Brian Clark, assistant professor of banking and corporate finance at the Lally School of Management, tells his students to embrace the importance of risk in business, not fear it.
Clark teaches the Lally class Risk Management, which explores this important concept in business and how to manage different types of risks (market, credit, liquidity, operational, business, and strategic). Students also learn how to apply leading-edge tools and instruments for risk management used globally in business, with a particular focus on the finance industry.
In Clark’s research, “Risk Shifting and Regulatory Arbitrage: Evidence from Operational Risk,” (2017) with Alireza Ebrahim of the Office of the Comptroller of the Currency, the team studies how banks respond to regulations and manage risk.
For this study, the researchers considered the state of the banking industry leading up to the financial crisis of 2007-2009 using operational loss data collected by regulatory agencies for a sample of large U.S. banks. They show that banks drastically increased their exposure to operational risk in the years leading up to the recent financial crisis and attribute this to a lack of prudent regulations during this time.
The study points out that before the financial crisis, regulators didn’t really examine operational risk in financial institutions—considering it benign—opening the door for banks to increase their exposure over time and leverage as much as possible without having to account for this risk on their books. Operational risk is not just simply exposure to loss due to small mistakes or errors in daily business transactions, such as transposing numbers on a check.
The researchers identify that operational risk goes deeper than that. It can include insufficient or failed procedures, policies, or systems, as well as mistakes made by employees, disruptions in business, and even fraudulent or criminal activity. Examples of prominent operational losses include rogue traders such as the “London Whale,” the recent cross-selling scandal at Wells Fargo, interest rate (LIBOR) and foreign exchange market fixing schemes, and other high-profile cases that resulted in class action suits and regulatory fines that hit the industry in the aftermath of the crisis.
One study by the Boston Consulting Group (2017) estimates that approximately $321 billion in fines were paid by North American and European banks in the aftermath of the recent financial crisis. Moreover, operational risk is estimated to compose roughly 25 percent of the risk of large banks’ risk profiles, according to Basel II risk weighted assets.
Turning to the question of why banks would take on such exposure, Clark and Ebrahim argue that banks amassed operational risk as a means to get around regulations meant to limit the riskiness of financial institutions, a process known as regulatory arbitrage. They challenge the traditional view that operational risk a purely cost minimization problem and suggest that banks have profit motives for increasing operational risk.
“Banks pursued this avenue as a means of regulatory arbitrage, basically being able to profit from loopholes in the regulatory systems therefore mitigating or avoiding unpopular outcomes and policies,” said Clark. “One size does not fit all when it comes to regulatory arbitrage whether it is structuring transactions differently, financial engineering, or geographic relocation – such as a moving a company’s headquarters overseas.”
Ultimately, the study found that weak regulations leading up to the financial crisis created an environment where banks chose to pursue risk shifting to alleviate their concerns. The catastrophic results included the largest government bailout in this country’s history, a mortgage loan crisis, regulatory fines, and class action lawsuits – just to name a few.
“A large pitfall of operational risk is that it often is systemic in nature and therefore occurs across a large number of banks or financial institutions,” said Clark. “Operational risk also tends to have an effect in a delayed way with lag time in between the time when the risk is undertaken and the financial loss. For example, not investing or maintaining in the latest information technology infrastructure or cutting governance costs such as monitoring of employees can benefit banks in the short run in terms of costs savings or increased revenue, but come back to haunt them later on.”
A proud Rensselaer alumnus, Clark earned a Ph.D. in finance from Rensselaer in 2010, an MBA (2005) and a master of engineering in mechanical engineering from Clarkson University (2004), and a bachelor of science in biomedical engineering from Rensselaer in 2003.