iBusiness, 2013, 5, 154-157
http://dx.doi.org/10.4236/ib.2013.53B033 Published Online September 2013 (http://www.scirp.org/journal/ib)
Study on the Impact of Incentive Mechanisms and
Internal Control Systems on Risk Management in
Commercial Banks
Qi Zhang
School of Economics, Beijing Wuzi University, Beijing, China.
Received 2013
ABSTRACT
The operational risks for commercial banks could be divided into four scenarios, which are the risks caused by mali-
cious act, rational choice, inadequacy of capability and unconscious choices. Furthermore, these "initiatives" can be
reflected in financial corruption, moral hazard, bounded rationality and irrational behavioral tendencies. Operational
risk has become one of the three main risks for commercial banks since The New Basel Capital Accord released in 2004,
together with credit risk and market risk. This article accordingly puts forward related proposals of the commercial
banks’ ope rat ional risk management.
Keywords: Credit Risk; Incentive and Restraint Mechanisms; Intern al Control Systems
1. Introduction
Along with a series of operational risk accidents occurred
in banking system, banks have been paying more and
more attention on controlling operational risk since the
nineties of last century. According to a survey by British
Bankers Association (BBA), more than two-thirds of the
banks believe that operational risk is at least as signifi-
cant as market risk and credit risk. Another risk survey
by KPMG indicates that currently the ratios of risk capi-
tal to total capital required by credit risk, market risk,
operational risk and other risks are 40%, 35%, 20% and
5%, which might be shifted to 30%, 25%, 40% and 5%.
In recent years, with the frequent outbreak of operational
risk management cases, operational risk management has
been more and more important for commercial banks’
management activities.
There has been no standard definition about opera-
tional risk in academicians yet. In practice, financial in-
stitutions also have different understandings on opera-
tional risk. Financial Services Authority (FSA) defined
operational risk as all the risks other than market risk and
credit risk. Basle Committee (2001) gives an definition
on operational risk as well: the risk of loss resulting from
inadequate or failed internal processes, people and sys-
tems or from external events. Meanwhile, The Basel II
definition of operational risk excludes strategic risk and
reputation risk. Among all these definitions, the risk de-
rived by “people” is seen as an important part of opera-
tional risk. The generation of operational risk always
relates to the factor of "people". From the practical view,
it is very important to minimize risk caused by human
factors. Admittedly speaking, the sudden accident (such
as natural disasters, computer system crash) might also
lead to significant loss. However, the management tools
such as insurance and backup are relatively mature [1].
2. The Analysis on Causes of Operational
Risk
2.1. Operational Risk Arising from Financial
Corruption
Financial corruption includes the internal corruption of
bank employees and the corruption of financial regula-
tion authorities. Bank's internal corruption refers to the
rent-seeking behaviors by bank employees who hold the
configuration privileges of credit funds. The corruption
of financial supervision and regulation means that the
regulatory authorities seek rent from financial entities.
The operational risk due to the corruption of bank em-
ployees is obvious. The bank employees often loosen the
review of borrower’s potential risk after accepting brib-
ery [2]. They might approve "relationship loans" to bor-
rowers even knowing it is very risky. The risk arising
from such loans is not due to "information asymmetry",
since most banks have a clear understanding on bor-
rower's financial transaction history, profits and other
key financial information. The risk caused by corruption

Study on the Impact of Incentive Mechanisms and Internal Control Systems on Risk Management
in Commercial Banks 155
is mainly operational risk rather than credit risk.
Financial supervision corruption seems less direct and
obvious than in ternal corruption. Financial supervision is
generally believed as the means of controlling opera-
tional risk instead of causing it. However, the superv ision
authority corruption would change the bank’s risk pref-
erence and encourage banks to undertake high-risk even
illegal businesses, since they believe the corrupted su-
pervision authorities would have mercy on high-risk be-
havior. If there is a serious corruption in a country’s fi-
nancial regulation system, the operational risk of finan-
cial institutions also must be quite high.
2.2. Operational Risk Arising from Moral
Hazard
Moral hazard refers that because of information asym-
metry, the agents with info rmation superiority may make
use of system vulnerab ilities and information advantages
to maximize their own interests while damaging the in-
terests of clients who take the information disadvantages
[3]. In commercial banks, operational risk of moral haz-
ard includes the employee's moral hazard and the bank's
moral hazard. Strictly speaking, financial corruption can
also be incorporated into "agency problem”. Nevertheless,
financial corruption of bank employees is an extreme
case of moral hazard, the core of which is "conspiracy".
It will not facilitate the clear identification of the causes
of operational risk, also is not conducive to the opera-
tional risk con trol to analysis in agency model. This arti-
cle then separates financial corruption as an independent
cause of operational risk.
Moral Hazard of bank employees is closely related to
asymmetric information. What’s more the deeper reason
is that the inconsistency of interests between agents and
clients. Bank employees have options to be lazy or hard
working in maximizing personal interest. A hard working
employee will actively manage the credit risk and pay
close attention to the borrower's risk profile; wh ile a lazy
employee who lacks of initiative will not striv e to collect
borrower’s information, and will not seriously analyze
the hidden risk, leading to operational risk consequently.
It seems that rational employees should work hard to
maximize self-interest since lazy employees may be dis-
missed. However, banks often can not directly observe
whether an employee is "lazy" or not unless absenteeism
or refuse to work. Besides, banks often determine the
efforts of employees by the security of the credit funds,
which means the return situation of loans. Employees can
then attribute the loss to adverse external effects, such as
the so-called systemic risk, to avoid accusations from
banks. This kind of operational risk is usually shown in
the forms of market risk or credit risk forms.
Moral hazard from banks is closely related with the
two systems: one is that government (central bank) as the
lender of last resort, and second is the deposit insurance
system. The government "share the risk" to reduce the
risk of bank losses and costs, further increases the value
of risk decisions, which brings the incentives for banks to
take more risky projects. The phenomenon of “too big to
fail” caused by this system make banks have "never
bankrupt" expectations, which cause the relaxation of
operational risk control, or induce greater operational
risk. Especially in a crisis, the banks would choose to
gamble in higher risk business, because the outcome
could not be worse while the potential interest will be
great if succeed finally.
2.3. Operational Risk Arising from Bounded
Rationality
Bounded rationality is the n otion that in d ecision making ,
rationality of individuals is limited by the information
they have, the cognitive limitations of their minds, and
the finite amount of time they have to make decisions.
The factors affect the banking operations are complex,
multi-faceted, and with great uncertainty. Bank employ-
ees often have difficulty to accurately identify and meas-
ure the accuracy and importance of information. This
could generate errors in operations easily and result in
operational risk. What’s more, employees have limited
computing capacity and cognitive ability on various
business activities [4]. The collectio n, screening, analysis
and processing of information are subject to personal
qualities and capacity. They might reach an optimal pro-
gram by choosing a program which make them feel satis-
fied, but not necessarily the most effective one. If the
bank employee's self-satisfaction standards, which are
closely related to the quality and ability of employees,
are lower than the risk control standards, operational risk
arises. The errors in analyzing and judging information
will also cause a variety of operational risk.
Except for the wrong judgments and decisions in or-
dinary businesses, another important form of bounded
rationality is the model risk. With the deepening of fi-
nancial innovation, bank risk management tools become
more and more complex and the financial models are
becoming widely used in commercial banks. The accu-
racy of the models not only directly affects the risk
management quality, but also directly reflects the size of
operational risk. However, the accuracy of models is
closely related to the quality of designers. On one hand,
because of the limitations of model designers and users’
abilities, the models may have their own defections. On
the other hand, model application error, which means the
inappropriate use of the model, will lead to disaster. In
many cases banks gamble in the model parameters (such
as volatility, correlation coefficient) unconsciously, which

Study on the Impact of Incentive Mechanisms and Internal Control Systems on Risk Management
in Commercial Banks
156
also increases operational risk.
2.4. Operational Risk Arising from Tendencies
of Irrational Behavior
The "tendencies of irrational behavior" are the habits or
preferences in making decisions, or a common tendency
(which is not an absolute tendency) in understanding
problems, making decisions and adjusting judgments.
These habits, preferences and tendencies do not meet the
“rational” requirement, but still play an impo rtant role in
people's behavior and decision-making process in real.
These tendencies always cause wrong judgments and
bring risks. In behavioral econ omics, bounded rationality
and the tendency of irrational behavior is not completely
separated. This article emphasizes on personal limitatio ns
such as knowledge and ability and external condition
limitations such as insufficient information when refer-
ring to "bounded rationality"; and focuses on the "irra-
tional" activities even under sufficient information when
referring to "irrational behavior tendency", which leads
to decision-making bias. Irrational behavior tendencies
include cognitive bias, "irrational" in deciding prospect
value, and "irrational" in adjusting confidence. The ten-
dencies might lead to bank operational risk include simi-
lar bias, availability bias, anchoring bias, group effect,
fuzzy aversion, regr et aversion and cognitive disorders.
3. Views on Controlling Operational Risk for
Commercial Banks
3.1. To Establish Sound Internal Control
Systems
The importance of the internal control system is indis-
putable. First, strict internal control system can effec-
tively prevent the bank employees from financial corrup-
tion and illegal activities, such as independent internal
audit, crossing control of assets, double signatures, ap-
proval system if exceeding a standard loan amount and
so on. Second, banks could avoid the operational risk
brought by "bounded rationality" to a certain extent.
Sound internal control system would develop a stylized,
standardized process. Good training and communication
mechanism also could alleviate personal knowledge
limitations and inadequate information problems. Third,
a sound internal con trol system is essential to the preven-
tion of "irrational behavior tendency".
"Irrational behavior tendency" is the habits when
making decisions, which is quite difficult for individual
to effectively control such risks. For example, it is espe-
cially inefficient to eliminate regret aversion tendency for
decision-makers. Therefore, the external forces to limit
the behavior tendencies of bank employees are necessary
to effectively control operational risk. This coercive
power is the bank's internal control system. For example,
the separation of decision-making process to a certain
extent could weaken the group effect then making the
bank more neutral on decision-making (decision-making
process is not simply to avoid the intervention of powers
and the interference of human). Finance committee
which makes collective decisions can undermine the an-
choring effect as well. Each of decision-makers has dif-
ferent "anchor" thus increased the decision-making "an-
chor" of objectivity. Another example is that credit ap-
proval authority could limit the maximum amount of loss
which could control the concentration of credit risk to
some extent though passively. When facing the blind
confidence of decision-makers, internal control system
must plank down the case under which banks could in-
tervene (similar to a compulsory liquidation the securities
dealer system), and the risk index level which the top
officials should handle. These measures can prevent the
delay of rectifying decisions caused by "irrational" regret
aversion [5].
A sound internal con trol system should include at least
the following five elements: management oversight and
control culture; risk identification and assessment; seg-
regation of control activities and duties; information and
communication; behavior monitoring and correction. The
internal control system needs to be strictly implemented.
Often the poor implementation of bank’s internal control
is a kind of operational risk [6]. The most common
causes of operational risk are not the absence of good
internal control system, but the poor implementation of
the system. The implementation process of internal con-
trol system should adhere to the "rigid" principle: any
authority expansion or the change of the risk warning
value should be implemented after careful discussion.
This measure is necessary because the agents often have
"100 percent" reasonability that should change those
"conservative" and "rigid" system constraints once the
deviations occurred. What’s even worse, the availability
bias may also occur in many people at the same time[7].
Therefore, the internal con trol system should be carefu lly
considered even before it is set. Once the system is de-
veloped, everyone must comply with it. All kinds of ob-
struction should be ruled out to assure the implementa-
tion of the system.
3.2. To Establish Effective Incentive and
Restraint Mechanisms
Effective incentive and restraint mechanisms are helpful
to prevent moral hazard. For the moral hazard of em-
ployees, it is crucial to design effective in centive mecha-
nism to assure the bank profits while maximizing per-
sonal interests. The incentive methods include remunera-
tion, reputation, promotion, etc. The empirical study of

Study on the Impact of Incentive Mechanisms and Internal Control Systems on Risk Management
in Commercial Banks
157
agent incentives found that remuneration can improve the
motivation of agents, and because compensation is
measurable, in reality this method is quite feasible. One
thing in designing incentive compensation system is that
both the profit and revenue targets and the risk indicators
should be considered [8]. As to the moral hazard for
banks, government should improve the lender of last re-
sort and deposit insurance system. First, the "lender of
last resort" must distinguish and separate the insolvent
banks from the banks lack of liquidity. Second, the offi-
cials should take appropriate punishment to those im-
prudent operators and shareholders. Crockett said:" The
moral hazards will be greatly reduced if the management
team realizes that they will lose their jobs, and share-
holders realize that they will lose their capital once the
bank fails"[9]. Third, on the basis of compulsory deposit
insurance of all banks, government should collect risk-
related premium according to the different risk situations
of banks. Fourth, banks should insist that insurance
companies and depositors should engage in co-insurance,
which means that the bank restrain the maximum deposit
insurance amount according to the different deposit in-
surance rates. This measure could guarantee the insur-
ance company and bank depositors share the risk. As to
the moral hazard of employees, an effective compensa-
tion, reputation and promotion incentive system is nec-
essary [10]. In addition, banks should improve recruit-
ment and training system; financial supervision and
regulation authorities should create a favorable financial
environment, implement strict financial risk supervision.
4. Acknowledgements
This paper is sponsored by Beijing Philosophy and So-
cial Science Planning Project--Beijing Land Transporta-
tion and Port Development Research (Project Number:
09A Bjg298) and Beijing Municipal Commission of
Education 2011 Project for Developing Advanced Hu-
man Resources for Higher Education -- academic inno-
vation team on exploring the mode for trade and econ-
omy development in Jing-Jin-Ji Region (Project Number:
PHR201106139).
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