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Indices of Riskiness: Management and Regulatory Implications - November 14-15, 2013

The financial crisis sparked immediate efforts to stabilize the financial system and was followed by the adoption of new policies intended to reduce substantially the risk of future crises. Now that some time has passed, economists and other researchers have begun to reconsider what happened leading up to the crisis and the implications of policies to prevent future ones.

These issues and others were explored in a recent conference, Indices of Riskiness: Management and Regulatory Implications, which was hosted by the Atlanta Fed’s Center for Financial Innovation and Stability (CenFIS). Georgia State University’s Center for the Economic Analysis of Risk and the Department of Banking and Finance at the University of Zurich cosponsored the conference.

Interconnections as an important source of strength, of fragility, or neither
Two of the presentations dealt with the issue of interconnections among banks. Conventional finance theory suggests that risk sharing across the financial system reduces the risk of individual bank failure. The paper "Systemic Risk and Stability in Financial Networks" by Daron Acemoglu, Asuman Ozdaglar, and Alireza Tahbaz-Salehi says risk sharing among banks does indeed make the financial system more stable in the face of small adverse shocks. However, their model also shows that risk sharing can make the system less stable in response to large shocks.

A paper by Jean Helwege and Gaiyan Zhang questioned whether interbank exposure was a significant source of contagion over the period from 1980 to 2010. The authors point out that many financial firms face strict regulatory limits on their exposure to a single borrower and that consistent with these regulations, the interconnections were typically small.

Limits on bank compensation bring unintended consequences
One of the policy responses by supervisors throughout the world has been to impose limits on banks compensation policies. Two of the papers at the conference, Paul Kupiec’s "Incentive Compensation for Risk Managers When Effort Is Unobservable" and "Banker Compensation and Bank Risk Taking: The Organizational Economics View" by Arantxa Jarque and Edward Simpson Prescott address the issue of incentive compensation for bankers below the senior level who may have a material effect on bank risk taking. The results of both papers show that seemingly common-sense policies to reduce risk can actually increase a bank’s risk. In doing so, they highlight the importance of understanding exactly how different people in a given bank influence risk when supervising their compensation.

The conference also included papers on the effect of regulatory actions, predicting bank failures, interest rate risk, and bank compensation policies. It also featured a panel discussion on regulatory limits on compensation policies in the United States and Europe.

To learn more about the conference, check out the agenda, which provides links to the papers and presentations. Also, Notes from the Vault, the monthly newsletter from CenFIS, offers a more in-depth discussion on bank compensation policies.