In bank supervision, a dangerous consensus has taken root. Proposed updates to supervisory frameworks – such as the recent initiative by the Federal Financial Institutions Examination Council (FFIEC) to reshape the "M" (Management) in the CAMELS rating system – seek to anchor supervisory downgrades strictly to currently visible, realized "material financial risks.”
The underlying logic sounds pragmatic: Strip away subjective compliance checklists and require examiners to act only when balance-sheet evidence – such as credit losses, capital erosion, or liquidity stress – presents itself.
However, as highlighted in our research paper The "M" Factor's Role in Bank Safety and Soundness: How Management Bias, Incentives, and Governance Affect Bank Failure, waiting for material financial risk to manifest on a bank’s ledger ensures that supervisors will operate permanently in the autopsy phase of bank regulation.
Dr. Clifford Rossi
Whether reviewing historical collapses like Washington Mutual in 2008 or the 2023 failures of Silicon Valley Bank, Signature Bank, and First Republic Bank, post-mortems reveal a clear pattern: By the time "material financial risk" breaks through onto the income statement, the institution has already crossed a point of accelerating risk that leads to a liquidity run or insolvency.
Realized balance sheet losses are inherently lagging indicators. The true catalysts of bank failure are upstream behavioral drivers: executive cognitive bias, unadjusted incentive compensation, and compromised risk governance.
Academic literature traditionally attributes bank failures to either depositor runs or fundamental balance-sheet insolvency. Yet both mechanisms share identical behavioral roots. Unhedged security portfolios, extreme reliance on uninsured deposits, or rapid expansion into high-yielding, toxic assets are deliberate executive strategic choices rather than random exogenous shocks.
To evaluate how these choices accumulate, our framework breaks down four core behavioral drivers:
1. Incentive Compensation Distortion: When executive payouts heavily reward short-term deal volume, rapid asset growth, or unadjusted book yields without multi-year risk adjustments, deferred equity cliffs, or clawback windows, management operates under an asymmetric reward structure. Executive teams capture immediate cash bonuses during expansions while passing long-term downside default risk onto the FDIC’s Deposit Insurance Fund (DIF).
2. Management Cognitive Bias: Psychological overconfidence and disaster myopia lead executives to treat low-probability, high-severity tail shocks as near-zero probability events during prolonged economic expansions. Biased management filters out warning signs, aggressively expanding the bank's actual risk appetite.
3. The Governance Defense Shield: Internal governance acts as an institution's primary defense filter. Because governance functions holistically, if a Board of Directors abdicates its oversight role or if aggressive executive leadership strips the Chief Risk Officer (CRO) of independence and authority, the institution's entire risk mitigation system collapses.
4. Behavioral Reinforcement: Crucially, management bias and distorted incentives reinforce one another. An overconfident executive team armed with volume-driven bonus contracts will aggressively scale unhedged asset concentrations at the absolute peak of a market cycle.
The fatal conceptual flaw of a retrospective regulatory framework lies in the Profit Channel Illusion.
During benign economic periods, loans are early in their lifecycle and default rates hover near zero. Under a retrospective examination regime, a bank operating with aggressive risk targets and minimal internal governance brakes focused strictly on current balance-sheet materiality, appears exceptionally safe, highly profitable, and well-capitalized. The supervisory framework mistakes high risk-taking during quiet times for genuine management capability.
However, when macroeconomic conditions deteriorate, underlying vulnerabilities activate rapidly. Credit default rates spike non-linearly, asset-class correlations converge, and unhedged market exposures wipe out equity capital.
By requiring examiners to wait for "material risks" to show up on the ledger before assigning lower supervisory ratings, regulators guarantee that intervention occurs only after capital has entered a terminal deficit.
Shifting away from lagging balance-sheet autopsies requires developing and embedding a Management Risk Rating Scorecard (MRRS) directly into the CAMELS "M" (Management) rating. By evaluating each scorecard pillar on a standardized 100-point scale, supervisors can replace subjective checklists with objective, auditable behavioral metrics across four key regulatory actions:
Safety and soundness begin in the boardroom, not on financial ledgers. Anchor-based regulatory frameworks that demand current "material financial risk" condemn supervision to a perpetual cycle of post-collapse autopsies. Operationalizing upstream behavioral and governance factors restores bank supervision to its true intent: an early-warning regulatory structure that preserves financial stability before capital destruction takes place.
Clifford Rossi is Executive-in-Residence, Johns Hopkins University, Carey Business School. Over a 25-year industry career spanning the S&L and 2008 financial crises, Dr. Rossi worked for both Fannie Mae, Freddie Mac as well as some of the largest banks and nonbank institutions in various C-level risk management positions.