals.
• Place more emphasis on management judgement and less reliance on potentially unrealistic and inflexible risk models.
• Enhance risk appetite frameworks, so appetite for risk is set correctly and communicated effectively.
• Change from a compliance-orientated approach to risk management to a more strategic focus.

For regulators

• Work to raise the quality of company management and the appropriateness of financial institutions’ risk cultures.
• Promote risk awareness and preparedness over mechanistic approaches to modelling risk. There needs to be more of a balance between modelling and judgment.
• Improve the skills and experience of supervisors to focus on the human and social aspects of financial institutions, rather than just their financial health.
• Enhance transparency through improved disclosure rules to support the effective operation of the free market.
• Promote the principles of so-called high reliability organisations in those financial institutions whose failure would cause excessive market turbulence or economy-wide disruption.

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