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While the financial turmoil has left the business approach of ethical banks unchanged, as evidenced in the striking stability of their balance sheet from 2007 to 2009, the pattern shown by big banks has substantially changed over this same period. These developments would tend to suggest the need to reform the business model of big banks. There is no clear empirical evidence that a banking system with a large number of small institutions would be any more stable than the system as it currently stands. Besides, financing certain big projects would always require the existence of large international banks. Both types of financial institutions are in fact complementary. How to regulate the banking and financial sector is thus a complex and multifaceted issue. One cannot impose the same requirements on big international-oriented banks and small domestic banks. As this paper has tried to demonstrate, both have a distinct business model. The following statements and assessments represent the author’s opinion only. They should not be interpreted as official statements or assessments from Deutsche Bundesbank. “[...] risk monitoring and management reduces to the basics of getting the right information, at the right time, to the right people, such that those people can make the most informed judgments possible.” 24 If a bank wants to earn money it has to take risks. From an economic point of view this is a good thing to do. In a world without banks and without institutionalised financial markets each consumer would need to look for a potential counterpart he could lend money to (savings he currently doesn‘t need) and would need to bear the risk of his contract partner‘s insolvency personally. Conversely, enterprises willing to invest in the real economy might be restricted by not finding enough consumers to collect the amount of money needed for these investments. Even if they do so, these consumers might not be willing to lend their money long enough. Financial intermediaries are lowering transaction costs in the economy as a whole, take over counterparty credit risk from their depositors and fulfil important maturity transformation functions. This is especially important for emerging markets like the countries from central, eastern and south eastern Europe (CESEE countries) where financial markets have only started to develop. Taking risks is not enough, however. For permanent financial stability it is equally important that banks are able to survive stress situations in which risks have become virulent. Otherwise depositors will lose their confidence in the sound functioning of financial 24 Counterparty risk management group (2008), p. 70. markets causing a shortage of savings needed to refinance investments. Financial regulation aims at minimising the risks for financial stability. For this purpose supervisory authorities all over the world have implemented rules that are supposed to mitigate banks‘ insolvency risk. Under these rules banks have to hold enough capital and liquidity to survive stress situations. To guarantee a level-playing field for banks (and for banking supervisory authorities!) worldwide the Basel Committee on Banking Supervision (BCBS) has published a framework for Capital standards and Capital measurement (called Basel II 25 ) on credit, market and operational risk and several complementary guidelines, for instance on the management of liquidity or on stress testing. On the European Union level two directives have been adopted that implement the Basel II framework. The Banking Directive (2006/48/EC 26 ) sets minimum capital requirements for credit and operational risk, the Capital Adequacy Directive (2006/49/EC 27 ) minimum capital requirements for market risk. Both directives are subsumed under the term ―Capital requirements directive‖ (CRD). However, holding enough capital and liquidity under a regulatory perspective might still not be enough. Even well capitalized institutions have gone bankrupt (or have come close to bankruptcy) in the past because they have become victims of rogue traders like Nick Leeson from Baring‘s Bank or 25 BCBS (2006a). 26 EU (2006a). 27 EU (2006b). Risk governance & control: financial markets & institutions / Volume 1, Issue 3, 2011 41 Jerome Kervel from Société Général 28 . In such cases risk management has had some serious shortcomings. On the other hand, if risk management in a credit institution is sound, capital and liquidity cushions might not need to be that strong since taking certain (excessive) risks is either avoided completely or risks are managed in a way that they do not become excessive at all. In that respect, a sound risk management is the first line of defence against a bank‘s possible bankruptcy. Consequently, the Basel II framework also contains some rules concerning risk management in general and an independent risk control function in particular. The following article takes a closer look at these provisions and – primarily driven by the financial crisis at current suggestions for strengthening these rules further. Risks in financial institutions Risk management plays a decisive role within financial institutions. Risk identification, risk measurement, risk control and risk management in a narrower sense (in terms of hedging, reducing or completely selling off risky positions) are crucial for institutions which business it is to earn money by taking risks without being killed by those risks. The most important risks a bank is facing are

The role of the risk control function under the Basel II framework