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88 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
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neration. This again increases the managers’ efforts, which can
in turn create additional firm value.
Third, if management compensation is linked to firm performance,
it is also linked to various types of risks, some of which cannot
be influenced by the management’s own efforts. Capable managers,
that is, managers who have a comparative advantage in
managing some of these risks, have an incentive to manage those
risks which they cannot influence 184 and for which they do not
have a superior ability. 185 Hedging these risks (completely) will
reduce “noise” and make their management capability more transparent,
which in turn will increase their reputation and their
(expected) income. 186 Less capable managers have an incentive
to speculate or not to reduce risk at all to hide their disability. 187
However, as mentioned previously, in some incentive system regimes,
risk management will reduce the value of the managerial
option positions, incurring opportunity costs for the managers.
Capable managers will, under these circumstances, only conduct
risk management if the gains from an increase in their reputation
will be higher than these opportunity costs.
Therefore, the risk-management strategy chosen by the managers might
diverge from that which is optimal for the shareholders (the risk preference
problem). However, by using risk management to make the
managerial efforts more transparent and to remove those risk components
that cannot be influenced by the management, managers will show
more effort and, therefore, will increase firm value. Yet, all of this will
only occur if the managers’ compensation scheme is designed accordingly
(see above).
184 See for example, Brealey and Myers (1991), p. 629. Risk management can relieve
managers of risks outside their control. However, there are no explicit contracts on
whether and how to manage the firm’s risk exposure. This might lead to additional
agency problems and costs.
185 Or abilities that do not influence shareholder value.
186 See, for example, Tufano (1996), p. 1127 and Table VI, who finds that less tenured
board members are more inclined to manage risk, because they are less capable
(or confident) and have a smaller fraction of their total wealth invested in the firm
(and its stocks).
187 See Raposo (1999), pp. 46–47, who also provides a more extensive list of references
to the literature. One example of this behavior is the degree of detail on
corporate risk-management activities in annual reports: When managers are less capable,
they have an incentive to only broadly report on risk management to allow
for a wide range of risk-management activities to hide their lack of competence.