Banks are Brought Down by Overblown Bureaucracies

LONDON - Bureaucratic management systems that enable executives to take risks without responsibility are largely to blame for the economic crisis, according to a new study funded by the Advanced Institute of Management Research (AIM Research). Poor risk management was at the heart of the sub-prime meltdown in 2007, can be blamed for Lehman Brothers’ failure and it continues to haunt the banks today.

‘Imagine a plane, where the decision about whether it is safe to fly is taken not by the pilot but the airline boss and you get an idea of how some financial institutions are managing risk,’ says Julian Birkinshaw of the London Business School.

He points out that in the years leading up to the credit crisis, financial institutions focused unduly on the formalisation and externalisation of risk management. Risk was evaluated through bureaucratic procedures. Validation was handed to a bureaucracy of outside regulators and credit-rating agencies. This, he says, allowed individuals to detach themselves - legally and morally - from the system in which they worked.

The study argues for a shift towards greater personalisation of risk management, particularly in large firms - where individuals who make the decisions take personal responsibility for evaluating the risk and for the consequences of decisions.

It is not that formal procedures and outside agencies are redundant. The best-managed firms balance formalisation and externalisation of risk management with a personalisation approach. This means there is true ownership of the decision to underwrite a risk by the manager, who has the appropriate level of expertise and information. There are formal systems for setting the limits for exposure to the types of risks the organisation will tolerate. And, periodically, external agencies are brought in to validate and quality assure the internal processes.

Professor Birkinshaw cites JP Morgan Chase, a major player unaffected by the crisis. It has a highly cohesive top team that takes ownership of its risk-management agenda. In 2006, they saw early warning signals of the credit risk on mortgages and reduced the bank’s level of exposure to mortgage backed securities.

By contrast, the large banks had hundreds of employees working in risk management, using procedures so carefully defined they could no longer see the bigger picture. They have borne disproportionate losses.

Personalisation of risk is not straightforward - a conducive and supportive corporate culture is required. In line with AIM Research’s objective to impact on management practice, the research outlines basic principles firms can apply:

- Develop high quality information, effective analytical tools and the competence to interpret this information. - Ensure rewards are linked to decisions taken. - Avoid situations where the decision maker is too far removed from the action to feel responsible. - Build a supportive culture that includes a commitment to a set of non-financial objectives. - Refuse to simplify the big picture.

Contact: Colin Hallmark: Tel: +44(0)7745-914170; colin@3nine.co.uk AIM Research is funded by the ESRC and EPSRC and was launched in November 2002. www.aimresearch.org

Source: Aim Research

Contact: Colin Hallmark: Tel: +44(0)7745-914170; colin at 3nine.co.uk