New research suggests a significant number of national and international American banks hired new Chief Risk Officers to mitigate risk but may have actually helped lead the industry into widespread insolvency.

Newswise — Starting in the 1990s, many major banks hired Chief Risk Officers (CROs) in a response to new laws and regulations put in place following financial meltdowns in the 1980s. In an effort to comply, banking officials elevated risk analysts to corner offices to show they were serious about tackling risk.

These CROs were expected to reduce risky behavior and mitigate the likelihood of insolvency - or, at the very least, protect bankers from going to jail.

However, according to new research in the June 2017 American Sociological Review, the hiring of these officers actually led to increases in risky behavior helping lead Wall Street into its biggest crash since the Great Depression.

“The industry is thought to have been indifferent to the potential of taking on risky investments but that’s actually not true,” says Kim Pernell, a professor of sociology at the University of Toronto and the lead author of the study. “However, one of the ways they intended to fix the problem appears to have exacerbated it.”

Several new regulations and laws, such as the Sarbanes-Oxley Act of 2002 - put in place after the Enron scandal - required banks and other major corporations to better manage risk and address fraud.

“The punchline here is that many banks responded to these laws by taking risk experts and putting them up in the C-suite, making them executives and giving them a lot more power in the bank. CEOs did this to show that, ‘We are complying with the law and taking risk seriously.’ However, for a number of reasons, their efforts had the opposite of the intended effect.”

In their study, "The Hazards of Expert Control: Chief Risk Officers and Risky Derivatives," Pernell and her colleagues discovered that many of the banks that employed CROs actually engaged in even riskier behavior. For example, JP Morgan held credit derivatives based on $366 million worth of underlying assets in 2002, the year they promoted a CRO. That ballooned to more than a $1 billion the next year and was valued at more than $8 billion in 2008, the year of the crash. Bank of America and Wells Fargo also saw dramatic increases after taking on CROs.

According to Pernell, a number of factors may have been at play. For one, during the boom times of the 1990s, some banks questioned the need for these powerful risk managers since solvency was not an issue.

“As a result, CROs rebranded themselves,” Pernell explains. Instead of attempting to minimize risk, they looked to maximize profits by reducing the safe zones – financial cushions banks used to protect themselves. “The thinking was that this margin for error didn’t serve shareholders.” This new agenda encouraged CROs to promote derivatives, which they saw as tools to help them bring risk up to the edge of allowable limits.”

Pernell notes that appointing CROs may have also encouraged other bank managers to let down their guard when taking risks.

The article "The Hazards of Expert Control: Chief Risk Officers and Risky Derivatives," was authored by Kim Pernell, Jiwook Jung and Frank Dobbin, Hear a podcast on this study here.



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