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84 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
risk management. Like the owners of a closely held firm, managers may
have invested a large fraction of their personal wealth in the company
in the form of stocks and human capital (i.e., the NPV of their expected
future income stream from that firm). This makes them poorly diversified
and limits their ability to diversify. 155 Managers are, therefore, not
indifferent with regard to firm-specific (unsystematic) risks and care about
the total risk of the firm. This sets the preference for them to reduce
those risks to which they are exposed. 156
For risk-averse managers, an increase in the volatility of the underlying
cash flows of the firm means a higher probability of default, 157
which results in a decreasing expected utility of their human capital and
their stock holdings. Hence, managers have an incentive to adjust the
firm’s investment, capital structure, and risk-management policy to
change the risk profile that is preferred by shareholders (the risk preference
problem). They favor a reduction in the variance of total firm
value (that is, due to the volatility in the firm’s cash flows), because
convincing the firm to manage risks makes the managers strictly better
off by improving their own utility at little or no expense to other stakeholders.
158 Otherwise, they could sell their stake (which might be impossible
in the short run) and invest the proceedings in a diversified
portfolio and risk-free assets or keep their stake but conduct risk management
on their own (and at a potentially much higher cost). 159
Therefore, managers can have an incentive to manage risks at the
corporate level not to increase the value of the firm, but rather to protect
their own wealth position 160 out of self-interest. 161 Managerial
risk-aversion can be consequently an important rationale for risk man-
155 See Stulz (1984), Allen and Santomero (1996), p. 14, and the list of references to
the literature provided there.
156 See Tufano (1996), p. 1109.
157 And hence the (potential) loss of the reputation of their managerial capabilities.
158 As long as the firm has committed itself to conducting risk management to ensure
a stable risk profile and there are little or no transaction costs. See Froot et al. (1993),
p. 1631.
159 See Stulz (2000), p. 3-27.
160 See Smithson (1998), p. 13.
161 The economic decision makers face a nonlinear optimization problem, which in
turn leads them to be concerned about both the expected firm returns and their
distribution (variability is a choice variable usually assumed to be selected by management
subject to the usual constraints of optimization) around the expected value.
See Allen and Santomero, pp. 13–17.