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

Rationales for Risk Management in Banks 97
Reducing the probability of firm default—either via reducing debt or by
conducting risk management as a substitute (which additionally conserves
the tax shield for debt, because this allows the firm to keep the leverage
constant or even to increase it) 224 —will also reduce the debt holdershareholder
conflict of underinvestment. Risk management can, thus, reduce
the associated agency costs in the form of higher promised payments
to debt holders and the turning down of positive NPV projects, and will,
therefore, increase firm value.
The underinvestment problem is more pronounced in firms with more
shareholder and managerial discretion in the choice of investment projects. 225
This is the case when firms derive a relatively higher proportion of their
market value from growth options relative to the assets in place. 226 Therefore,
the more growth options and the higher the leverage of a firm are, the
more likely it is that the firm conducts risk management to decrease the
underinvestment problem.
Coordination of Investment and Financing In a world of perfect and complete capital
markets, a firm’s losses accompanied by a reduction in cash flows (and hence
the need to turn to external sources) would not affect a firm’s investment
spending: A project that is worth funding internally would be worth funding
externally, and external funds would be always available at fair terms. 227
However, as we have seen above, capital markets are not perfect. And the
imperfections can lead to inefficient investment, 228 because (inefficient) capital
markets may not be able to evaluate investment projects fairly—due to agency
problems and asymmetric information 229 —and hence may not provide external
funding for positive NPV projects at all or may do so only at a higher
price. 230 Nonetheless, even in the neoinstitutional world the (implicit) key
M&M insight is still valid: increasing the firm value can only be achieved
by making good investment decisions that will, in turn, increase the firm’s
(operating) cash flows. 231
224 Alternately, as we have seen, the debt holders can use restrictive covenants, which
have their own agency problems.
225 However, in general, this has little relevance for banks.
226 See Mian (1996), p. 421.
227 See Fenn et al. (1997), p. 19.
228 See Froot et al. (1993), pp. 1632–1633.
229 See Fenn et al. (1997), p. 19. For example, agency costs of managerial discretion
and other costs resulting from conflicts of interest between managers and outside
investors can blur the information about the company prospects.
230 See Pritsch/Hommel (1997), pp. 675 and 681.
231 See Froot et al. (1994), pp. 92–93. The authors label the availability of positive
NPV projects as the first step in how risk management can help to create firm value.