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Rationales for Risk Management in Banks 105 bank’s creditworthiness, debt and equity not only get much more expensive at the same time but are also simply unavailable, 278 indicating that the pecking order theory might not perfectly apply to banks. To ensure its creditworthiness, a bank needs to hold a certain amount of equity 279 (as is also required by regulation), which depends on the riskiness of both its existing business portfolio and the new investment opportunities. The availability of equity therefore protects the planned investment program in two ways: ■ ■ External funds are available. The required pro rata equity investment can be made. It is thus extremely important for a bank to either invest in positive NPV projects to generate and enhance the value of its equity or to protect its value via risk management. 280 Transaction Costs as a Rationale for Risk Management As shown in the right-hand part of Figure 3.2, there are the following four types of transaction costs that can create a rationale for risk management, because the reduction of these transaction costs can increase the firm’s value (these are discussed in the sections of the same name later in this chapter): ■ ■ ■ ■ Costs of financial distress Costs of implementing risk management Costs of issuing external financing Costs of ensuring a stable risk profile The Costs of Financial Distress Most companies, and also banks, 281 perceive equity to be a costly source of financing and tend to avoid it. However, debt financing is not without cost: taking on too much debt limits a company’s ability to raise funds later and can lead to situations in which the firm can encounter cash shortfalls that could trigger financial distress or even bankruptcy. 282 In general, the costs of financial distress are defined as the costs result- 278 As we have seen, bank stakeholders are extremely concerned about whether the bank can meet its obligations. 279 Since equity is also costly for banks, this can create a rationale for risk management on its own. 280 As soon as equity is destroyed through losses, no further investment might be possible and at the same time, typically, no external funds are available for banks. 281 See Miller (1995), p. 484. 282 See Brealey and Myers (1991), pp. 628–630.
106 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS ing from difficulties a firm may have in coping with its debt service. 283 Since the M&M world assumes that there are either no financial distress situations at all or no costs associated with them, a change in the probability of encountering financial distress does not affect firm value in this world. As depicted in Figure 3.7, in such a world a change in the firm value after financial distress costs (especially as shown in the dotted line beyond the default point (DP), which is irrelevant in this world) is a linear function of the changes in the firm value before financial distress costs. However, if financial distress is costly, firms have an incentive to reduce its probability of occurrence, 284 that is, to narrow the distribution (or the variance) of firm values, because it leads to a nonlinear relationship between the firm value before and after financial distress costs. This can increase firm value because one can define: Firm Value = Firm Value without Transaction Costs – PV(Expected Financial Distress Costs) 285 (3.3) Firm Value after Financial Distress Costs Probability DP Without default costs With default costs DP Figure 3.7 Influence of bankruptcy costs on firm value. Source: Adapted from Stulz (1996), p. 16. Firm Value before Financial Distress Costs 283 See Stulz (2000), p. 3-39. 284 See Mian (1996), p. 420. 285 This approach (as suggested by Stulz (2000), p. 3-7) is similar to the Adjusted Present Value concept suggested by Brealey and Myers (1991), p. 458. However it assumes—for the time being—that financial distress costs are the only market imperfections.
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isk management and value creation i
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Copyright © 2002 by John Wiley & S
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preface From an empirical as well a
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acknowledgments No book is solely t
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x CONTENTS Goals of Risk Management
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xii CONTENTS Definition of RAROC 24
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xiv FIGURES Figure 5.5 Figure 5.6 F
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symbols ↑ ↓ α β i xvi Increas
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xviii SYMBOLS ln Natural logarithm
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abbreviations APT BIS bn bps CAPM C
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2 RISK MANAGEMENT AND VALUE CREATIO
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CHAPTER 2 Foundations for Determini
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Foundations for Determining the Lin
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156 RISK MANAGEMENT AND VALUE CREAT
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eferences Aguais, Scott D., and Ant
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References 295 Blanden, Michael (19
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References 297 and Abuses,” Journ
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References 299 Froot, Kenneth A., a
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References 301 risiken aus Handelsg
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References 303 Investments in Stock
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References 305 Institute of Technol
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References 307 Sharpe, William F. (
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References 309 Wall, L.D., and John
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312 INDEX Approach (continued) top-
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314 INDEX Capital: Tier-1, 139, 146
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316 INDEX Credit: derivatives, 178,
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318 INDEX Expectations: homogeneous
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320 INDEX Incentive(s), 22, 33, 45,
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322 INDEX Managers, poorly diversif
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324 INDEX Overinvestment, 75, 79, 8
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326 INDEX Reserve(s) (continued) lo
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328 INDEX Risk, liquidity, 3, 165 R
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330 INDEX Sharpe ratio, 244, 252 Sh
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332 INDEX Value at risk (VaR) (cont
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