Why Risk Managers?
Speaker(s) Kaushalendra Kishore, Carlson School of Management, University of Minnesota, USA Publication CAFRAL Conference room on Mezzanine Floor, Main Building. Reserve Bank of India, Fort, Mumbai 400 001

Banks rely on risk managers to prevent their employees from making high risk low value investments. Why can't the CEOs directly incentivize their employees by offering them the right contract instead of relying on the risk manager? I show that having a separate risk manager is more profitable for banks and is also socially efficient. I study a multi-task principal agent problem where a bank employee has to be incentivized to do two tasks-choose the investment with the highest value and then exert effort on it-and show that there is a conflict between providing incentives for both tasks. Incentivizing effort requires offering a high powered contract (convex payoff) which will incentivize the employee to indulge in risk shifting and choose riskier investments with lower value. If the tasks are split between a risk manager who approves the investments and a loan officer (or trader) who exerts effort, then both optimal investment choice and optimal effort can be achieved. I further examine some reasons for risk management failure wherein a CEO may ignore the risk manager when he suggests safe investments.

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