ABSTRACT
Chapter 3 provides a primer on corporate governance and the principal-agent relationship that underlies conflicts of interest in a corporation. Conflicts are pervasive in financial institutions. These firms enjoy an informational advantage and the incentives to exploit it. The chapter includes a methodology for identifying, assessing, and mitigating conflicts vis-à-vis institutional and retail customers. The chapter also examines how the ‘source of strength’ doctrine helps resolve the conflicting duties of bank boards and the boards of their parent holding companies. The chapter discusses the core components of a bank’s risk management function: the role of ‘risk appetite’ and a risk assessment framework, the need to make risk measurement independent of its management, and the industry’s use of Value-at-Risk as a measurement tool. The chapter covers the basic components of a bank compliance function. State corporate law and the federal prosecutorial policies incentivize firms to build meaningful corporate compliance programs. Nonetheless, a board conducts a risk-return analysis of compliance cost and risk that seeks to reduce inherent risk to a level of residual risk commensurate with a firm’s risk appetite. The chapter discusses the ‘three lines of defense’ model, the two primary third-party enterprise risk management systems, and the role of corporate culture and the challenges in establishing a ‘culture of compliance’ in financial institutions.
