NY Fed Publishes Review on Behavioral Risk Management in the Financial Services Industry

The Federal Reserve Bank of New York (“NY Fed”) published a special issue of its Economic Policy Review, in which economists outlined behavioral risk management in the financial services industry. The special issue explores the roles of financial culture, governance and reporting, and includes articles on the following topics:

  • the effect of corporate culture in the banking industry and a proposed framework for diagnosing and changing corporate culture in ways that support banks’ growth strategies more effectively;
  • the role of culture in the financial industry and a proposal that would change that culture through “behavioral risk management”;
  • how governance, culture, and risk management affect risk-taking in banks;
  • how deferred cash compensation can enhance stability in the financial services industry;
  • the effect of the 2007 financial crisis on compensation in financial firms, and a proposed cash-holding requirement that would induce financial firms to adopt a more conservative approach to risk-taking;
  • how to address the corporate governance problems of banks by imposing a more rigorous standard of conduct on bank directors;
  • the role of financial reporting and transparency in corporate governance;
  • the consequences of accounting policy choices for individual banks; and
  • the relationship between the amount of information disclosed by bank holding companies and their subsequent performance.

Lofchie Comment: Several articles in the Economic Policy Review take the position that the cultural (and other organizational and management) issues that arise at banks are not fundamentally different from those that arise at other large institutions (including governments), but may be different in degree. In an article that is worth reading, Ohio State University Banking and Business Professor Rene M. Stulz frames the position in the following terms: “One might be tempted to conclude that good risk management reduces the exposure to danger. However, such a view of risk management ignores the fact that banks cannot succeed without taking risks that are ex ante profitable. If good risk management does not mean low risk, then what does it mean?”

Some of the writing on executive compensation in the review seems unduly biased towards regulatory intervention and dismissive of economic considerations, particularly the article on delayed compensation authored by Mehran and Tracy, which effectively dismisses the cost of losing personnel through punitive pay policies with the observation that corporate CEOs did not quit their jobs in the wake of the added responsibilities imposed on them by Sarbanes-Oxley or FDICA (an inexact analogy that the authors seem to believe so dispositive as to hardly require discussion).