Risk Management and Value Creation in ... - Arabictrader.com

80 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
information to risk trading and the reduction of participation costs. 128 As
we have already mentioned, in facilitating this risk transfer, risk management
has become a key area of banking.
The Central Role of the Likelihood of Default
As indicated by the arrows in Figure 3.2 above, the likelihood of default
plays a central role in deriving rationales for risk management in
the neoinstitutional world and, therefore, forms the starting point of our
discussion.
As a firm starts to finance itself through debt, every increase in its financial
leverage also increases the probability of default. 129 Risk management
can reduce the probability of a firm encountering financial distress, by reducing
the variance in the distribution of the firm’s value. As shown in Figure
3.3, the asset distribution of a firm without risk management is broader
(solid line), and the area below the default point DP, that is, probability p 1
,
is relatively large. By conducting risk management, the firm can narrow the
distribution (dotted line). However, since risk management (most likely) only
comes at a cost, the expected value of the distribution is lower than in the
Probability
p 1
p 2
DP
E(V)
Figure 3.3 Variations in firm value and default point.
Source: Adapted from Smithson et al. (1990), p. 368.
Firm Value
128 See Allen and Santomero (1996), p. 1.
129 See Stulz (2000), p. 3-39. Without debt of some sort, there are no bankruptcy
costs and no tax benefits of debt.