Risky Business: The Credit Crisis and Failure (Part II)

Arewa, Olufunmilayo B. | June 6, 2010

I. Regulatory Failures and Regulatory Reform The credit crisis underscores the need for reform of regulatory and industry approaches to risk. Reframing risk should entail greater limitations on leverage and more comprehensive internal company risk management, with both external regulatory monitoring and more robust internal efforts. As a number of post-credit crisis compensation proposals have recommended, companies should also be encouraged to follow best practices with respect to compensation and bonuses based on performance.[1] Best practices should involve greater consideration of the ways in which compensation rewards take account of risks, particularly for traders whose activities entail significant risk exposure.[2] Such best practices in compensation might include, for example, creating a clawback or tail for compensation that matches the time horizon of receipt of compensation to the time horizon of trading activities for which an employee is compensated. Regulated companies in the financial services industry should also be required to disclose their internal risk management strategies in detail, as well as the alignment between compensation and risk, in order to comply with mandatory disclosures in risk disclosure discussions. All regulated and unregulated firms should also be required to immediately report all material incidents that reflect a failure of risk controls or risk management to a market stability regulator. External regulation can be used to promote development of internal risk management in the financial industry. The credit crisis, however, raises serious questions about the effectiveness of existing financial market regulatory approaches.