Abstract

Can Chief Risk Officers (CROs) act as insurance against litigation risks in financial institutions? In most financial institutions, CROs and their risk management staff fulfill a key role in managing risk exposures, yet their lack of involvement in the governance of banks has been cited as an influential factor that contributed to management team failure and the financial crisis of 2007-2008. A variety of legislative and regulatory bodies have pressured financial firms to improve their risk governance structures to better weather any potential future crises. Assuming that CROs are indeed given sufficient power to influence the corporate governance of financial institutions, can they provide these firms with the promised benefits? To partially answer this question, we consider one of the final outcomes of risky behavior: shareholder litigation. By comparing the risk governance characteristics of sued firms with their non-sued peers, we show that proper risk governance reduces a firm’s litigation probability. We accomplish this by using principal component analysis and by constructing a single measure that captures various aspects of risk management in a firm. In addition, we show that the addition of our risk management factor to models that have been previously proposed in the literature improves the accuracy of those models in identifying companies that are most susceptible to class action lawsuits.