A well-governed bank takes the amount of risk that is expected to maximize its share-holder wealth, subject to the constraints imposed by laws and regulators. The role of risk management in such banks is not to minimize or reduce the banks’ total risk. It is rather to identify and measure the risks the banks are taking, aggregate these risks into a measure of the banks’ total risk, enable the banks to avoid or eliminate bad risks, and ensure that the banks’ level of risk is consistent with their risk appetites.
Organizing the risk management function to play such a role is challenging not only because of the difficulty of measuring risk with precision, but also because the use of more detailed rules, although potentially effective in preventing destructive risk-taking, limits the flexibility of an institution to take advantage of opportunities that increase firm value. The limitations of risk measurement together with the decentralization of risk-taking in most large financial institutions mean that setting appropriate incentives for risk-takers and promoting the development of an appropriate risk culture are essential to the success of risk management in performing its function.
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