Capital standards and risk alignment in the banking firm

This paper examines the question of how to efficiently align the investment decisions of managers in a bank with the risk/return goals of the centre of the bank. It argues that the contemporary approach aimed at achieving such alignment, which involves the top-down allocation of some proportion of the total bank’s capital against positions taken by managers, and then remunerating managers based on the return generated on this capital, serves as a poor mechanism for achieving alignment of incentives. This arises when bank capital is measured in terms of a predetermined solvency standard, which has at its core a risk-neutral attitude to risk. If bank stakeholders are risk-averse, and desire that this risk attitude be captured in bank investment decisions, then risk measures used internally for investment selection and performance measurement must diverge from those used to measure total bank capital.