A well-governed bank will have processes in place to identify the optimal amount of risk and ensure that its risk stays close to this optimal amount, notes a research paper from Ohio State University.

René Stulz of Ohio State University in the research paper titled: “Governance, Risk Management, and Risk-Taking in Banks” highlights how governance and risk management affect risk-taking in banks.

Good vs bad risks

According to the paper, banks are exposed to good risks and bad risks. Good risks are risks that have an ex-ante private reward for the banks on a stand-alone basis. On the other hand, bad risks won’t have such a reward. The paper highlights that a well-governed bank will take the amount of risk that maximizes shareholder wealth subject to constraints imposed by laws and regulations.

The author notes such an approach would involve eliminating or mitigating all bad risks to the extent it is cost effective to do so. Thus, the role of risk management in such a bank is not to trim the bank’s total risk per se. Rather, it’s to identify and measure the risks the bank is taking, aggregate these risks as a measure of the bank’s total risk, enable the bank to eliminate, mitigate and avoid bad risks, and ensure that its risk level is consistent with its defined risk appetite.

Well-governed banks: Ratings vs value

Stulz points out the optimal rating for a bank is generally not the highest AAA rating, as achieving an AAA rating generally requires the bank to give up too many valuable risky projects. The author notes if a specific bank’s value is highest with an A rating, a higher rating than A would necessarily limit its activities so that it would have to give up projects.

Moreover, citing Standard & Poor’s, the author points out from 1981 to 2011, the annual average default rate for A-rated credit is 0.08%, and hence by targeting a specific probability of default, the bank can achieve its desired level of risk.

The following graph highlights the relationship between ratings and bank value for two different banks.

Banks Ratings Vs Value

As can be deduced from the above graph, for both the banks, the relationship between ratings and bank value is concave, and hence there is a maximum value. However, in the case of Bank Safe, firm value drops steeply if the bank is riskier than its target rating and increases only moderately as it increases its risk towards its target rating.

On the other hand, Bank Risky has a substantially different relation between its value and its rating. Its target rating is BBB and its value enhances substantially as it increases its risk towards its target and falls sharply if it exceeds it. The author points out that for some banks, having too much risk is extremely costly in terms of their value.

The author concludes that the success of banks and the health of the financial system depend critically on how they take risks. A bank’s ability to measure and manage risks creates value for shareholders. Stulz notes there is no simple recipe that enables a bank to measure and manage risks better. For risk-taking to maximize shareholder wealth, a bank needs not only the right risk management, but also the right governance, the right incentives and the right culture.