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Rationales for Risk Management in Banks 77
vantages of their part of the firm’s cash flows because they are utility maximizers,
113 and so on).
If capital markets are less than perfect, the risk management irrelevance
proposition does not hold anymore. Therefore, under these more realistic
assumptions, the value of the firm can be increased when risk taking within
a firm is rewarded more highly than what can be achieved by selling
the risk to the capital markets, that is, than what someone else would be
willing to pay for bearing the same risk. 114 From this, one can directly deduce
that, in this world, it is not the purpose of risk management to protect
the firm’s value against changes in market values at any price. These changes
can occur, but shareholders are still able to adjust their exposure, just as in
the neoclassical world, to the various risk factors according to their preferences.
The purpose of risk management is rather to reduce the frictional
costs that are associated with these changes in market values and to create
value by doing so.
These frictional costs can stem from the following market imperfections,
115 which are a relaxation of the assumptions of the M&M world:
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Asymmetric information
Agency problems and management incentive structures
Limited availability of external funds (i.e., external funds are costly)
Transaction costs
(Direct and indirect) default costs
(Convex schedule of) taxes
Additionally, one should also assume that investment opportunities are
stochastic, that is, the investment program is not fixed and dependent on the
prevailing economic conditions and, hence, a function of the cash flows
generated by the firm’s assets in place. 116
Irrespective of these relaxed assumptions, the basic workings of the
neoclassical world are still valid, and investors are still able to adjust their
portfolios and can undo corporate decisions by home-made risk management.
It is therefore obvious, as long as investors are well-diversified, 117 that
it is unlikely that risk-management decisions by the firm can influence the
denominator of Equation (2.1) by changing the systematic risk. If risk
management does not reduce the firm’s required rate of return, then it must
113 See Jensen and Meckling (1976), p. 308.
114 See Stulz (2000), p. 3-3.
115 See Pritsch and Hommel (1997), p. 675.
116 See Froot et al. (1993), p. 1638.
117 See for example, Fenn et al. (1997), pp. 13+, and Smith (1993), pp. 17+.