The paradoxes of risk management in the banking sector

This paper uses empirical evidence to examine the operational dynamics and paradoxical nature of risk management systems in the banking sector. It demonstrates how a core paradox of market versus regulatory demands and an accompanying variety of performance, learning and belonging paradoxes underlie evident tensions in the interaction between front and back office staff in banks. Organisational responses to such paradoxes are found to range from passive to proactive, reflecting differing organisational, departmental and individual risk culture(s), and performance management systems. Nonetheless, a common feature of regulatory initiatives designed to secure a more structurally independent risk management function is that they have failed to rectify a critical imbalance of power - with the back office control functions continuing to be dominated by front office trading and investment functions. Ultimately, viewing the 'core' of risk management systems as a series of connected paradoxes rather than a set of assured, robust practices, requires a fundamental switch in emphasis away from a normative, standards-based approach to risk management to one which gives greater recognition to its behavioural dimensions.     

Good decisions,bad decisions: the interaction of process and outcome in evaluations of decision quality

Process‐based considerations are generally accepted by experts and analysts as being the fundamental drivers of decision quality. However, little work has been done to account for the role of a risk management decision’s outcome as a key driver of the public judgments about decision quality. To this end, the objective of the research reported here was straightforward to determine – via an experiment – the relative importance of decision‐making process and the associated outcome in lay evaluations of decision quality. Our results demonstrate that people seem to have a difficult time unpacking decision‐making processes, even ones they strongly prefer, from their associated outcomes when evaluating decision quality. From a practical standpoint, our results cast doubt on the generally accepted belief that participatory and deliberative decision‐making processes (e.g., for risk management) will – on their own – contribute to positive evaluations of decision quality.     

Relational delegation

We analyze a cheap talk game with partial commitment by the principal. We first treat the principal's commitment power as exogenous and then endogenize it in an infinitely repeated game. We characterize optimal decision making for any commitment power and show when it takes the form of threshold delegation—in which case the agent can make any decision below a threshold—and centralization—in which case the agent has no discretion. For small biases, threshold delegation is optimal for any smooth distribution. Outsourcing can only be optimal if the principal's commitment power is sufficiently small.     

Globalization,paradox and the (un)making of identities: Immigrant Chartered Accountants of India in Canada

We study the labour market experiences of immigrant accountants in Canada, to reveal the tensions contradictions and paradoxes embedded in neoliberal globalization. Drawing on themes within pragmatic sociology (Boltanski & Thévenot, [1991] 2006), we argue that globalization has differentially impacted on the moral orders underpinning the identity projects of the Canadian state and the elite sector of the accountancy profession and this has in turn created three paradoxes: paradox of the state, paradox of the market and paradox of place.     

An Insurance Pricing Game

Understanding data and statistical distributions is a fundamental part of an undergraduate business student's education. The insurance pricing game presented here gives the students a unique way to apply statistical analysis in the classroom. The game requires decision making about risk with limited information. Specifically, the students must decide what “premium” to charge the members of a hypothetical risk pool. The game provides teachers with a discussion platform for numerous aspects of insurer risk pooling.     

AN INTRODUCTION TO GAME THEORY AND BUSINESS STRATEGY

Sound managerial decision making often requires “putting yourself behind your rivals' desk.” Assuming rivals are rational and acting in their selfinterest, what decisions are they likely to make and how are they likely to respond to your actions? A complicating factor is that rivals' optimal choices typically will depend on their expectations of what you will do; their expectations in turn depend on their assessments of your expectations about them. This type of circularity or recursive thinking might appear to make the overall problem completely intractable. Yet, this situation is precisely where game theory is most useful. This article introduces the basic elements of game theory within the context of business strategy and shows how managers might use these tools in decision making. This analysis also provides managers with a richer understanding of competition within different market settings. For example, it provides insights into why there is fierce competition in some concentrated industries (such as commercial aircraft), but not in others. Although the authors focus primarily on interactions among rival firms in product markets, these concepts also are useful to managers when dealing with other parties, such as suppliers, employees, or gov‐ernment officials.     

The index fund rationality paradox

Mutual funds that track the S&P 500 are popular because they have significantly lower costs than the average, actively managed equity fund. However, a measurable number of investors select index funds with excessive fees and uncompetitive returns. We call this observation the Index Fund Rationality Paradox because it conflicts with the belief that index fund investors are making a rational, low-cost choice in their ‘type of fund’ decision. In our analysis of this paradox, we find that both retail and institutional index investors tended to make better choices in recent years, but the cost of poor choices among both groups continues to be significant. In fact, we are able to identify an arguably naïve group of retail investors that seem to be unduly influenced by brokers and financial advisors. These investors are largely responsible for the remaining paradox.     

CEO Power and Firm Performance under Pressure

Are powerful chief executive officers (CEOs) more effective in responding to pressure from the economic environment? Concentrating decision‐making power may facilitate rapid decision making; however, the quality of decision making may be compromised, with severe consequences for the firm if a powerful CEO is less likely to receive independent advice or to have her decisions scrutinized. We empirically investigate the performance of firms with powerful CEOs when industry conditions deteriorate. We focus on industry downturns as these represent an exogenous shock to a firm's environment and on settings in which CEO power and access to quality information is likely more consequential: innovative firms, firms with relatively little related‐industry board expertise, firms operating in competitive industries, and firms operating in industries characterized by relatively greater managerial discretion. In each of these settings we find powerful CEOs perform significantly worse than other CEOs, suggesting contexts in which centralized decision making is potentially of greater concern.     

Emotions,attitudes, and appraisal in the management of climate-related risks by fish farmers in Northern Thailand

Many previous studies have documented that farmers are risk-averse, while other studies have shown that farmers analyze and estimate risks. Conventional risk aversion measures and analytical judgment often do not fully explain decision behavior. Thus, it may be necessary to consider emotions. The objective of this study was to enhance understanding of the interactions between attitudes, analysis, and emotions in making risk decisions. The study used a mixture of methods, including: a tablet game, risk aversion scales, in-depth interviews, and focus group discussions with fish cage farmers in Northern Thailand. There was no significant difference in risk aversion with respect to gender, age group, or region. Having sufficient capital made it possible to take more risks. Recently being impacted by floods or droughts, or being very concerned with climate change, was not associated with taking fewer risks. Measures of risk aversion did not predict risk decisions. Feeling worried, concerned, anxious, or stressed were the most common negative emotions referred to in interviews. Fear was a reason for not taking risks. Common positive emotions were joy, excitement, and feeling relaxed or relieved. Men who expressed feeling excited or thrilled chose riskier, higher stocking densities in games than women. A common belief was that men were quicker and more confident when making decisions. Another was that emotions had little impact on decisions, but were a response to success and failure – a claim inconsistent with other findings that imply emotions are also important prior to stocking decisions, and while waiting for the harvest. Fear and anxiety in the period prior to harvest may help motivate risk management practices, such as close monitoring and aeration. In conclusion, emotions may play a more important role in making decisions about climate-related risks than was previously recognized.     

DO STRATEGY AND MANAGEMENT MATTER IN MUNICIPAL ORGANISATIONS?

In Sweden, a large share of public services are organised, produced and delivered by municipalities, large and small, rich and poor. Contextual conditions (size and location) and economic conditions (efficiency and wealth) differ considerably among these service‐providing organisations. The question raised in this paper is whether a municipality's economic situation is a direct consequence of the contextual situation or the organisation's strategy and management – that is: Do strategy and management matter? Our analysis rests on a resource‐based view of organisation strategy. Both quantitative and qualitative observations have been made. First, cost savings data from 50 municipalities were examined for patterns and relationships between contextual and economic conditions. Second, about 100 representatives – municipal executive board members and leading officials – from 20 municipalities with different characteristics were interviewed. In this paper we outline an analytical framework and propose that sound and sustainable provision of municipal service depends on whether organisational decision‐making is in harmony with work methods and objectives. The results indicate that strategy and management do matter. Among the municipalities included in our study, we identify four prevalent basic strategies. Strategy tends to coincide with the economic situation rather than the contextual situation. A low‐performing municipality tends to have a predominantly outward orientation in its decision‐making, whereas a higher‐performing municipality makes decisions with both inward and outward orientation.     

Investment in concealable information by biased experts

We study a persuasion game in which biased—possibly opposed—experts strategically acquire costly information that they can then conceal or reveal. We show that information acquisition decisions are strategic substitutes when experts have linear preferences over a decision maker's beliefs. The logic turns on how each expert expects the decision maker's posterior to be affected by the presence of other experts should he not acquire information that would turn out to be favorable. The decision maker may prefer to solicit advice from just one biased expert even when others—including those biased in the opposite direction (singular)—are available.     

Bank Panics,Government Guarantees,and the Long‐Run Size of the Financial Sector: Evidence from Free‐Banking America

Governments attempt to increase the confidence of financial market participants by making implicit or explicit guarantees of uncertain credibility. Confidence in these guarantees presumably alters the size of the financial sector, but observing the long‐run consequences of failed guarantees is difficult. We look to America's free‐banking era and compare the consequences of a broken guarantee during the Indiana‐centered Panic of 1854 to the Panic of 1857 in which guarantees were honored. Our estimates of a model of endogenous market structure indicate substantial negative long‐run consequences to financial depth when panics cast doubt upon a government's ability to honor its guarantees.       

A game-theoretic approach to decision making under uncertainty

We discuss the problem of decision making under uncertainty. Here an action choice must be made without knowing the value of all relevant variables. The importance of decision attitude, i.e. optimistic/pessimistic, is emphasized and a unified approach for evaluating alternatives under different attitudes is discussed. We show the connection between decision making under uncertainty and competitive decision making—game theory. We then draw upon a key concept used in game theory, the association of a selection probability with each alternative rather then a decisive selection of an alternative, and apply this idea to decision making under uncertainty. Copyright © 1999 John Wiley & Sons, Ltd.     

International Insurance Society Roundtable on Risk Management After the Crisis

In this roundtable, an adviser to several central banks and founding member of the Group of 30 discusses regulatory reform and corporate risk management strategies with senior executives from three of the world's largest insurance companies. Much of the discussion attempts to explain why insurance and reinsurance companies have proven less vulnerable to the crisis than commercial and investment banks. Part of the explanation has to do with their financial conservatism, which is attributed to a habitual tendency to decision‐making that gives heavy weight to long‐term probabilities and risks. But along with this “actuarial” cast of mind is a growing willingness to accept and make use of risk‐based capital requirements—a decision‐making framework that is, in some respects, in conflict with the accounting and regulatory capital conventions that still prevail in the industry. In particular, “Solvency II”—the risk‐based capital guidelines that are set for adoption in 2012 by insurers in the European Union—is held up as a possible model for global use.     

Portfolio Selection and Asset Pricing Models

Finance theory can be used to form informative prior beliefs in financial decision making. This paper approaches portfolio selection in a Bayesian framework that incorporates a prior degree of belief in an asset pricing model. Sample evidence on home bias and value and size effects is evaluated from an asset-allocation perspective. U.S. investors' belief in the domestic CAPM must be very strong to justify the home bias observed in their equity holdings. The same strong prior belief results in large and stable optimal positions in the Fama–French book-to-market portfolio in combination with the market since the 1940s.     

Using Organizational Architecture to Lead Change*

Effective leadership involves more than developing and communicating the right strategic vision for the company. To encourage employees to carry out the corporate vision, companies must ensure consistency among the following three main components of their “organizational architecture:”

• ? the allocation of decision‐making authority (that is, who in the organization gets to make what decisions);
• ? performance measurement systems (for evaluating the performance of individuals as well as business units); and
• ? reward systems (the rewards for success, both financial and otherwise, and the consequences of failure).

The authors illustrate the application of this framework with the case of Xerox's (eventually) successful attempt to create a customer‐oriented workforce in the 1980s. But a more effective demonstration of the importance of these principles, as the authors go on to suggest, might well be the same company's well‐known failure to realize the commercial promise of the many inventions by its research group in Palo Alto. This organizational framework is especially useful for evaluating the likely effects of major corporate initiatives such as “Six Sigma” or the “Balanced Scorecard.” For example, it could be used to help top management determine whether, and under what circumstances, decentralization is likely to improve decision‐making and performance, as well as the changes in the firm's performance management and incentive systems that would be required to make decentralization work. Finally, the authors apply the framework to another important leadership issue: corporate ethics. In response to the scandals of the past decade and the passage of Sarbanes‐Oxley, many U.S. companies have issued formal codes of conduct, appointed ethics officers, and instituted training programs in ethics. But a key question for top management is whether the incentives established by the firm's organizational architecture reinforce or undermine the code of conduct. In this sense, ensuring consistency in organizational design is an important leadership function—one that is critical to encouraging ethical behavior as well as the pursuit of shareholder value.     

Is performance measurement and management fit for the future?

Performance measurement and management (PMM) is a management and research paradox. On one hand, it provides management with many critical, useful, and needed functions. Yet, there is evidence that it can adversely affect performance. This paper attempts to resolve this paradox by focusing on the issue of “fit”. That is, in today's dynamic and turbulent environment, changes in either the business environment or the business strategy can lead to the need for new or revised measures and metrics. Yet, if these measures and metrics are either not revised or incorrectly revised, then we can encounter situations where what the firm wants to achieve (as communicated by its strategy) and what the firm measures and rewards are not synchronised with each other (i.e., there is a lack of “fit”). This situation can adversely affect the ability of the firm to compete. The issue of fit is explored using a three phase Delphi approach. Initially intended to resolve this first paradox, the Delphi study identified another paradox – one in which the researchers found that in a dynamic environment, firms do revise their strategies, yet, often the PMM system is not changed. To resolve this second paradox, the paper proposes a new framework – one that shows that under certain conditions, the observed metrics “lag” is not only explainable but also desirable. The findings suggest a need to recast the accepted relationship between strategy and PMM system and the output included the Performance Alignment Matrix that had utility for managers.     

Diversification,Refocusing and Firm Value

At any point in time a firm faces three restructuring choices: diversify, refocus, or do nothing. This study analyses the causes and the consequences of these actions in a unified framework using the appropriate methodologies. Various factors, such as firm's characteristics and multinational nature, its industry's characteristics, its exchange and index inclusion, and divested (or acquired) segment(s)' industry conditions, are considered as the determinants of the diversifying and the refocusing decisions. The estimation results from the corresponding multinomial logit model suggest that refocusing occurs generally due to firm‐specific reasons, and diversification due to outside factors, such as industry and economic conditions. Added or dropped segment's industry profitability, its relationship to the core business of the firm, and its relatedness to the businesses of the conglomerate's other segments have a nontrivial effect on either decision. In a related analysis, the paper explicitly models and estimates the valuation consequences that are sustained by the firm after it undertakes a refocusing or a diversification action. To isolate the changes in firm's value that are due to these decisions only, a 2SLS estimation is used to control for endogeneity that arises because the factors that affect a firm's value are likely to have also induced the firm to make the corresponding decision. The novelty of my approach is in its inclusion of variables measuring the consequences due to both actions, the diversification and the refocusing, in the same valuation equation. Contrary to some earlier findings, I find no evidence of ‘diversification discount’ or ‘refocusing premium.’ The choice of this paper to analyse all corporate restructuring decisions in a unified framework yields valuable business insights into the reasons for undertaking such corporate events.     

Corporate Governance,Managers' Independence,Exporting, and Performance of Firms in Transition Economies

Using data on 157 large companies in Poland and Hungary, this paper employs Bayesian structural equation modeling to examine the relations among corporate governance, managers' independence from owners in terms of strategic decision making, exporting, and performance. Managers' independence is positively associated with firms' financial performance and exporting. In turn, the extent of managers' independence is negatively associated with ownership concentration, but positively associated with the percentage of foreign directors on the firm's board. We interpret these results as indicating that concentrated owners tend to constrain managerial autonomy at the cost of the firm's internationalization and performance, but board participation of foreign stakeholders enhances the firm's export orientation and performance by encouraging executives' decision-making autonomy.     

A Bayesian's Bubble

The acceleration of the U.S. productivity growth in the late 1990s suggests a significant advance in technological innovation, making the perceived probability of entering a “new economy” ever increasing. Based on macroeconomic data, we identify a Bayesian investor's belief evolution when facing a possible structural break in the economy. We show that such belief evolution plays a significant role in explaining both the stock market boom and crash during 1998 to 2001. We conclude that a rational investor's uncertainty about the future of the U.S. economy provides an alternative explanation for the late 1990s stock market “bubble.”