Achieving risk congruence in a banking firm

Abstract

One of the reasons for firms decentralising aspects of their operations is to enable managers to gain specialised knowledge of local conditions. For credit managers in a banking firm, this may take the form of knowledge of investment opportunities and the risk profiles of each of these opportunities. In light of principal-agent problems that arise when information is asymmetrical, the focal point of this dissertation is the development of incentive-compatible mechanisms that facilitate the free and accurate disclosure of the private information of managers on the risk profile of investments to the centre of the bank at the time investment decisions are being implemented. These mechanisms are required because managers may have strong incentives to misrepresent their private information when doing so has the potential to favourably impact on the size of their remuneration. This, in turn, has a direct impact on the ability of the centre to optimally allocate the capital of the bank and effectively price risk into bank investments. The dissertation commences by examining which internal risk measures act to align the investment decisions of managers in a bank with the risk/return goals of the centre of the bank. This requires knowledge of the bank risk preference function. It is initially assumed that managers have developed specialised knowledge of the opportunity set of available investments, and have no reason to misrepresent this information to the centre. This assumption is later removed and the implications assessed. In order to ensure incentive-compatibility between the centre and managers, a truth-revealing mechanism is employed in the capital allocation process and tied to the compensation payment function of the bank. This mechanism acts to ensure managers disclose their private information on the expected risks and returns in the investments under their control, and facilitates the efficient investment of capital within the bank.

Date of Award	2005
Original language	English