Integrating governance and risk-preference in banking institutions

All banks must hold capital equal to the minimum regulatory requirement. However, in many cases the level of regulatory capital diverges from the actual (economic) capital held by banks. A bank's actual capital is typically linked to a target credit rating, which is in tum determined by the probability of default. If actual capital held by the bank is allocated against the positions/portfolios held by managers, and performance measured against this capital base, it could be that capital at risk is driven more by external forces such as ratings agencies, or the prerogative of senior executives in the bank, rather than a disciplined and consistent analysis of risk based on the entire distribution of potential outcomes - both upside and downside. Subject to the chosen risk measure and the structure of compensation packages within the bank, managers and traders may be incentivised to take on higher risk portfolios than deemed appropriate by the centre because a capital charge based on the actual capital held by the bank - in tum based on target credit rating - is invariant to the magnitude of potential losses. The basis upon which the risk measure is formulated is thus critical to incentive compatibility between principal and agent within the bank. In this paper we discuss the risk preference functions for the various stakeholders of a bank, regulators, depositors, debt holders, shareholders and management. We further put the risk preference functions in context of actual (economic) capital held by the bank based on the bank's desired external credit rating and discuss further issues resulting from the aggregation of capital for stand-alone risks.