Value at risk, capital standards and risk alignment in banking firms

Guy Ford, Tyrone M. Carlin, Nigel Finch

Research output: Chapter in Book/Report/Conference proceedingChapter

Abstract

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.
Original languageEnglish
Title of host publicationThe VaR modeling handbook
Subtitle of host publicationpractical applications in alternative investing, banking, insurance, and portfolio management
EditorsGreg N Gregoriou
Place of PublicationNew York
PublisherMcGaw-Hill
Pages97-122
ISBN (Print)9780071625159
Publication statusPublished - 2009

Publication series

NameMcGraw-Hill finance & investing
PublisherMcGaw-Hill

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  • Cite this

    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.