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Rationales for Risk Management in Banks 87
trol power from a principal to an agent is sensible as long as the agent
has better information or better qualifications than the principal. However,
due to uncertainty and asymmetric information the principal is not
able to perfectly observe whether the outcome of the agent’s decisions
is due to his ability and effort or due to circumstances that are outside
the agent’s control. Therefore, agents have an incentive to use risk
management to reduce asymmetric information and thereby increase the
transparency of their management capabilities, 176 so that it is easier for
the principal to differentiate good management skills and talent from
luck (e.g., favorable developments in the financial markets). 177 This
attempt of the agents to use risk management as a tool is, therefore,
called the “signaling of higher management quality.” 178
There are three lines of reasoning behind this idea:
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■
The first argument is based on the agency theory explaining the
relationship between firm performance and managerial compensation.
While the argument might not be immediately convincing,
observed outcomes of firm performance may—because of
asymmetric information—influence the perception of managerial
talent by the labor markets. 179 Since that will be eventually reflected
in management compensation, the assumption that managers
will behave in a way consistent with a concave objective
function, that is, that they are risk-averse, seems to be justified.
Therefore, managers may engage in risk management to better
communicate their skills to the labor market 180 in an attempt to
influence the labor market’s perspective. 181
The second argument reflects the managers’ interest in reducing
the volatility of corporate earnings so that financial markets and,
hence, the shareholders can better evaluate their true ability and
performance. 182 Smoothing the company’s performance by risk
management can convince shareholders that managers are capable,
which improves their prospects, evaluation, 183 and remu-
176 See Pritsch and Hommel (1997), pp. 675–676.
177 See Brealey and Myers (1991), p. 629.
178 However, signaling is used in this context not in the sense of the adverse selection
theory, that is, before contracting, but rather in the sense of “positive” moral hazard,
that is, agents are much better than they are perceived and not dangerous for the
organization.
179 See Froot et al. (1993), p. 1632.
180 See Breeden and Viswanathan (1996) and Tufano (1996), p. 1111.
181 See Froot et al. (1993), p. 1632.
182 See Fenn et al. (1997), p. 20.
183 See Mason (1995), p. 30, and DeMarzo/Duffie (1991).