What we need to consider is whether the risks that a firm takes are chosen by managers acting in accordance with their own interests, to increase shareholder value or in accordance with the wider interests of society.
There is certainly evidence that a firm's risk-taking is influenced by the interests of managers. In particular, share options can give managers an incentive to take significantly more risks, because they benefit from the upside if the decisions are successful and the share price increases, whereas they do not suffer the downside if the decisions are unsuccessful and the share price declines, in which case they do not exercise the options.
A number of academic studies have confirmed that this happens in practice. For example, a survey of North American gold mining firms showed that some of them hedged the gold price risk they faced, but where managers had share options, they tended not to.
Therefore, firms need to have procedures in place to ensure that managers take decisions that help meet the objectives of the firm - shareholder value, say - rather than line the pockets of the managers even if they don't. It is up to shareholders to arrange the firm's governance and managerial incentives in a way that aligns their goals.
Among the most important steps firms need to take to achieve this is to review their remuneration structures. For example, rewarding through shares is likely to produce less risk-taking than using share options as managers suffer the downside if shares perform badly (whereas share options are not exercised if share performance is poor). However, deciding on the right structure requires judgment.
They also need to review the conditions for bonuses: if, for example, a bank increases its lending, does the manager get a bonus immediately, or does he have to wait until they see whether the borrowers default? Deferring compensation gives the opportunity to check that risk decisions have worked out well for the firm.
Then they need to put in place risk governance structures that give the board an oversight of risk management, with non-executives being given an opportunity to check that there is proper analysis of risky decisions, and that they are contributing to shareholder value.
Finally, they need to appoint a chief risk officer (CRO), who can help establish a system of enterprise risk management, considering risks on a holistic basis, rather than in silos. The CRO should be in a position to advise the board on structuring incentives to achieve the desired outcome for shareholders.
Politicians and regulators have both been heavily involved in the sensitive issue of bankers' remuneration. There is a danger that new rules will be made on the basis of emotion rather than with the benefit of an understanding of how managers respond to incentives. However, it is clearly in the interests of shareholders to ensure that the remuneration structures for managers are consistent with what they, the shareholders, require. Aside from possible regulation, firms need good governance.
Outside of financial services, the CRO role is less common. However, risk governance is still relevant, and the CRO can alert the board to this. A firm that is aware of potential conflicts of interest is more likely to be able to manage them.
Government may, however, feel that risk decisions taken in a firm's interests are not the right ones from society's perspective. This could be for a variety of reasons. For example, as firms have limited liability, their downside is limited, and this may lead them to take too much risk. Alternatively, other stakeholders - particularly employees and customers - may not understand the risks they are exposed to. And where the Government gives a guarantee on, for example, bank deposits, the Government needs to protect its potential liabilities from excessive risk-taking.
It is up to Government and regulators to work out how relying on the market can lead to the wrong risk decision for society. This has been recognised elsewhere: for example, health and safety regulators devise rules with this in mind. The pressure is now on Government and financial services regulators to review their rules and tax structures so that banks don't take risks that imperil the economy.
Chris O'Brien is director at the Centre for Risk and Insurance Studies, Nottingham University Business School
