Risk management, corporate governance, and bank performance in the financial crisis Vincent Aebi a , Gabriele Sabato b , Markus Schmid c,⇑ a Swiss Institute of Banking and Finance, University of St. Gallen, CH-9000 St. Gallen, Switzerland b Royal Bank of Scotland, Group Risk Management, 1000EA Amsterdam, Netherlands c University of Mannheim, Finance Area, D-68131 Mannheim, Germany article info Article history: Received 13 April 2011 Accepted 27 October 2011 Available online xxxx JEL classification: G01 G21 G32 G34 Keywords: Chief risk officer Corporate governance Risk governance Bank performance Financial crisis abstract The recent financial crisis has raised several questions with respect to the corporate governance of finan- cial institutions. This paper investigates whether risk management-related corporate governance mech- anisms, such as for example the presence of a chief risk officer (CRO) in a bank’s executive board and whether the CRO reports to the CEO or directly to the board of directors, are associated with a better bank performance during the financial crisis of 2007/2008. We measure bank performance by buy-and-hold returns and ROE and we control for standard corporate governance variables such as CEO ownership, board size, and board independence. Most importantly, our results indicate that banks, in which the CRO directly reports to the board of directors and not to the CEO (or other corporate entities), exhibit sig- nificantly higher (i.e., less negative) stock returns and ROE during the crisis. In contrast, standard corpo- rate governance variables are mostly insignificantly or even negatively related to the banks’ performance during the crisis. Ó 2011 Elsevier B.V. All rights reserved. 1. Introduction This paper investigates whether the presence of a chief risk officer (CRO) in the executive board of a bank, the line of report- ing of the CRO, and other risk management-related corporate governance mechanisms (which are also termed ‘‘risk gover- nance’’) positively affect bank performance during the recent financial crisis. The paper combines and further develops relevant previous findings from three major areas of research: corporate governance, enterprise risk management (ERM), and bank performance. Whereas scandals such as Enron and Worldcom gave primarily rise to new developments in accounting practices, the financial cri- sis following the subprime meltdown in the US has led to a further growing awareness and need for appropriate risk management techniques and structures within financial organizations. 1 In quan- titative risk management, the focus lies on how to improve the mea- surement and management of specific risks such as liquidity risk, credit risk, and market risk. On a structural level, the issue of how to integrate these risks into one single message to senior executives is being addressed. Earlier literature on risk management focused on single types of risk while missing out on the interdependence to other risks (Miller, 1992). Consequently, only in the 1990s, the academic literature started to focus on an integrated view of risk management (e.g., Miller, 1992; Miccolis and Shaw, 2000; Cumming and Mirtle, 2001; Nocco and Stulz, 2006; Sabato, 2010). 0378-4266/$ - see front matter Ó 2011 Elsevier B.V. All rights reserved. doi:10.1016/j.jbankfin.2011.10.020 ⇑ Corresponding author. Tel.: +49 621 181 3754. E-mail addresses: vincent.aebi@alumni.unisg.ch (V. Aebi), gabriele.sabato@rbs. com (G. Sabato), schmid@bwl.uni-mannheim.de (M. Schmid). 1 There are also recent academic studies which emphasize that flaws in bank governance played an important role in the poor performance of banks during the financial crisis of 2007/2008 (e.g., Diamond and Rajan, 2009). Also a recent OECD report concludes that the financial crisis can be to an important extent attributed to failures and weaknesses in corporate governance arrangements (Kirkpatrick, 2009). Moreover, Acharya et al. (2009) argue that a strong and independent risk manage- ment is necessary to effectively manage risk in modern-day banks as deposit insurance protection and implicit too-big-to-fail guarantees weaken the incentives of debtholders to provide monitoring and impose market discipline. Moreover, the increasing complexity of banking institutions and the ease with which their risk profiles can be altered by traders and security desks makes it difficult for supervisors to regulate risks. Journal of Banking & Finance xxx (2011) xxx–xxx Contents lists available at SciVerse ScienceDirect Journal of Banking & Finance journal homepage: www.elsevier.com/locate/jbf Please cite this article in press as: Aebi, V., et al. Risk management, corporate governance, and bank performance in the financial crisis. J. Bank Finance (2011), doi:10.1016/j.jbankfin.2011.10.020