Regulating Risk Culture in Banks

Abstract

The paper analyzes the role of financial regulation in facilitating the development of organizational norms to enhance risk culture in banking institutions. Specifically, it examines the regulatory responses and industry-led initiatives taken since the financial crisis of 2007-08 to address weaknesses in bank risk culture. The paper suggests that shortcomings in risk culture — particularly as understood through the lens of human agency theory — in large financial institutions are the result of collective agency problems. The paper argues that regulation has a role to play in addressing collective agency problems but that regulators should be selective in what tools they use to enhance risk culture in banks with consideration given to the regulation of remuneration and trusted financial products. It further suggests that to address collective agency problems in large financial institutions policymakers should consider the utility of senior managers’ liability regime to incentivize senior officers and directors to be more proactive and aware of misconduct and other behavior that results in agency costs for the firm and society. The paper concludes, however, that financial institutions themselves are best placed to channel the collective actions of individuals to improve governance and operations in a way that benefits overall firm performance and which mitigates socially costly behavior.