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

108 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
assets), 292 and somewhat larger for financial institutions (approximately
10% of the failed bank’s assets) .293
2. Indirect costs: However, the real driving factor for the costs of
financial distress is indirect costs, that is, the opportunity costs
associated with financial distress situations. They are much more
likely to occur than an actual default and can be differentiated
into two groups:
a. Indirect costs due to agency problems associated with financial
distress:
■ The underinvestment problem (as described previously for
“normal” levels of debt) can be exaggerated in financial
distress situations in the following ways:
– Financial distress may trigger debt covenants that place
additional (that is, above normal) restrictions on management
decision making and hence might induce the
systematical passing up of positive NPV projects.
– Due to the interference of the bankruptcy court in
investment and operating decisions, nonroutine expenditures
might not be approved, leading to underinvestment.
294
– The impossibility of raising external funds in financial
distress situations may lead to capital rationing and,
hence, underinvestment. 295
– The fact of living on the edge of bankruptcy means
that, consequently, the benefits of taking on positive
NPV projects accrue to debt holders most prominently.
Shareholders (and their managers), who then will not
expect a normally expected return, will tend to
underinvest.
■ Financial distress may provide the incentive for management
to behave more opportunistically (i.e., to increase
the firm’s level of risk) than usual in the presence of debt
finance (asset substitution). 296
292 See, for example, Weiss (1990).
293 See James (1991), pp. 1228 and 1241. The mean of his sample is 9.96% and the
median 9.51%.
294 See Smith (1995), p. 20.
295
See Damodaran (1997), p. 452.
296 Stulz (1996), p. 17, provides the supposed behavior of managers of nearly insolvent
savings and loans institutions in the United States in the 1980s and 1990s as an
example.