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

Rationales for Risk Management in Banks 81
case without risk management. Nonetheless, the (gray shaded) area left of
the default point p 2
is considerably smaller than p 1
.
Reducing the likelihood of default from p 1
to p 2
does not increase firm
value by itself. 130 However, it can lower the agency and transaction costs
stemming from the probability of default (and the costs of the various other
areas discussed in more detail below). These direct and/or indirect effects
indicate the benefit of risk management and hence the ability to create value
through it.
Agency Costs as Rationale for Risk Management
Agency conflicts are based on information asymmetries between information
insiders and outsiders (e.g., conflicts between shareholders and bond
holders, old and new shareholders, and management and shareholders).
Agents have incentives to undertake a real investment policy that deviates
from that of the principals because of financing and risk. 131 For instance,
since shareholders have a residual claim on the firm’s cash flows, they tend
to favor actions that increase the value of their holdings, even if that means
increasing the risk that bond holders (who have a fixed claim on these cash
flows) will not receive their promised payments. On the contrary, bond holders
want to preserve and increase the security of their claims. 132 However, because
the equity investors generally control the firm’s management and
decision making, their interests will dominate the bond holders’ interests,
unless bond holders take some protective action.
As mentioned previously, agency conflicts can be the result of adverse
selection and moral hazard. All of the agency problems related to risk
management result from moral hazard problems 133 and, therefore, occur
after contracting. Since the resulting agency costs 134 cause a reduction of the
market value of equity and/or debt, they can be split (as already indicated)
into agency costs of equity and those of debt. The (potential) benefit of risk
management lies in the reduction of these agency costs, 135 which, in turn,
can increase firm value and hence can build the basis for a rationale for risk
management. 136
130 As is shown in Figure 3.3, the cost of risk management can even decrease the
expected firm value E(V).
131 See Pritsch and Hommel (1997), p. 675.
132 This view is also the perspective of bank regulators for other reasons.
133 See Pritsch and Hommel (1997), p. 676.
134 Agency costs are the sum of monitoring and bonding costs as well as a residual
loss; see Jensen and Meckling (1976), p. 308.
135 See Pritsch and Hommel (1997), p. 675.
136 Note that both kinds of agency costs can be reduced via the market for corporate
control, as described by Jensen (1993).