A r ticle

OR G A N I Z AT I O N STRU CT U RE AN D R I S K TA K I N G I N B ANK ING

Anja n Roy
National Institute of Bank Management, Pune, Maharashtra, India
Correspondence: Anjan Roy, National Institute of Bank Management, NIBM Road, Kondhwa Khurd, Maharashtra, Pune 411048, India. E-mail: aroy@nibmindia.org

A b stra ct

Key wo rds

organizational structure; functional; business-line; risk taking Risk Management (2007) 0, 000000. doi:10.1057/palgrave.rm.8250043

I n tro duction

Journal: RM Article: 8250043

orporate failure due to reckless decision actions has emerged as a matter of great concern in the business world. Scandals such as Enron and Tyco have prompted the legislature in the United States to enact the Sarbanes Oxley (Sox) Act for enabling more effective monitoring and governance over risk taking by corporate managements. This act introduced a new approach labeled as structural model that requires corporations to devise structural channels to aid information ow and

Risk Management 2008, 0, (000000) 2008 Palgrave Macmillan Ltd 14603799/08 $30.00 www.palgrave-journals.com/rm

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Organization structure plays an important influence on the elicitation of the desired risk-taking behavior in banks. Risk taking can be viewed as the susceptibility to problems such as moral hazard, conflict of interest and adverse selection that are precipitated due to the decision context and availability of information. Different structural forms have different informational properties and, therefore, the capacity to facilitate transparency and risk control. This study reviews the organization structure and risk types in banking and explores the possible links between the structural contingency and incidence of risk. The findings may assist decisions regarding organization structure of banks.

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disclosure for improved internal governance (Moberly, 2006). While King (1999) had earlier pointed out that organization structure may perform a signicant role in encouraging decision to report an observed misconduct, the Sox Act has signaled the realized importance of the structural form of organization to impact risk-taking actions by rms. A study of the inuence of organization structure upon risk taking in banking is highly relevant because while banks are inherently faced with several types of risks, deregulation, increased scope of activities and competition are driving business conduct towards greater aggressiveness, which can optimally be constrained only through appropriate structural means. As nancial intermediaries, banks create value by managing risks in their intermediation process. The main types of risk are (1) credit risk emerging from potential losses due to failure of borrowers to honor the terms of a loan agreement, (2) market risk arising from adverse changes in interest rates, exchange rates or from uctuation in bond, equity or commodity prices and (3) operational risk due to failure of routine operational processes such as non-compliance with policies, laws and regulations, from fraud or breakdown in services and systems. These apart, banks also face several other strategic risks as they merge, acquire and ally with other businesses to diversify their products and services in non-traditional areas. There are risks of business loss emerging from low competitive image and lack of customers acceptance of its services. Excessive focus on costs and operational matters may lead to diversion of attention from the changing market realities and strategy failure. Banks may face risk of technological change when new developments render past investments in technology obsolete. In particular, new entrants may use advanced technologies to gain competitive advantage over the low-technologybased incumbents. There are also risks of imitation of the unique service features that can steal away any differentiation advantage that a bank might invest upon. Bank organizations today, are well-diversied conglomerates having complex corporate structures, such as the integrated or universal bank, bank parentsubsidiary company, bank holding company, nancially holding company, etc. These hierarchies are in response to the challenges that the nancial conglomerates faced, as discussed in Staikouras (2006a), in the management of multi-product businesses. But to what extent these have inuenced risk-taking behavior and risks in the banks are yet to be ascertained. Reports on the losses and failure of banks and nancial institutions such as in Bank for Credit and Commerce International (BCCI), Barings, Daiwa, Natwest and several others have raised supervisory concerns making it pertinent to view risk-taking behavior from the structural angle even more (Hannan et al., 2003; Herrings, 2005). This paper is intended to explore the links between organization structure and risk-taking behavior in banks. The next section in this paper presents the basic structural forms of bank organizations. The subsequent section looks

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at the sources of the various types of risks associated with banks followed by a discussion on the vulnerability of various structural forms to risk events in the next section. The penultimate section then views the effectiveness of the structural forms to deploy risk capital for inuencing risk-taking behavior. The ndings from this study suggest that there are indeed structural properties that permit or inhibit risk-taking actions through various administrative means. This may form as a basis for inuencing structure decisions for design of effective organization (Goold and Campbell, 2002) of banks.

Ba s ic o rga n iz ational forms in bankin g in d u stry

The banking industry operations have traditionally been carried out through geographically dispersed network of branch ofces. Banks have been highly integrated organizations carrying out the entire set of banking activities such as customer account creation, transaction services, data processing, management reporting, etc. and, therefore, been structured as value chains or the factory model of organization (Lamarque, 1999). With branches operating almost independent of each other, banks have required a central headquarter for coordinating the pooled interdependencies (Marquis, 2006) and balancing resource mobilization and deployment between them. In the pre-computer era, coordination of bank branches had to rely heavily upon the formal organization and reporting structure and consequently, the functional hierarchy became the structural preference of banks.
Functional hierarc hy

The functional structure was implemented when banks sought to grow their branches across wider geographies without any wherewithal of communication technologies. Its design was premised upon collocating similar functions and resources into departments that resulted in efcient use of resources through sharing as well as through job specialization and skill intensication. Easily set up as pyramidal hierarchy, the structure comprised administrative positions at various levels following principles of unity of command and span of control. The functionally organized bank, however, was a single monolith with only one prot center which was the corporate while other units were organized as responsibility centers for revenues or expenses. It allowed centralization of strategic and operational decision making at the higher management level delegating responsibilities of coordination to functional managers in mid ofces such as zonal or regional ofce that supported and controlled the business units or branch ofces. The business units functioned almost independent of each other while drawing resources from the central ofce at certain transfer price rates.

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In the division structure, organizations are designed to accord autonomy to market groups depending on product, geography or the customer. This structure is usually favored when organizations pursue a strategy of diversication where strategic and operational problems need to be addressed separately (Renucci, 2002). Accordingly, a divisionalized structure may be fully decentralized or centralized depending upon the relatedness of the diversied businesses (Balmaceda, 2006). Bank organizations also had features of geographic division structure of operations with centralized control over their wide network of branches. Developments in technology and reduced cost of information transfer have enabled increasing centralization of decision making, but increased product variety, sophistication of customers and local nature of bank relationships have required higher delegation of authority to the frontline along with the need for new mechanisms for coordination of variety. The business line or product division structure of bank organization, therefore, came to be adopted by most multi-channel and multi-product banks. Business lines as prot centers were self-contained and constituting most of the value processes involved in the creation and distribution of the products while drawing corporate resources from the central ofce. The key advantage of this structure was its facilitation of coordination between related functions leading to a exible and responsive organization. This structure however, with its greater emphasis upon decentralized decision making and goal achievement at the divisional level, tended to drive product managers to become highly individual oriented and incentive driven to the extent of creating coordination problems between product lines. Therefore, while business line organizations were built to economize on service resources, their duplication and lack of sharing between lines could also have reduced the overall organizational efciency of the bank.

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Divisional hierarc hy

As banks grew further by diversifying into multiple product markets that included off balance sheet and non-banking products and services, the functional form gradually became constraining. Its key drawback was in slowing down the responsiveness and speed of service delivery. Such happened because as branches increased, information processing capabilities delimited the span of control of managers requiring additional layers of hierarchy that led to the creation of a tall organization where decision making was distanced from the market and the customer. Also, rigid departmentalization narrowed focus into specialized task areas that prevented cross function communication thereby clouding a concerted view of business problems. Consequent to the above hierarchical disposition, business unit controllers tended to spend more time on controlling rather than on support activities thereby weakening the business function (Rouwelaar, 2006).

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Sources of banking risk

Banking risks may be systematic or idiosyncratic depending upon whether their incidence is industry wide or particular to a bank. Systematic risks are caused due to factors linked to changes in external environment such as the economic condition, interest rate trend, market competition, etc. (Sinkey and Greenawalt, 1991). Idiosyncratic risks are caused due to bank-specic factors such as capital, balance sheet structure and quality of asset portfolio (Vennet et al., 2005). Diversications into multiple business lines and off balance sheet business activities have contributed to volatility in bank earnings and locus of risk have shifted to income statement (Stiroh, 2006). Staikouras (2006b) has pointed out that risk may vary with a banks size and nature of activity. The various categories of risk may therefore have origins in external or internal causes, for example while market risks are likely to be caused by external factors, credit and operational risk sources are more internal to the bank. Causes of credit risk, however, can be both external as well as internal to a bank. Risk types, therefore, may be interdependent and can occur jointly (Drehmann et al., 2007) or consequently such as when operational risk may lead to market, liquidity or credit risk or interest rate risk may precipitate credit risk and liquidity problems in a bank. Risk actually emerges with accumulation of errors in decision making due to information asymmetry and as consequence of problems of moral hazard, conict of interest and adverse selection. Moral hazard problems emerge when a person or an organization does not have to bear the full consequence of his action. Conict of interest arises when professional and personal interests compete leading to an improper conduct such as opportunism. Adverse selection or a wrong selection between choices may happen as a direct result of lack of information. Market competition inuences these behavioral tendencies leading to high or low risk-taking in banks. With bulk of bank funds being supplied by depositors, who are often small and numerous, the capital structure of banks allows a sharp asymmetry in the distribution of prots and losses. While prots can easily be appropriated to the shareholders, losses must be borne by the depositors. For such reason, the banking industry is recognized to be exposed to moral hazard and excessive risk taking (Demsetz et al., 1997) and, therefore, it has attracted deposit insurance that shift risk of losses to the government. Ironically, deposit insurance has been reported to exacerbate moral hazard as neither the banks have the burden of protecting the depositor nor the depositor does so much care to monitor the banks (Hooks and Robinson, 2002; Muslumov, 2005; McCoy, 2006). It has, therefore, been found that banks having substantially higher core deposits may tend to deal with informationally opaque rms thereby increasing the likelihood of becoming more fragile (Song and Thakur, 2005). In concentrated markets, banks may impose hold up costs and constraints on availability of credit. Bolton et al. (2004) have shown that banks having

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monopoly may have conict of interest leading them to prevent information disclosure in order to have higher bargaining power and increased loan rates. High rates of loans raise the borrowers debt load forcing them to engage in risky projects offering higher prots but having higher probability of default (Jimenez et al., 2007). Both moral hazard and conict of interest can be found in relationship lending contexts where banks have internal information about the borrower. It has been noticed that banks often lack the required toughness in enforcing credit contracts and tend to continue extending credit to a distressed borrower with the hope of recovering a previous loan (a situation which, as per Boot (2000), is prompted by soft budget constraints). Jimenez and Saurina (2003) have also reported that close bankborrower relationship increases the willingness of banks to take more risk by concentrating on a single relationship. They point out that problem arises when the borrowers realize that they can renegotiate their contracts easily and are induced to exert less effort to prevent a bad outcome from happening. Risk due to adverse selection arises due to biases in assessment of a project leading to over or underestimation of the expected consequences. Such biases may arise due to lack of complete information about the borrower as well as due to the organizational context such as the complexity and opacity of the bank. Banks require soft information in order to make a more complete assessment of a borrower or an investment project. Borrowers, however, deal with several banks and may not fully disclose information about their projects (von Rheinbaben and Ruckes, 2004) in order to secure better loan terms or even evade some of the necessary covenants. Managers risk preferences may be inuenced by the degree of monitoring and regulatory supervision (Wiseman and Catanach, 1997). Riyanto (1999) has pointed out that intense monitoring by head ofce decreases divisional managers effort levels particularly when an integrated structure is forced without clear synergies between divisions. Likewise, Liberti (2003) has also pointed out that delegation of authority, and greater empowerment increases the effort expended by managers in developing bank relationships. In another study of lending process in banks, McNamara and Bromiley (1997) identied organizational factors such as degree of standardization of loan review process, duration of customer relationships, pressure for protability, etc. as inuencing the lending decision. In other situations, the high performing divisions of the bank may be exempt from critical attention, as happened in the case of Barings Bank, and early warning signals may not be heeded leading to high risk-taking behavior (Sheaffer et al., 1998).

Risk c haracteristics of organizational stru ctu res

The organization structure, with its authority relationships, position limits and reporting systems, serves as a channel for communication of policy and

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operational information between the corporate and the frontline (Bolton and Dewatripont, 1994). Different structural forms have differing abilities to capture, process and transfer information and consequently the design of organization also determines the effectiveness of control systems and the likelihood of incidence of risk in banks. Mian (2003) has observed that organizational structure of banks can seriously limit their ability to capture soft information when making a loan-related decision. There is loss of informativeness when soft information is conveyed within large hierarchies (Liberti and Mian, 2006) and therefore credit approvals at higher levels have to rely more on hard information. In the same vein, Degryse et al. (2007) have shown that hierarchically organized banks tend to employ mainly hard information for loan decisions while decentralized banks relies more on non-veriable information required to make lending decisions. Di Cagno and Sciubba (2000) have also found that under a decentralized institutional framework the efcacy of borrower screening and identication of poor projects is enhanced. The failure of centralized organizations to capture soft information is owing to its heavy reliance on task standardization. In centralized hierarchies, lower level operatives tasks are standardized while decision authority is vested at higher levels. Standardization leads information gathering processes to follow routine ways that suit the operational requirements of the task but not the demand requirements of the task. As a result, only well-codied and hard information can be netted by such structure. The relevance of standard task organization becomes lost when the same is forced to address new and qualitatively different situations of risk. Consequently, the ability of such structures to capture variant data or soft information is diminished. Under such circumstance, Stein (2002) points out that with the separation of information expertise from authority to allocate capital, the incentive for diligent effort towards research and information production is reduced. Therefore, as the responsibility for business performance lie with the top executive authority and the functional managers who coordinate the task processes, managers down the hierarchy may tend to shirk or even take risks irresponsibly. At the same time, given higher slack of departmental resources in functional organizations, observability and monitoring may be severely limited thereby allowing greater opportunity for free riding on others efforts and hence shirking or acting irresponsibly (Jones, 1984). A second reason behind the failure of such organizations to nely segregate borrowers is its inability to make available information at the spot and time of decision making. Consequent to this, the probability of making an adverse selection of choice, such as to approve or reject a loan application, under competitive conditions becomes higher. Extreme allegiance to the departmental group may lead to hold up of information that might be valuable elsewhere. Also, lower level managers responsible for executing tasks without

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decision-making authority may not be motivated to share task information with the superiors. Pinckney (2006) has observed that in spite of developments of quantitative models and statistical decision rules to assess riskiness of borrowers, commercial lending process in banking has resisted their implementation and remained the least automated function owing to its silo department structure and narrow perspective of managers. He points out to risk creating aspects in loan processing such as lack of status visibility, inconsistent management information and inefcient communication. The divisional structure has its own issues in generating risks. Mudambi and Navarra (2004) have modeled the divisional structure situation where managers have their own objectives that diverge from the rm as a whole. Divisional managers may create incentives for themselves by generating prot and appropriating rent from maximizing their divisions share in the value created by the rm. In a product division setup, therefore, managers might tend to make independent risk choices rather than a combined risk portfolio depriving the organization from capital preserving synergies. With greater autonomy, managers might even be prompted to take costly unobserved actions without the central authority being able to exercise any control over risk events (De Motta, 2003). Corporate management in such structure, therefore, must have higher information processing capability. Barua and Suryanarayanan (1996) have pointed out that decentralized decision units, such as product divisions, could also turn out to be silos with little sharing of information among themselves. Consequently, default information may not be organizationally known leading to increase in customer risks. Beyond the above-mentioned risks associated with different organization structures, there are also possibilities of disruption caused due to organizational failure. Vulnerability, in the event of organizational failure in functional and product hierarchies has been discussed at length by Malone and Smith (1988), who have examined the probability and extent of disruption of operations due to failure at different management levels. They observe that the functional hierarchy, given its high specialization and resource slack, is operationally less vulnerable than the product hierarchy, whose organization is much leaner. But in a more dynamic and complex business environment, failure at executive levels in a functional hierarchy would have far-reaching organizational impacts compared to failure in product hierarchy where the impact can be limited to the concerned product market.

Structure , cap it al al l ocation an d risk man agemen t

Basle II guidelines have evolved a new direction for regulation in banking towards self-assessment of risk by banks and provisioning of capital to cover for the same. When fully applied, banks would be required to maintain and allocate risk capital, an amount invested in risk-free asset to insure the value of

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a rm against insolvency (Merton and Perold, 1993), at the business line level in order to cull out the risk contribution of each business separately. It is recognized that the nature of risks and management challenges can vary considerably between businesses, and failing to measure and differentiate risk at the business line level can lead to under or over allocation of capital thereby starving a potentially protable business or fuelling unwanted risk taking in unprofitable ones (Kupper, 1999). Risk capital is allocated by assessing the value at risk of a business line from measurements of risk exposure and probability of default. By allocating risk capital to businesses and setting a target rate of return, a strategic context for value-based performance can be created. The rationale behind the allocation of risk capital to evoke responsible risk taking is to create a notion of managerial ownership. Managerial ownership helps to resolve the agency conict between shareholders and managers (Chen and Steiner, 1999) and as Dolde and Knopf (2006) have pointed out, a threshold level of capital ownership is required in order to achieve the efcient frontier between and return. However, it has also been found that direct stock ownership by managers can increase total risk of the bank (Sullivan and Spong, 2007) and hence the concept of notional ownership is important. Risk capital is allocated to businesses to achieve exactly this effect and by linking the capital return to managerial performance can create a strong tool for risk behavior control by enabling greater transparency and facilitation of market discipline. According to Boot and Schmeits (1996), this methodology can provide a dynamic mechanism to respond continuously to actual risk choice adding to the optimality of conglomeration. Another reason behind the use of risk capital as a tool for strategic control is its leading to informational efciency. According to Gibson (1998), effectiveness in risk management is a function of cost of gathering and assembling risk information and use of measurement technique. Risk capital can achieve superior economies of information by delegating decision authority to appropriate responsibility centers and therefore be more preferred mechanism for exercising control over risk decisions. The usefulness of risk capital may be contingent upon organizational context, in particular the structure, which determines observability and monitoring. In this regard, it can be argued that the different structural forms of bank organization may enable supervisory performance, both internal and external, in different degrees. Matten (1996) has shown that organizational structure can lead to misallocation of capital if such decisions are made at the inappropriate level in the hierarchy. Allocating capital rst to business units and then to business lines (as would be in a functional structure) can have a signicant implication of lowering value creation compared to allocating capital directly to business lines. In a functional structure the impact of risk capital for exercising behavioral inuence over risk-taking decisions at the unit level (e.g., the branch) may be

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Through the above discussion an attempt has been made to examine the main types of organization structures in banking, namely the functional and the product division structure, in respect of their effectiveness in enabling risk control. Risk in banking emerges from behavioral events such as moral hazard, conict of interest and adverse selection, depending on the competitive pressures and requirement of information in a decision situation. Different structural forms, primarily the functional and the divisional or business line hierarchy, have different capacity for information production, transmission

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limited because the managers involved in decision making may not get a clear line of sight of business drivers and results. With risk unit dened as geographic locations, unit managers face a variety of balance sheet and non-balance sheet risks which they would at best look at as aggregate asset portfolio problem rather than a business line risk-taking decision problem. Therefore, the role of risk capital in drawing managerial attention to the appropriate source of risk and thereby creating the required performance management context (of maximizing return on allocated capital) can be severely undermined. Without strategic control, the only means for managing risk taking is through hierarchical control means (or by limit authorizations) that may be prone to greater inefciency and reduced effectiveness. Saita (1999) notes that the impact of risk management technique on actual risk decisions is dependent on the depth achieved by the process, that is, the extent to which appropriate risk measures are dened for individual business units. There can be no single multipurpose measurement for risk and the same must be chosen based on the characteristics of each business unit. Risk specialization is, therefore, important to produce higher returns. The business division structure, by identifying each business line as a separate risk entity, allows specialization and concentration of managerial attention to actual sources of risks. Since business line managers are likely to have better information and measurement of their risks, by clearly demarcating businesses as divisions, this structure enables goal setting toward risk-adjusted performance making them fully accountable for their risk choice. In such way, risk capital allocation and cost of capital can be better used to create the desired managerial incentive and performance context for risk taking. As developments in information technology makes it less costly to assemble and aggregate risk information, business line and product risks can be observed and accurately assessed even with a centralized hierarchical structure. As a consequence, risk measurement will emerge to be a specialized activity serving business line risk decisions. Risk management will, therefore, dovetail from a corporate function into a divisional responsibility and become a systemic and organization wide endeavor.

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and processing and accordingly have unique properties of facilitating transparency. The various studies and arguments discovered from the review points out that the functional structure, in spite of its bureaucratic conservativeness, may not be favorable for optimal risk taking in a multi-product banking environment. The business division structure, in spite of the numerous challenges of measurement, integration and allocation seem to be more potent for inuencing and eliciting the desired risk-taking behavior in the bank.

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