This chapter examines the perplexing question of how to efficiently align the investment decisions of managers in a bank with the risk-return goals of the center 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 aligning incentives. This arises because bank capital standards have evolved around the concept of a predetermined solvency standard-conversant with the value-at-risk measure of risk-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. This chapter shows how alternative measures to value at risk serve as better mechanisms for aligning incentives within banking firms.
|Title of host publication||The VaR modeling handbook|
|Subtitle of host publication||practical applications in alternative investing, banking, insurance, and portfolio management|
|Editors||Greg N Gregoriou|
|Place of Publication||New York|
|Publication status||Published - 2009|
|Name||McGraw-Hill finance & investing|
Ford, G., Carlin, T. M., & Finch, N. (2009). Value at risk, capital standards and risk alignment in banking firms. In G. N. Gregoriou (Ed.), The VaR modeling handbook: practical applications in alternative investing, banking, insurance, and portfolio management (pp. 97-122). (McGraw-Hill finance & investing). New York: McGaw-Hill.