An experienced risk manager with multi-national experience raises this question in responses to the “I told you so” blog:
“The quotes contained in the article crystallize the inherent conflict of interest that exists between dealmakers and risk managers, often at all levels in an organization. Given this conflict of interest, I raise the question: - how can banks structure their risk management departments in a manner that effectively eliminates this inherent conflict of interest?
“The conventional organizational reporting structure where the CRO reports to the CEO is questionable in my view, considering that the CRO and the CEO may have very different views of risk and profit generation.
“Based on this, is there not an argument that the CRO of a bank should report directly to the board or a sub-committee of the board, which is responsible for performance evaluation and remuneration determination. I am fully aware that this goes against the traditional corporate structure where the board's responsibility is strategic decision making, high level policy setting and governance and that the board is not involved in the day to day running of the organization. However, given the inherent conflict as mentioned above and that banks use public money to achieve their objectives, is such a structure feasible and if so, would it eliminate the conflicts that often undermine effective risk management?”
This is one of the most creative solutions to the problems mentioned in the “I told you so” blog. It parallels the normal structure where the auditors to the firm report to the audit committee of the Board, rather than the CEO, to make it harder for the CEO to cover up fraud, Satyam notwithstanding. The direct board reporting link has an added benefit that it will involve the Chief Risk Officer more actively with the Board of Directors and help raise their level of risk management experience. That too will put more pressure on the CEO to gain a more complete and realistic understanding of the risks the firm faces, because he fears that he would be overshadowed by the expertise of the CRO and key board members.
Another approach has been proposed by Laurence Kotlikoff of Boston University. Given past performance, many have argued that banks have simply taken risks that they fundamentally were incapable of understanding. In a March 23 paper, Professor Kotlikoff proposes an alternative solution to a change in reporting lines:
“There is a better way to restore trust in our financial system and get our economy rolling than by having [Uncle] Sam pledge to always clean up the mess. It’s not to let the mess happen to begin with. This alternative reform is called Limited Purpose Banking (LPB). It’s a simple and essentially costless change in our financial system, which limits banks to their legitimate purpose, namely connecting (intermediating between) borrowers and lenders and savers and investors.
“Under Limited Purpose Banking, all financial companies with limited liability (e.g., C-corps, S-corps, LLPs) engaged in financial intermediation (henceforth, banks) would operate as mutual funds that sell safe as well as risky collections of securities to the public. As mutual funds, the banks would simply function as middlemen. They would never, themselves, own financial assets. So they would never be in a position to fail because of ill-advised financial bets.
“No-risk banking? Yes, no-risk banking. Intermediation requires no risk taking whatsoever. And letting intermediaries bear risk jeopardizes their fulfilling their critical mission of intermediation.”
Professor Kotlikoff’s solution is the more radical solution, but it would certainly insure that the LPB equivalent of depositors would have a much greater incentive to monitor the bank’s risk than depositors do now.
We think the CRO reporting switch is an essential first step. If that doesn’t help, Professor Kotlikoff’s solution may be the only one that bankers have left.
Donald R. van Deventer
Honolulu, May 29, 2009
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